Allowance for Loan and Lease Losses  
By Brian Franey
Community Bank Advisor, 2008 Winter

Many Midwest banks have experienced a significant decline in loan asset quality; specifically, among owner-occupied residential mortgages, home construction, and land development portfolios. Sales throughout the region have decreased significantly and pushed the inventory of properties to record levels, causing a steep decrease in prices.

Residential mortgage portfolios are being hit hard. The current sub-prime lending crisis, low teaser rates on adjustable rate mortgages (ARM) offered over the past several years, and an overall decline in property values have made it increasingly difficult for banks to stay ahead of the delinquencies. Many ARMs are repricing and borrowers are not able to obtain conventional refinancing due to the decrease in appraisal values. This is causing many borrowers to simply walk away and leave banks with repossessed homes they were not expecting.

In the residential land development area, delinquent loans are rising rapidly. Many markets have significant inventory levels of vacant lots, speculative homes, and condominiums that far exceed the current sales activity. In most cases, the developers have depleted the interest carry allowed on their loans, and have found that they do not have the financial stability or cash flow to pay the interest due each month. The increase in delinquencies has resulted in increased non-performing and classified loans.

With increased delinquency and problem credit issues, management, regulatory agencies, and auditors are reviewing allowance for loan and lease losses (ALLL) methodologies with a tremendous amount of scrutiny. Arriving at an appropriate allowance involves a high degree of management judgment. The calculation itself is imprecise, and management, regulators, and auditors acknowledge that an appropriate level of allowance falls within a range of estimated losses.

Based upon guidance from regulators (Interagency Policy Statement on ALLL) and generally accepted accounting principles (GAAP), we have derived a Top Five List of items for management and boards of directors to review as they continue to refine their ALLL calculation in 2008.

Historical loss percentages (SFAS 5 allocations) should include a proper level of detailed segmentation

Gone are the days when banks can look at their loan portfolios by the three main categories of loans — commercial, mortgage, and installment — and assign historical loss percentage based on losses in these three broad categories. Banks should identify the “buckets” within these portfolios that are truly causing the increase in delinquencies and non-performing loans and apply their SFAS 5 allocation based on the segmentation of the portfolio. For example, banks with mortgage delinquencies should review the types of mortgages that are driving the increase — owner occupied, speculative homes, rental properties, etc., to better capture the anticipated loss within these portfolios. Further analysis and detail in this area will help to validate the data integrity of the ALLL calculation.

Quarterly averages for historical loss percentages should be reviewed to determine if the most recent data indicates a further trend

For example, if a bank is using an average historical loss percentage of ten quarters for each segmented portfolio, and historical loss factors for the past three quarters are double the previous year’s net charge off activity, management should consider weighting the most recent data more heavily in its SFAS 5 allocation, as that may be more indicative of what is happening in the portfolio. As trends begin to improve, banks can scale this back to more traditional averages (eight, ten, or 12 quarters) as warranted.

Valuation of impaired loans

Management should have a well documented methodology to determine which loans to review for potential impairment. SFAS 114 requires creditors to measure impairment based on the present value of expected future cash flows or based on the net realizable value of the underlying collateral. The fair value needs to be supported by current financial information. Discount factors used in determining impairment need to be supportable — i.e., if a bank uses a discount of 20 percent on a 2006 appraisal, management needs to document why that that discount is appropriate through review of similar appraisals from the time frame in similar markets. Furthermore, management should determine time frames for liquidation of collateral when using the present value of future cash flow method. The length of time it takes for the market to absorb the properties will be a key factor in determining the discount period.

Qualitative factors should be directionally consistent in regard to changes in credit risk

Adjustments to the qualitative factors should be in line with past-due statistics, the volume of nonaccrual and non-performing assets, and recent charge off history. While it is difficult to thoroughly document and audit qualitative factors, trends — including fluctuations in delinquencies and nonaccrual loans, increases and decreases in the volume of loans by segment, turnover in the lending department, and charge off and provision history — are all observable items that should be considered. Management should also thoroughly document the thought process for changes in qualitative adjustments quarter-over-quarter as that will have an impact on the final evaluation of the adequacy of the ALLL calculation.

Treatment of previously accrued interest on loans in nonaccrual status

GAAP requires the reversal of all previously accrued but uncollected interest for loans in nonaccrual status against appropriate income and balance sheet accounts. Interest income going forward, as the loan remains in nonaccrual status, should be captured in a secondary accrual within the bank’s loan application system, resulting in no accrual basis interest income recognition. This accounting treatment should continue until the loan is paid off or returned to accrual status. Uncollected interest that has accrued during previous calendar years should be reversed against the allowance for loan loss, presuming bank management’s additions to the ALLL have taken into account the income statement impact and the collectibility of the loan as it determines an individual loan’s impairment under SFAS 114. Payments on loans in nonaccrual status should be applied to principal until the loan is restored to accrual status, unless the ultimate collectibility is supported by current, well documented credit evaluation of the borrower’s financial condition and repayment history.

As a reminder, a nonaccrual asset may be restored to accrual status when each of the following criteria is met:

• All contractual principal and interest due on the loan is paid current.
• No reasonable doubt exists regarding the willingness and ability of the borrower to repay under the contractual terms of the loan agreement.
• Reinstatement is supported by a period of sustained performance — six consecutive monthly payments, four consecutive quarterly payments, three consecutive semi-annual payments or two consecutive annual payments.