Leveraged Lending

Accounting for Leveraged Lending

This appendix highlights key accounting requirements with respect to leveraged lending. While it highlights the pertinent accounting, it is not a substitute for the actual standards. These standards evolve over time. Bankers and examiners should ensure the standards they follow are current. Examiners should contact the Office of the Chief Accountant if accounting issues arise.

Commitment to Lend

For leveraged lending commitments to originate loans where the fair value option under Statement of Financial Accounting Standards (FAS) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” has been elected, the commitments would be recorded at fair value with gains and losses recognized in current period earnings.

When FAS 159 is not elected, the commitments would not be recorded at fair value; however, banks may need to recognize losses related to these commitments. The determination and consideration of any such losses depends on the bank’s intent to either sell or hold the loan after origination.

Loan commitments that relate to loans that a bank intends to hold for investment should be evaluated for credit impairment in accordance with FAS 5, “Accounting for Contingencies.” Similar to the accounting for loans held for investment, losses on commitments for these loans should be based on credit related losses, not market related losses. Loan commitments, or portions of loan commitments, that the company intends to sell should not be considered held for investment.

For loan commitments that relate to loans a bank intends to hold for sale, there are two acceptable alternatives for accounting. Under Alternative A, the bank accounts for these loan commitments at the lower of cost or fair value. The bank should recognize any loss and record a liability to the extent that the terms of the committed loans are below current market terms.

Under Alternative B, the bank accounts for these loan commitments under FAS 5. If it is probable that the loan will be funded and then held for sale, any loss related to market conditions should be recognized and a related liability recognized (even though the commitment has not yet been funded). Both interest rate and credit risk should be considered in measuring the fair value of the commitment.

Under both Alternative A and Alternative B, the premise is that it is inappropriate to delay recognition of a loss related to declines in the fair value of a loan commitment until the date a loan is funded and classified as held for sale. If it is probable that a loss has been incurred because it is probable that an existing loan commitment will be funded and the loan will be sold at a loss, then the loss on that commitment should be recognized in earnings.

Banks should follow the guidance in FAS 157,”Fair Value Measurements,” in estimating the fair value of loan commitments. Under FAS 157 “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 absence of an active market, loan commitments should be valued using valuation techniques that are appropriate for the circumstances and consider what a third party would pay to acquire the commitments, or demand to assume the commitments. The method that banks use to estimate the fair value should be reasonable, well supported, and adequately documented.

OCC Advisory Letter 99-4 (AL 99-4) states, “Agent banks should clearly define their hold level before syndication efforts begin.” Generally there is no prohibition in GAAP for a bank to change their intent to sell. However, to comply with AL 99-4, and as the accounting is affected by intent, adequate “intent” documentation should be completed in a timely manner. This would include the bank’s rationale for the change in intent and their analysis from a credit and interest rate risk perspective of how the intent change is consistent with their overall risk management policies and procedures.

If a bank enters into a commitment with the intention to hold the funded loan for sale, it should account for that commitment under Alternative A or Alternative B described above. If the bank subsequently changes its assertion to an intent to hold a loan for investment, it should continue to consistently apply its previously selected accounting alternative through the date that its

intent changed, including recording any loss that would be required under Alternative A or B immediately prior to the change in intent; the bank should not reverse any prior loss recognized under selected method.

Loans Held for Investment

AICPA Statement of Position 01-6, “Accounting by Certain Entities that Lend to or Finance the Activities of Others” (SOP 01-6) states that non-mortgage loans should only be accounted for as held for investment if “management has the intent and ability to hold for the foreseeable future or until maturity or payoff.” Loans classified as held for investment are initially recorded at their unpaid principal balance net of discounts, premiums, nonrefundable fees and costs.

Following the guidance in FAS 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases,” nonrefundable fees and costs should be deferred and amortized over the life of the loans as an adjustment to yield. Finally, loans classified as held for investment must be evaluated for impairment following the guidance, as appropriate, in either FAS 5 or FAS 114, “Accounting by Creditors for Impairment of a Loan,” as amended and in accordance with the OCC Bulletin 2001- 37, “Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions,” and OCC Bulletin 2006-47, “Allowance for Loan and Lease Losses.”

Loans Held for Sale

Banks must account for loans held for sale under one of the following methods: fair value under the fair value option (FAS 159), the lower of cost or market value (LOCOM) under SOP 01-6, or as the hedged item in a hedge qualifying for fair value hedge accounting under FAS 133, “Accounting for Derivative Instruments and Hedging Activities.” Each reporting period, banks must calculate the fair value of their held for sale loans following the guidance for fair value measurement in FAS 157. The accounting for value changes will vary depending on whether the bank elects LOCOM accounting, FAS 133 hedge accounting, or the fair value option (FAS 159).

For loans accounted for at LOCOM, the carrying amount should be adjusted through a valuation allowance (if the fair value is less than carrying amount) with changes in the valuation allowance reported in earnings. In contrast, if the bank hedges the loans and qualifies for fair value hedge accounting pursuant to FAS 133, the bank will adjust the carrying amount of the hedged loans, through earnings, to reflect the change in fair value that is attributable to the hedged risk.

As noted previously, under the fair value option (FAS 159), all changes in the fair value of the loan will adjust the carrying amount and be reflected in current period earnings.

Transfers from Held for Sale to Held for Investment

If a bank decides not to sell a loan after recording the loan at the lower of cost or fair value under held for sale accounting, the loan is transferred to the held for investment category at the current carrying value of the loan (that is, at the lower of cost or fair value.) The transfer date is important, as the lower of cost or fair value on that date is used to establish a new cost basis for that loan. After the transfer into the portfolio, the loan should be evaluated in accordance with the bank’s normal credit policies for purposes of establishing an allowance for loan losses related to any probable losses that are incurred after the transfer.

As noted earlier, for loans accounted for as held for investment, management has the intent and ability to hold for the foreseeable future or until maturity or payoff. Consequently, the bank must document it now has the positive intent and ability to hold the loans for the foreseeable future or until maturity. A bank changing its intention and selling the loan(s) or transferring the loan(s) back to the held for sale portfolio would likely cause increased skepticism and scrutiny by the auditor and examiner, especially if the sale occurred during the period the bank originally considered its foreseeable future.

Transfers from Held for Investment to Held for Sale

A bank should transfer loans from the held for investment category to the held for sale category when it no longer has the intent and ability to hold the loans for the foreseeable future or until maturity or payoff. See OCC Bulletin 200115, “Loans Held for Sale,” for further guidance on these transfers.

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