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Appeal of Loan Classifications, Composite and Component Ratings, and Troubled Condition Designation (Third Quarter 2012)

Background

A community bank appealed the supervisory office decision to classify a segment of the residential real estate (RRE) portfolio as substandard and the entire portfolio of loans advanced for the payment of taxes or insurance on RRE loans as doubtful.  The bank also appealed the composite rating and component ratings for capital, asset quality, management, earnings, and liquidity as assigned at the most recent examination.  Lastly, the bank appealed the “troubled condition” designation.

Discussion 

Loan Classifications

The appeal asserted the OCC’s premise for classifying a segment of the RRE portfolio as substandard was flawed and inconsistent with guidance promulgated by the Office of Thrift Supervision (OTS).  The appeal further stated that regulatory guidance classified retail loans based on repayment performance and to meet the definition of substandard there must be a material element that jeopardizes the liquidation of the debt.  In addition, the OTS Handbook does not require classification of assets as substandard based on a borrower’s failure to pay taxes or insurance alone.  Consequently, if the mortgage loans are not classified as substandard, the advances to pay the taxes and insurance should not be classified as doubtful.

Composite and CAMEL ratings

The appeal asserted the composite rating is based on erroneous component ratings and abruptly placed the bank in “troubled condition.”  The composite should be restored to an overall 2 rating rather than downgraded to 4.

The appeal asserted if the disputed adverse classifications were eliminated, the regulatory criticism citing added pressure on the sufficiency of capital would be unrealistic; therefore, capital should be restored to 2 rather than downgraded to 3.

The appeal stated that all suppositions of risk to interrelated components are instantly unsupported.  Asset quality should be returned to 2 rather than downgraded to 4.

The appeal stated all criticisms of management were completely wrapped around the notion that the RRE portfolio was high risk and poorly administered.  Further, the Report of Examination (ROE) discussed various charges of transactions with affiliates and insider dealings as being of high concern, yet the OCC did not cite a violation of law or noncompliance with OCC policy.  Management should be rated 2 rather than downgraded to 4.

The appeal asserted the bank has been and continued to be one of the highest-earning, highest-performing banks in the country in terms of profitability.  The total exposure of the advances, in a worst-case scenario, represented a minimum percentage of the bank’s capital base.  The rating for earnings was clearly a 1 rather than the downgrade to 2.

The appeal asserted the bank had ample sources of liquidity.  The downgrade to 3 was based upon the alleged risk that funding sources will dry up or dwindle in the face of the supposed decline in asset quality and designation as being in troubled condition.  The liquidity rating should be restored to 2 rather than downgraded to 3.

Conclusion 

The ombudsman thoroughly reviewed the information submitted by the bank and the supervisory office.  The ombudsman conducted the review using standards in effect at the time of the examination.  Specifically, the ombudsman relied on the Office of Thrift Supervision (OTS) Asset Quality Handbook Section 212 One-to- Four Family Residential Real Estate Lending and Section 260 Classification of Assets.  Both of these sections incorporate guidance issued by the Federal Financial Institutions Examination Council (FFIEC) applicable to both banks and savings associations.  More specifically, the ombudsman relied on the Interagency Guidelines Establishing Standards for Safety and Soundness and the Uniform Retail Credit Classification and Account Management Policy.  The ombudsman also based decisions on the Uniform Financial Institutions Rating System (UFIRS) issued by the FFIEC.  Lastly, the ombudsman relied on 12 C.F.R. § 163.555 to address the appeal of the “troubled condition” designation.


Based on the above information and standards, the ombudsman made the following determinations:

Loan Classifications

The supervisory office appropriately applied guidance contained in the Uniform Retail Credit Classification and Account Management Policy when classifying a segment of the residential real estate portfolio.  The advancement of taxes and insurance, in and of itself, is an accepted and expected practice to protect the bank’s collateral position.  However, the ombudsman found two issues that fully support the wholesale classification of this segment of the portfolio:

  1. Failure to include taxes and insurance when determining a borrower’s repayment capacity at loan origination.  This practice is inconsistent with regulatory guidance, represents an inherent structural weakness in the portfolio, and exposes the bank to undue credit risks.
  2. Failure by the borrower to pay taxes and insurance when due.  This may be an indication of financial distress and places the mortgagor in default of the mortgage agreement, creating a well-defined credit weakness.

The practice of including taxes and insurance when determining a borrower’s repayment capacity is supported in OTS Handbook Section 212 which states “…the institution should assess borrowers’ ability to pay by comparing their debt-to-income ratio for housing debt (to include principal, interest, taxes, insurance, HOA, condo fees, and mortgage insurance)….”  The Uniform Retail Credit Classification and Account Management Policy allows examiners to classify segments of retail portfolios where underwriting standards are weak and present unreasonable credit risk.  The underlying underwriting weakness and well-defined credit weakness support the substandard classification of this segment of the residential real estate portfolio.  

With respect to the doubtful classification of the portfolio of loans advanced for the payment of taxes and insurance, the supervisory office appropriately applied the guidelines.  Failure to establish a repayment plan consistent with the purpose of the advance is an underwriting weakness, as is failure to determine that the collateral value supports the additional advance.  The portfolio is characterized by the distinct possibility that loss may be sustained if the above deficiencies are not corrected.  Pending determination of the borrower’s ability to repay the loan within reasonable timeframes and/or collateral sufficiency to support the additional advance, doubtful is the appropriate classification for this portfolio of loans.

Composite and CAMEL ratings

With respect to the downgrade in the capital component rating from 2 to 3, the standards were not appropriately applied.  The ombudsman determined the appropriate rating is 2.  A rating of three indicates a less than satisfactory level of capital relative to the bank’s risk profile and indicates a need for improvement.  However, the supervisory office did not support that the level of capital warrants improvement relative to the risks facing the bank.  The level and quality of capital was within the ranges deemed appropriate by the supervisory office.  Although the volume of problem assets is high, the bank continues to maintain satisfactory capital, even after increased provision expenses and dividend payouts.  Earnings are the primary contributor to capital and secondary sources of capital are available to maintain appropriate levels relative to the bank’s risk profile.

With respect to the downgrade in asset quality from 2 to 4, the standards were not appropriately applied.  The ombudsman determined the appropriate rating is 3.  A rating of 4 represents deficient asset quality that may threaten the viability of the bank.  A rating of 3 represents asset quality or credit administration practices that are less than satisfactory and require an elevated level of supervision.  The volume of adversely classified assets is high.  However, the supervisory office did not support that asset quality was sufficiently deficient to erode earnings and capital, thus threatening the viability of the bank.  The root cause of the classification was the advancement of funds to pay taxes and insurance and the undocumented financial capacity of the borrower to repay those advances.  The underlying mortgage loans were deemed to be well secured with the majority of the loans paying in accordance with the loan agreement.  Management can address the root cause of the classification by establishing a repayment plan supported by the borrower’s repayment ability.  Notwithstanding the confined source of the loan classifications, weaknesses in underwriting, problem loan identification, Other Real Estate accounting, and external loan review elevate the bank’s credit risk exposure and warrant increased supervisory attention.

With respect to the downgrade in management and board supervision from 2 to 4, the standards were not appropriately applied.  The ombudsman determined the appropriate rating is3.  Management and board supervision need improvement.  In addition to credit risk management weaknesses, the supervisory office identified transactions with affiliates and insiders that raise concerns.  These issues reflect negatively on management and the board.  A rating of 3 recognizes management and board supervision that is insufficient for the risk profile of the bank.

With respect to the downgrade in earnings performance from 1 to 2, the standards were not appropriately applied.  The ombudsman determined the appropriate rating is 1.  A rating of 2 represents sufficient earnings performance while a rating of 1 indicates strong earnings that are more than sufficient to support operations and maintain adequate capital and allowance levels.  Historically, earnings have provided a return on average assets (ROAA) ranging from 1.6% to 2.1%.  Even after large provisions to the ALLL during the examination and a high dividend payout, the bank earned a return of 1.65%.  The core source of earnings, interest income and fees from selling loans to the secondary market, is sustainable.  There were no pending events that jeopardize earnings performance.

With respect to the downgrade in liquidity from 2 to 3, the standards were appropriately applied.  The high level of classified assets is a threat to the bank’s ability to access funds on reasonable terms.  The bank has a significant reliance on wholesale funding.  Credit lines at the Federal Home Loan Bank and Federal Reserve Bank are the primary sources of liquidity.  The cost to access these credit lines may be impacted by the overall condition of the bank and the quality of the loan portfolio.

With respect to the downgrade in the composite rating from two to three, the standards were appropriately applied.  The overall condition of the bank is of supervisory concern.  Management’s willingness or ability to address the issues identified during the examination is also a concern.  The magnitude of deficiencies in asset quality require management’s and the board’s immediate attention.  

Based on the above ratings, the standards to assign a “troubled condition” designation were appropriately applied.  12 C.F.R. § 163.555 define “troubled condition” as a federal savings association:

  1. Having a composite rating of 4 or 5 as defined in §116.5(c):
  2. Subject to a capital directive, a cease and desist order, a consent order, or a formal written agreement, or a prompt corrective action directive relating to the safety and soundness or financial viability of the savings association unless otherwise informed in writing by the OCC; or
  3. Informed in writing by the OCC that it is in troubled condition based on information available to the OCC.

The bank was notified in the ROE of the “troubled condition” designation.  The “troubled condition” designation places restrictions on changes in directors and senior management as well as severance agreements.  Management and the board should contact the supervisory office regarding specific requirements.

The ombudsman based the above decisions on the facts and circumstances of this appeal and these decisions do not extend to other institutions not presenting the same facts and circumstances.