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Review Your Junior Lien Portfolio for Allowance for Loan and Lease Loss

On January 31, the regulatory agencies issued an Interagency Supervisory Guidance on Allowance for Loan and Lease Loss Estimation Practices for Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties. When the agencies issue an interagency guidance such as this, it generally means three things. First the agencies detect a significant risk that the institutions they are examining are not sufficiently addressing; second, they detect a weakness in the process that institutions are utilizing in monitoring the risk; and third, this is an area that they will stress in future exams with the expectation that financial institutions will pay serious attention to the guidance.

For many community banks, junior 1-4 family secured loans, whether closed end or HELOCs, are a significant portion of their loan portfolio and because of current economic times, a significant part of their risk profile. Every community bank that has a significant residential junior lien exposure should have a rigorous ALLL review process following the interagency guidance.

The guidance places fundamentally three responsibilities on institutions and their management. The first is to gather sufficient information to make a reasoned determination about the status of a borrower and the collateral property. In most cases, the community bank that holds a second mortgage on a residential property does not hold the first mortgage. Accordingly, the financial institution should determine the delinquency status of the senior lien either by reviewing the borrower’s credit report or by the use of a third party monitoring source. An institution should review the credit quality of the borrower by obtaining the borrower’s current credit score or using other methods. Finally, the institution should determine the combined loan-to-value ratio, which is the unpaid balance of the first mortgage plus the outstanding balance of the second mortgage divided by the value of the property. Finally, to the extent useful, apply general economic indicators. In our local newspaper recently, there was an analysis of the change in home values over the last year. In some zip codes, properties had appreciated by as much as 20%. In others, property values were continuing to drop significantly. If you have home valuation information available to you, use it in your ALLL determinations.

The second direction of the guidance is to segment your portfolio based on the risk characteristics of your individual loans. Most ALLL calculations are done by applying a percentage to a portfolio of loans. The examiners warn that if you apply a percentage to your entire second mortgage portfolio, the ALLL you calculate may not be sufficient. To obtain a more accurate calculation the guidance suggests that you segregate your portfolio based on some or all of the following criteria and then apply a separate percentage to each segregated portion:

  • delinquency and modification status of your loan,
  • delinquency and modification status of the senior lien,
  • borrower’s credit score,
  • combined loan to value ratio,
  • origination channel,
  • property type (investor vs. owner occupied/ condominium vs. single unit, etc.),
  • location of collateral,
  • age of loan,
  • HELOC with history of minimum payments, and
  • HELOC with potential of payment shock.

Finally, the guidance suggests that each institution review its charge-off and non-accrual policies. Generally accepted accounting principles (GAAP) require that an estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

  • Information available before the financial statements are issued or are available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements; and
  • The amount of the loan can be reasonably estimated.

In general, there is nothing in the guidance that is new. Primarily, it is a rehash of present rules with a dose of common sense. The issuance of the guidance, however, should be a wake-up call to institutions to review their overall ALLL calculation policies and procedures and for those with a significant portfolio of residential junior mortgage loans to review their procedures for calculating the ALLL for that portfolio.