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Appeal of Accounting Treatment and Rating of Foreclosed Asset (Second Quarter 2013)


A community bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the supervisory office’s decision at a recent bank examination to charge off the remaining balance of an economic development revenue bond (bond). The bond is collateral that the bank acquired from a defaulted loan.  The supervisory office also directed that the bond, which the bank rated “Substandard,” be placed on nonaccrual status. The bank appealed whether the impairment of the bond should be accounted for as temporary impairment or other-than-temporary impairment (OTTI).

The bank originated a line of credit to its commercial borrower (borrower) several years ago as part of overall financing to develop a commercial and retail real estate project. When the loan defaulted prior to the start of a recent OCC examination, the bank acquired, through foreclosure, the bond, which secured the loan, and a controlling interest in a company partly owned by the borrower (Company A). The bond was originally issued by a development authority to the borrower for financing acquisition of land and construction of buildings and improvements designated for retail and office space development. An unaffiliated community bank previously provided a loan to Company A. That financing was secured by the commercial real estate property. The unaffiliated community bank and Company A agreed to subordinate the company’s loan to the bond. At the time of the appeal, the bank was involved in several protracted lawsuits with various parties involved with the project.


When the borrower’s note defaulted, the bank classified the bond “Substandard” using the same amount as the outstanding balance of the note as a cost basis. The bank believed the bond value it obtained from an external valuation consultant more than adequately supported the recorded investment. The analysis of expected future cash flows anticipated essentially the full development of the property over the remaining 28 years of the bond.

The supervisory office disagreed with the assumptions used in the bond valuation report in addition to the “Substandard” classification amount. In order to determine a “proxy” fair value of the bond upon foreclosure as its new cost basis, the examiners only considered the cash flow streams of two projects and arrived at a net present value (NPV) that was lower than the cost basis determined by the bank. As a result, the supervisory office split-classified the foreclosed bond as “Substandard/Loss.” The review of the report of examination for this appeal found no references to the “Loss” classification being related to a decline in fair value or distinguishing between temporary and OTTI. The bank believed that the “Loss” classification amount could be reversed later, any impairment could be temporary, and thus a valuation allowance should be used instead.

In its appeal, the bank stated that the supervisory office’s accounting treatment did not conform to generally accepted accounting principles (GAAP) and that the impairment should be considered temporary because (1) GAAP requires that there be specific evidence the bank will not receive all the principal of the bond back over the life of the instrument and (2) GAAP allows the future development opportunities to be considered in assessing possible impairment calculations, not just current probable cash flow. The bank’s additional concerns were that OTTI treatment of the bond was not in accordance with GAAP and that a write-down of an asset on a permanent impairment basis could not be reversed in the future if the value of that asset increased back to its original cost basis.


The Ombudsman reviewed the information submitted by the bank and the OCC’s supervisory office. The Ombudsman relied on the following pronouncements from the Accounting Standards Codification (ASC) for his analysis: ASC 310. “Receivables”; ASC 320, “Investments—Debt and Equity Securities”; and ASC 820, “Fair Value Measurements and Disclosures.” The Ombudsman also relied on standards provided in OCC Bulletin 2004-25, “Classification of Securities: Uniform Agreement on the Classification of Securities”; OCC Bulletin 2009-11, “Other Than Temporary Impairment Accounting: OCC Advisory on Financial Accounting Standards Board Changes”; and the Call Report Glossary definition on “foreclosed assets.”

Although the bank stated that the issue for appeal is the temporary impairment versus OTTI designation, through a thorough review of the facts and circumstances, the Ombudsman determined the actual issue was the valuation of the bond upon the bank’s acquisition. Therefore, his analysis focused on determining how the bond should have been valued at foreclosure.

The Ombudsman determined from the outset that when the bank received the bond in full satisfaction of the defaulted note, it should have accounted for it at its fair value at the time of the restructuring. The fair value became the new cost basis of the foreclosed asset. At the time of foreclosure, the amount by which the recorded investment of the note exceeded the fair value of the foreclosed asset should have been charged to the allowance for loan and lease losses. The concept of impairment (either temporary or OTTI) for the bond applied only to subsequent measurement, that is, measurement in any reporting period after the foreclosure date. As such, the Ombudsman concluded that the discussion and use of “impairment” concepts by the bank did not apply.

To establish a new cost basis of the bond, the bank should have used ASC 820, which defines fair value and establishes a framework for measuring fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the asset’s or liability’s principal (or most advantageous) market at the measurement date, that is, the acquisition date of the asset. ASC 820 ranks three levels of fair value measurement inputs, based on their observability. Level 1 fair value measurement inputs are quoted prices in active markets for identical assets or liabilities. The bond in question was an unregistered private agreement and had not been issued in the public securities markets. As a private transaction, there were no transactions from which to obtain market prices of the bond between knowledgeable and willing buyers and sellers. As a result, there were no Level 1 market price inputs available to estimate the fair value of this asset.  Level 2 inputs are inputs—other than quoted prices included in Level 1 that are observable—for the asset, or a similar asset, that are directly or indirectly observable. These inputs were also unavailable because the unrelated registered bonds issued by the development authority had not traded since issuance. Without either Level 1 or Level 2 observable inputs available, Level 3 inputs, such as projections of future cash flow streams, must be used as the basis for determining the fair value of the bond.

Although these inputs may not be readily observable in the market, the fair value measurement objective is, nonetheless, to develop a fair value or “exit” price for the asset from the perspective of the market participants. Therefore, these inputs should reflect assumptions that a market participant would use in pricing an asset and should be based on the best information available in the circumstances. As a result, the Ombudsman’s analysis focused on determining the fair value of the asset at the time of the acquisition based on these standards with Level 3 inputs. As the bond had no available market price, the analysis focused on the value of a long-term real estate development workout project supporting enough future tax revenues to repay a debts previously contracted obligation from a defaulted customer.

Per ASC 820-10-55-5, a fair value measurement of an asset or liability, using present value, should capture all of the following elements from the perspective of market participants as of the measurement date:

  1. An estimate of future cash flows for the asset or liability being measured.
  2. Expectations about possible variations in the amount and/or timing of the cash flows representing the uncertainty inherent in the cash flows.
  3. The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows (risk-free interest rate).
  4. The price for bearing the uncertainty inherent in the cash flows (risk premium).
  5. Other case-specific factors that would be considered by market participants.
  6. In the case of a liability, the nonperformance risk relating to that liability, including the reporting entity’s (obligor’s) own credit risk.

The Ombudsman reviewed three cash flow streams and the third-party bond valuation analysis.

Regarding the first cash flow stream, the appeal stated that upon foreclosure, the bank assigned the borrower’s interest in Company A to a management company the bank formed. The bank contracted the management company to pay its costs, one of which was bond payments due on the undeveloped land. The Ombudsman found that the bank was essentially making bond payments due on the undeveloped land to itself via the management company. The bank as a bondholder estimating receipt of cash flows from itself rather than an independent third party raises significant uncertainty from market participants’ perspective on the reliability of the cash flows in the fair value assessment of the bank. Since the bank is paying itself, the Ombudsman found that this payment stream did not lend any value to the bond.

Regarding the second cash flow stream, the Ombudsman found that the builder of a nearly complete office building refused to complete the work and obtain a certificate of occupancy, which would trigger the obligation to begin generating tax payments on the bond. The builder was involved in ongoing lawsuits with the bank. Therefore, the project did not produce the cash flow stream that the supervisory office used in its evaluation in the report of examination. The Ombudsman further determined that the bank should have incorporated into its fair valuation of the bond as of the foreclosure date, from the perspective of market participants, the level of uncertainty about the outcome of the ongoing litigation and the resulting impact on development prospects in accordance with ASC 820-10-55-5. The valuation the bank obtained from the third party failed to analyze this uncertainty. Therefore, as there was no cash flow at the time of the examination or prior to that time, and the lawsuits represented additional significant uncertainty in the cash flows, the Ombudsman determined that the second cash flow stream did not lend any value to the bond.

Regarding the third cash flow stream, the bank included in its valuation certain acreage that had previously been released from the bond structure when another unaffiliated bank foreclosed on its collateral. There was no documentation or binding agreement in place evidencing a commitment between the parties to placing any structures built upon that acreage back under the bond. Therefore, the bank should have incorporated into its fair valuation of the bond at the time of foreclosure, from the perspective of market participants, the level of uncertainty about its right to the revenue stream. The valuation the bank obtained from the third party failed to do so. The Ombudsman also determined that the supervisory office did not appropriately reflect the uncertainty of the payment source in its valuation. Accordingly, since the third cash flow stream is not currently part of the bond structure, and based on the perspective of market participants as of the measurement date and the uncertainty of the ongoing litigation, the Ombudsman determined that the third cash flow stream did not lend any value to the bond.

The Ombudsman also noted several observations regarding the third-party bond valuation analysis the bank obtained. The analysis contained extensive qualifiers including

  • the statement that actual bond revenues applied to debt service will almost certainly differ from the projections provided and could materially differ.
  • the fact that no effort has been made to verify information obtained from other sources.
  • the assumption that the project(s) will be developed as contemplated herein. No effort was undertaken to assess the feasibility or likelihood of this development.
  • estimates or assumptions with respect to property performance, economic conditions, absence of material changes in the competitive environment, and the ability of the property owners to pay bond fees. The report stated some of these assumptions will inevitably not materialize and unanticipated events and circumstances will occur. As a result, actual results will vary from the estimates in this report and the variations may be material.

Further, the analysis provided the following information:

  • Bond revenues have thus far been insufficient to pay any of the scheduled debt service, whether for interest or schedule principal reductions. To date, three scheduled payments have been missed.
  • The third cash flow stream was included in the valuation; however, as noted above, this tract was not part of the bond structure.
  • The analysis is based on the protracted maturity of the bond and the bank providing much of the financing needed to facilitate the proposed developments, thus generating the future payment streams to pay off the bond’s face value.

Based upon this information, the Ombudsman determined there was no indication when or if future development will occur. The valuation was based on multiple assumptions regarding the full development of the property that appear unverifiable and highly speculative. Pending protracted litigation and the lack of continued development indicate a long-term workout situation. In addition, there is little or no precedent or published standard that allows an asset to remain on the books pending a long-term workout of a troubled real estate development, especially when (1) litigation is present and (2) the collateral is not land but instead, the collection of future tax revenues.

OCC Bulletin 2004-25, “Classification of Securities: Uniform Agreement on the Classification of Securities,” states assets classified “Loss” are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value; it means rather that it is not practical or desirable to defer writing off an essentially worthless asset even though partial recovery may be effected in the future. In this case, a market participant may be willing to pay a marginal amount for the bond; for classification purposes, however, the bond has no value.

The Ombudsman determined that when a new cost basis is measured at fair value upon foreclosure of an asset, the concepts of temporary impairment or OTTI do not apply. The bank believed its positions in the lawsuits were appropriate and supportable; however, as of the foreclosure date, the bank was unable to predict with any certainty the ultimate outcome of the lawsuits or when they would be resolved. The third-party bond valuation analysis takes into account only the long-term full development of the property (especially, assuming the ultimate favorable resolution of the lawsuits), and, therefore, it assumed a higher amount of expected future cash flow. While the property may eventually be fully developed by the maturity date of the bond, the fair value of the asset should be assessed from the perspective of market participants as of the measurement date, based upon the significant uncertainty inherent in the cash flows. Finally, there was no current cash flow source except from the bank itself. Therefore, it can be reasonably concluded that the bond was not a bankable asset at the time of the examination and the cost basis of the asset should have been zero at the foreclosure (measurement) date, given all the facts and circumstances presented. The Ombudsman’s determination was that the bank needed to charge off the remaining recorded investment of the bond, effective the quarter of the foreclosure, and amend call reports as necessary.