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OCC BULLETIN 2004-39
To: Chief Executive Officers of All National Banks, Federal Branches and Agencies, Department and Division Heads, and All Examining Personnel

Description: Risk Management Expectations

PURPOSE

In recent years, banks have increased their holdings of tax lien certificates, in part, because of active marketing by third-party vendors and also because of their comparatively higher yields in a low interest rate environment. This document describes the risk management practices that the Office of the Comptroller of the Currency (OCC) expects banks to exercise when purchasing tax lien certificates.

Background

When a property tax bill becomes delinquent, the taxing authority places a tax lien on the property. In many states, the taxing authority is authorized to sell tax liens by issuing tax lien certificates. A tax lien certificate transfers to a third party the taxing authority's right to collect delinquent property taxes and the right to foreclose on the property. A tax lien has a superior priority status that supercedes any existing non-tax liens, including first mortgages. Tax lien certificates accrue interest and fees and often generate attractive returns for an investor. The laws governing the redemption and transfer of tax lien certificates vary among states and municipalities.

Prior to 1996, the OCC concluded that the purchase of tax lien certificates was an unsafe and unsound banking practice primarily because the bank would be advancing funds solely on the value of collateral, rather than on the borrower's ability to repay. In 1996 the OCC revised this position and asserted that under certain conditions national banks could acquire tax lien certificates. Under section 24(7), national banks have the right to "discount and negotiate . . . evidences of debt" and the OCC's Interpretive Letter No. 725, dated March 22, 1996, concluded tax lien certificates were "evidences of debt." However, because national banks are prohibited from purchasing a delinquent taxpayer's property (12 USC 29), state or local law must confirm that a tax lien certificate represents a security interest in the property and not title to the property. Thus, if delinquent property taxes are defined as debt under state or local law, and the tax lien certificate represents an interest in the debt, a national bank may purchase a tax lien certificate. If applicable law of a jurisdiction does not contain these conditions, a national bank may not purchase the tax lien certificates.

RISKS

The OCC views conforming tax lien certificates as extensions of credit. By purchasing a tax lien certificate, a bank is financing a taxpayer's delinquent taxes with a real estate-secured loan. Tax lien certificates contain credit, operational (transaction and compliance), liquidity, and reputation risks.

As with all extensions of credit, tax lien certificates have credit risk, which is the risk that the obligation will not be repaid. Although the credit risk in a tax lien certificate is somewhat mitigated by its structure, a tax lien certificate is fundamentally an interest in a delinquent tax obligation. A delinquent obligation indicates a high level of credit risk. Due to the level of credit risk in tax lien certificates, banks that purchase them should have policies, procedures, and other risk management practices in place to control the risk.

Tax lien certificates have operational risk because of the notification and filing requirements and the potential effect of subsequent tax liens. This risk escalates when a bank owns tax liens from multiple jurisdictions. In addition, because tax lien certificates are considered real estate-secured loans for assessing legal permissibility, banks must comply with the real estate lending standards of 12 CFR part 34.

Tax lien certificates increase liquidity risk because they tie up funds for an extended period without generating interim cash flows. The redemption period (the period during which the delinquent taxpayer can bring taxes current) for a tax lien certificate may be as long as five years.

Finally, tax lien certificates expose a bank to reputation risk. Banks that purchase tax lien certificates may face reputation risk if they undertake significant numbers of foreclosures arising from tax lien certificate holdings. Reputation risk is higher if the foreclosed properties are concentrated geographically. In the worst case, the bank could be portrayed as engaged in predatory lending practices if it is advancing funds on the value of the collateral, without knowledge of the taxpayer's ability to repay.

RISK MANAGEMENT EXPECTATIONS

The OCC expects banks that purchase tax lien certificates to implement a risk management program to control the inherent risks. Banks need board-approved policies, procedures, and controls to address the credit, operational, liquidity, and reputation risk factors described above. In addition, the OCC has identified four specific concerns that must be addressed in a tax lien certificate risk management program.

  1. The OCC's anti-predatory lending standards1 and guidance2 prohibit a bank from making any loan based predominantly on the foreclosure value of the property. Therefore, a bank's decision to purchase tax lien certificates must be based on the likelihood that the real estate taxes will be paid, not on the value of the real property securing the instrument. Banks will need to conduct a repayment analysis for each transaction. Sole or heavy reliance on historic repayment statistics does not demonstrate the repayment capacity of an individual property owner.
  2. Banks need to establish concentration limits for tax lien certificates. Limits should be established for the overall volume and by property type and geographic location. To establish such limits, a bank will need to identify the type of real property securing the tax lien certificate, e.g., single-family residential, multifamily residential, commercial property, vacant or occupied property, unimproved land, etc.
  3. Banks should know the condition of the property and whether there are factors that will increase or decrease its value, in particular whether there are any environmental issues.
  4. Because the OCC considers tax lien certificates to be the equivalent of real estate-secured loans, banks must comply with 12 CFR part 34, "Real Estate Lending and Appraisals." When a bank has a real estate-secured loan, either an appraisal or an evaluation is required, depending on the amount of exposure. Tax assessment valuations do not meet the standards detailed under 12 CFR part 34.

RISK RATING, ACCOUNTING, and RISK-BASED CAPITAL CONSIDERATIONS

Tax lien certificates are considered extensions of credit and, as such, need to be assigned ratings in conformance with the bank's risk rating system. Tax lien certificates with an interest in a personal residence should be analyzed like residential real estate mortgage loans; tax lien certificates with an interest in commercial property should be analyzed like commercial real estate loans. Because tax lien certificates arise through nonpayment of taxes, the repayment source has well-defined weaknesses, and a "substandard" classification is generally warranted.

Although considered loans for purposes of assessing legal permissibility and risk management practices, banks should report tax lien certificates as "Other Assets" in the Reports of Condition and Income (call report). This is because tax lien certificates do not meet the definition of a loan contained in the call report instructions, which is, " . . . an extension of credit resulting from direct negotiations between a lender and a borrower. The reporting bank may originate a loan . . . or it may purchase a loan or a portion of a loan originated by another lender that directly negotiated with a borrower." Because a tax lien certificate represents an interest in a tax obligation that resulted from no direct negotiations between the holder of the certificate and the property owner, or between the taxing authority and the property owner, a tax lien certificate does not meet the call report definition of a loan.

Accrual status should be determined in accordance with call report instructions and the bank's nonaccrual policy. Delinquency should be calculated from the date the taxes were due to the taxing authority. At the time an institution purchases a tax lien certificate, the property owner's real estate tax payment obligation typically meets the criteria for nonaccrual status set forth in the call report instructions and, therefore, income should be recognized on a cash basis. As a consequence, tax lien certificates should be reported in the past due and nonaccrual schedule of the call report in the item for "Other Assets." When income is recognized on a tax lien certificate, it should be reported as "Other Noninterest Income" in the call report.

For risk-based capital purposes, tax lien certificates are not claims on the taxing authority and carry a 100 percent risk weight.

Questions regarding this bulletin should be directed to the Credit Risk Policy Division at (202) 649-6670.

Barbara Grunkemeyer
Deputy Comptroller for Credit Risk Policy

1 12 CFR Parts 7.4008(b) and 34.3(b).

2 OCC Advisory Letter 2002-3, "Guidance on Unfair or Deceptive Acts or Practices," March 22, 2002; OCC Advisory Letter 2003–2, "Guidelines for National Banks to Guard Against Predatory and Abusive Lending Practices," February 21, 2003; OCC Advisory Letter 2003-3, "Avoiding Predatory and Abusive Lending Practices in Brokered and Purchased Loans," February 21, 2003.