Friday, August 20, 2010

Loss Sharing Accounting

FDIC-assisted transactions bring with them a new and evolving set of accounting and financial guidelines. Accounting and consulting firms will be hired to help institutions navigate through a byzantine maze of sometimes obscure and often unfamiliar accounting rules that might otherwise slow down the asset resolution process.

Many banking institutions and investors may be unaccustomed to loss sharing accounting which differs from the accounting for originated loans. Loss Sharing Agreements (defined) require their own set of books.

The assets in an FDIC-assisted transaction are transferred to the acquiring institution at book value.

At the time of the failed bank bid, a fair value is established by the acquiring bank as part of the bid. Fair value is the marked down value of the failed bank assets and is based on the initial estimates collectability of the loans determined through the acquiring bank’s due diligence. At closing FDIC-assisted banks receive cash for the difference between book value and fair value of the assets. The books are balanced at this point.

Fair values for loans are most often based on a discounted cash flow methodology (or a modeled approach) that is called a “level 3 valuation in the fair value hierarchy”. Put very simply, level 1 and 2 methods in determining fair value use actual asset sales in very active and somewhat less active markets, respectively.

Level 3 valuation is used in inactive markets or nonfunctioning loan markets like we have had since 2008; valuations are not based on asset sales or trades. Fair value requires the bank to make estimates about discount rates, market conditions, expected cash flows and other future events that are highly subjective in nature and subject to change.

Level 3 valuations of acquired loans includes the use of projected cash flows, type of loan and related collateral, classification status, contractual interest rate, term of loan, amortization status, current market conditions, market illiquidity and discount rates. Loss sharing loans are grouped together according to similar characteristics and are evaluated in the aggregate when applying various valuation techniques. The present values of projected cash flows are measured using discount rates that are based on current market rates for new originations of comparable loans.

The Indemnification Asset

In addition the FDIC provides coverage or a guaranty to the acquiring bank for possible additional losses on the acquired assets. These expected future losses are quantified in the “threshold” amount.

FDIC-assisted banks carry on their balance sheet the FDIC “indemnification asset”, a receivable or "IOU" from the FDIC for the loss sharing agreement obligation due from the agency over time. The indemnification asset value will adjust over time as the condition or "collectability" of the individual assets is determined and changes due to borrower and market conditions. The individual values are “rolled up” into what become the cumulative losses of the LSA portfolio.

An FDIC indemnification asset represents the present value of the estimated losses on covered loans to be reimbursed by the FDIC based on the applicable terms of the loss sharing agreement. Individual assets can be sold; the indemnification is a non-transferable asset of the bank specifically tied to the loss sharing agreement.