Secured Consumer Debt Discharged in Chapter 7 Bankruptcy: Supervisory Expectations

Summary

The Office of the Comptroller of the Currency (OCC) is issuing this guidance to clarify the agency’s supervisory expectations for national banks and federal savings associations (collectively, banks) regarding secured consumer debt discharged in Chapter 7 bankruptcy proceedings.

Highlights

This guidance describes

• the analysis necessary to “clearly demonstrate and document that repayment is likely to occur,” which would preclude any charge-off as required by the Uniform Retail Credit Classification and Account Management Policy.¹
• when a bank may consider post-discharge payment performance as evidence of collectability and when this performance demonstrates both capacity and willingness to repay the full amounts due.

Background

The OCC encourages banks to work constructively with troubled borrowers and to provide viable foreclosure or repossession alternatives as appropriate. The OCC reminds banks that they remain responsible for accurately reporting troubled assets in accordance with generally accepted accounting principles (GAAP) and regulatory reporting instructions and for fairly presenting their financial condition.

General Treatment of Secured Loans in Bankruptcy Proceedings

The Uniform Retail Credit Classification and Account Management Policy requires loans in bankruptcy be charged down to collateral value (less costs to sell) within 60 days of notification from the bankruptcy court, unless the bank can clearly demonstrate and document that repayment will likely occur.² When full payment of principal and interest is not expected, management should place these loans on nonaccrual or follow other acceptable methods to ensure revenue recognition is not overstated. Any balance not charged off should be classified substandard.

This guidance describes the analysis necessary to “clearly demonstrate and document that repayment is likely to occur.” Immediate charge-off of amounts exceeding collateral value is not required if an analysis indicates that orderly repayment is likely to occur after the bankruptcy discharge.³ No single factor determines the likelihood of repayment, and management should use judgment and consider all facts and circumstances when assessing the situation. The repayment analysis should document the following three factors:

1. The existence of orderly repayment terms for structured collection of the debt without the existence of undue payment shock⁴ or the need to refinance the balloon amount.
2. A history of payment performance that demonstrates the borrower’s ongoing commitment to satisfy the debt before and through the bankruptcy proceeding.
3. The consideration of post-discharge capacity that indicates the borrower can make future required payments from recurring, verified income.

Standards for post-discharge repayment capacity should mirror established ability-to-repay requirements (e.g., debt-to-income ratio, net disposable income) for new loans or sustainable loan modification programs. Banks may use income and debt information from bankruptcy proceedings if such information is available and deemed reliable. Documentation should enable a third party (such as a person responsible for the control function within the bank, an examiner, or an auditor) to reasonably reconstruct the analysis and accept the conclusion after the fact.

Lack of consideration of these three factors could subject the bank to examiner criticism. If the factors considered clearly demonstrate that repayment in full is likely to occur despite the bankruptcy discharge, the loan may remain on accrual status at the existing recorded balance. If objective evidence demonstrates that a portion of the loan is uncollectible, management should charge down the loan to the fair value of the collateral (less costs to sell) within 60 days of notification from the bankruptcy court. In either event, exposures should be monitored and considered separately for loan loss allowance purposes and generally charged down to the fair value of the collateral less costs to sell if they subsequently become 60 days past due.⁵

Posting of Payments and Returning Discharged Loans to Accrual Status

For loans maintained on nonaccrual status, when doubt exists as to the collectability of any remaining recorded investment (e.g., after any charge-off), post-discharge payments received must be applied to reduce the recorded investment until doubt no longer exists. Once the remaining recorded investment is considered fully collectible, interest income may be recognized on a cash basis.⁶ The collectability analysis requires judgment, including consideration of payment performance, lien position, collateral values, and other relevant factors. In general, nominal collateral coverage alone is not sufficient to satisfy collectability questions, especially where values or valuation methods may be unstable or uncertain.

A nonaccrual asset may be restored to accrual status if the loan meets the Federal Financial Institutions Examination Council’s (FFIEC) return-to-accrual conditions.⁷ Generally, the loan may be restored to accrual status when none of its principal and interest is due and unpaid and the bank expects full repayment of the remaining pre-discharged contractual principal and interest (including any previously charged-off amounts). In a Chapter 7 bankruptcy proceeding, discharge of the obligor introduces uncertainty, and evidence supporting the expectation of full repayment requires judgment and must be credible and well documented before returning a loan to accrual status.

Depending on facts and circumstances, a bank may consider post-discharge payment performance as evidence of collectability—if performance demonstrates both capacity and willingness to repay the full amounts due. A bank’s analysis may be performed at a pool or individual loan level, as long as the following three factors are considered:

1. Monthly payments include both principal and interest that fully amortizes the remaining debt over the remaining term. Payment performance that consists of interest-only payments or terms that require balloon amounts raise questions about whether collection of loan principal is reasonably assured. For a loan that does not require full amortization, the bank may consider other mitigating factors such as whether the borrower has demonstrated an ongoing ability to repay by consistently making payments above the minimum required that are sufficient to amortize the balance over a reasonable period.
2. Sustained performance clearly demonstrates ongoing capacity and willingness to repay after the bankruptcy discharge. In accordance with call report instructions, timely post-discharge payments for a minimum of six months are necessary to provide evidence of willingness and ability to pay the full amounts due. Longer periods may be appropriate depending on specific circumstances, for example, when loan or pool characteristics indicate high re-default rates, when extended periods are necessary for borrowers to restore positive equity, or when economic conditions are unstable or deteriorating.
3. Collateral levels support the likelihood that the bank will recover the full amount due even if payments cease. The discharge of the debtor’s personal liability increases the importance of secondary sources of repayment, and substantial collateral deficiencies may make full collection (including charged-off amounts) uncertain and not reasonably assured.

If the bank has prudently considered and documented these and any other relevant factors and expects full repayment of the remaining contractual principal and interest (including any previously charged-off amounts), management may return the loan to accrual status. As with the initial analysis, loans returned to accrual that had been discharged in a Chapter 7 bankruptcy proceeding should be monitored and considered separately for loan loss allowance purposes and generally charged down to the fair value of the collateral less costs to sell if the loans subsequently become 60 days past due.

Further Information

Please direct questions to your supervisory office, the Credit and Market Risk Department at (202) 649-6360, or, for reporting matters, the Office of the Chief Accountant at (202) 649-6280.

Darrin Benhart
Deputy Comptroller, Credit and Market Risk

Kathy Murphy
Deputy Comptroller and Chief Accountant