On the Horizon - Managing the End of Loss Share Agreements

As memories of the financial crisis of 2007 - 2009 fade away, a number of financial institutions are still dealing with the Loss Share Agreements (LSAs) entered into with the Federal Deposit Insurance Corporation (FDIC) as a result of the numerous bank failures that occurred since 2007. There were 489 bank failures between 2008 and 2013 with more than 65 percent of those failures occurring in 2010 or later[1].

The FDIC was able to find buyers for the vast majority of these failed banks and entered into LSAs with many of the buyers. The LSAs were segregated into single-family and non-single family components. The life over which acquiring institutions can claim reimbursable losses from the FDIC under these agreements is 10 years for single family and 5 years for non-single family LSAs. Since a large number of the failures occurred during 2010 and 2011, a significant number of the non-single family LSAs are coming to the end of the reimbursement claim period in 2015 and 2016. This sets the stage for some challenges as financial institutions manage toward the end of the LSA claim period.

For LSAs entered into during the crisis, the FDIC generally covers and reimburses the acquiring institution for a percentage of the losses experienced on covered assets (generally acquired loans and other real estate owned “OREO”) and shares in recoveries for an additional three years after the expiration of the loss claim period. Institutions that acquired failed banks subject to LSAs typically recognized the right to receive payments from the FDIC for losses on assets covered under the LSA as an indemnification asset under Accounting Standards Codification (ASC) Topic 805 (specifically 805-20-25-27 & 28). The amount recognized as an indemnification asset represents the financial institution’s estimate of the amount and timing of expected future cash flows to be received from the FDIC on claimed losses.  

The initial and subsequent determination of expected losses in a covered asset portfolio is subject to significant estimation over long-term horizons because the estimation process encompasses the expected life of the loan, including ultimate conversion and disposition as OREO. As the end of the LSA claim period nears, more clarity is gained as to the actual likelihood of claim-eligible losses occurring prior to the end of the LSA. 

As an institution manages toward the end of the loss share agreement, here are a few things to keep in mind:

  1. Critically consider whether a realized loss on the covered asset will actually occur before the loss share coverage period expires. The covered asset may still have embedded losses, but those losses may end up being less than initially thought or may ultimately fall outside of the loss share coverage period.
  2. Consider strategies, such as auctions or other quick sale scenarios, to accelerate losses on OREO that might otherwise occur after loss share coverage ends, into the loss share coverage period.  Appropriately detailed documentation must be maintained to support the assertion that the chosen resolution scenario was the least costly alternative to the FDIC’s Deposit Insurance Fund, and is compatible with resolution strategies the institution would normally undertake on assets not covered by LSAs. For instance, including OREO not subject to LSAs in an auction that includes OREO covered by LSAs would reinforce the position that an auction is a resolution strategy normally undertaken by the institution for problem assets.
  3. If the LSA contains a true-up payment provision, revisit the true-up payment calculation. As the net loss amount used to estimate the true-up payment becomes less of an estimate, and more of an actual number, there could be changes to the true-up payment that may be payable to the FDIC at the end of the LSA term.

There are a few accounting issues to keep in mind as the end of loss share agreements near. The primary issue is the recognition of any difference between the recorded value of the indemnification asset and the actual expected losses on the covered assets. Many institutions find that due to the improving economy since 2010, the estimated losses on covered assets have not occurred. Generally, the improved economy results in greater expected cash flows on covered loans. Because many covered loans are accounted for under ASC 310-30, this improvement in expected cash flows leads to increased interest income on covered loans that is recognized over the expected remaining life of the loan. Improved expected cash flows on the covered loans also result in lower expected claims from the FDIC. The resulting loss on the indemnification asset can be recognized over the shorter term of the life of the loan or the term of the LSA, which in most cases is the latter.

However, if an institution determines that a loss on the covered loan is still expected, but it will not occur during the term of the LSA, the resulting decrease in the value of the indemnification asset should be recognized immediately, in accordance with ASC 805-20-35, rather than amortized over the remaining term of the LSA. This situation could lead to additional volatility in the last few quarters leading up to the expiration of an LSA as write-downs of the indemnification asset occur.

Another issue facing financial institutions is offers from the FDIC to terminate the LSA. The FDIC is actively reaching out to many institutions with LSAs where remaining covered assets are below certain thresholds to offer the institution terms to terminate the agreements. There are potential benefits to both the FDIC and the institution from mutually settling the LSAs. For the financial institution there may be substantial cost savings from the elimination of reporting, tracking and auditing expenses associated with certain requirements of the LSA. A financial institution should also weigh the benefit of loss share coverage with the alternative benefit of not having to share subsequent recoveries of previously claimed losses with the FDIC. For the FDIC, there are similar expense savings that result from the elimination of monitoring, tracking and supervision requirements of institutions subject to LSAs. A financial institution should consider the recorded value of the indemnification asset, true-up payment liability and any payment to or from the FDIC as part of the terms of the LSA termination. 

Given the significant number of items to consider as LSAs reach their expiration dates, good communication and coordination among an institution’s accounting, loss share and credit teams is essential to avoid potential surprises. Teams that work together early will be best prepared to identify potential issues and help their institution maximize benefits from the LSAs.

[1] https://www.fdic.gov/bank/individual/failed/banklist.html

 

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About the Authors

Wesley Allen, Director

Wesley is a Director in the DHG Financial Services practice in Charlotte. He has more than 12 years of public accounting experience, working with financial institutions in the areas of process and control evaluation, external financial reporting to regulatory agencies and investors, and compliance with laws and regulations. 

Contact Wesley: wesley.allen@dhg.com | dhg.com

 

Will Neeriemer, Partner

Will is a Partner based in Charlotte in the DHG Financial Services practice. Will began his career with DHG and has more than 15 years of experience performing external audit engagements, including merger and acquisition accounting and loss sharing agreements with the FDIC. 

Contact Will: will.neeriemer@dhg.com | dhg.com