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Inactive Financial Institution Letters
[Federal Register: March 28, 2005 (Volume 70, Number 58)]
[Notices]
[Page 15681-15688]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr28mr05-105]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
[Docket No. 05-08]
Office of Thrift Supervision
[No. 2005-14]
FEDERAL RESERVE SYSTEM
[Docket No. OP-1227]
FEDERAL DEPOSIT INSURANCE CORPORATION
Interagency Proposal on the Classification of Commercial Credit
Exposures
AGENCIES: Office of the Comptroller of the Currency, Treasury, (OCC);
Board of Governors of the Federal Reserve System (Board); Federal
Deposit Insurance Corporation (FDIC); and Office of Thrift Supervision,
Treasury, (OTS).
ACTION: Joint notice and request for comment.
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SUMMARY: The OCC, Board, FDIC, and OTS (the agencies) request comment
on their proposal to revise the classification system for commercial
credit exposures.
The proposal will replace the current commercial loan
classification system categories ``special mention,'' ``substandard,''
and ``doubtful'' with a two-dimensional based framework. The proposed
framework would be used by institutions and supervisors for the uniform
classification of commercial and industrial loans; leases; receivables;
mortgages; and other extensions of credit made for business purposes by
federally insured depository institutions and their subsidiaries
(institutions), based on an assessment of borrower creditworthiness and
estimated loss severity. The proposed framework would not modify the
interagency classification of retail credit as stated in the ``Uniform
Retail Credit Classification and Account Management Policy Statement,''
issued in February 2000. However, by creating a new treatment for
commercial loan exposures, the proposed framework would modify Part I
of the ``Revised Uniform Agreement on the Classification of Assets and
Appraisal of Securities Held by Banks and Thrifts' issued in June 2004.
This proposal is intended to enhance the methodology used to
systematically assess the level of credit risk posed by individual
commercial extensions of credit and the level of an institution's
aggregate commercial credit risk.
DATES: Comments must be received by June 30, 2005.
ADDRESSES: Interested parties are invited to submit written comments to
any or all of the agencies. All comments will be shared among the
agencies.
Comments should be directed to:
OCC: You should include OCC and Docket Number 05-08 in your
comment. You may submit comments by any of the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
OCC Web Site: http://www.occ.gov. Click on ``Contact
the OCC,'' scroll down and click on ``Comments on Proposed
Regulations.''
E-mail address: regs.comments@occ.treas.gov.
Fax: (202) 874-4448.
Mail: Office of the Comptroller of the Currency, 250 E
Street, SW., Mail Stop 1-5, Washington, DC 20219.
Hand Delivery/Courier: 250 E Street, SW., Attn: Public
Information Room, Mail Stop 1-5, Washington, DC 20219.
Instructions: All submissions received must include the agency name
(OCC) and docket number or Regulatory Information Number (RIN) for this
notice of proposed rulemaking. In general, OCC will enter all comments
received into the docket without change, including any business or
personal information that you provide. You may review comments and
other related materials by any of the following methods:
Viewing Comments Personally: You may personally inspect
and photocopy comments at the OCC's Public Information Room, 250 E
Street, SW., Washington, DC. You can make an appointment to inspect
comments by calling (202) 874-5043.
Viewing Comments Electronically: You may request e-mail or
CD-ROM
[[Page 15682]]
copies of comments that the OCC has received by contacting the OCC's
Public Information Room at regs.comments@occ.treas.gov.
Docket: You may also request available background
documents and project summaries using the methods described above.
Board: You may submit comments, identified by Docket Number OP-
1227, by any of the following methods:
Agency Web Site: http://www.federalreserve.gov Follow the instructions
for submitting comments on the http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: regs.comments@federalreserve.gov. Include docket
number in the subject line of the message.
FAX: 202-452-3819 or 202-452-3102.
Mail: Jennifer J. Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th Street and Constitution Avenue,
NW., Washington, DC 20551.
All public comments are available from the Board's Web site at
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as
submitted, except as necessary for technical reasons. Accordingly, your
comments will not be edited to remove any identifying or contact
information. Public comments may also be viewed electronically or in
paper in Room MP-500 of the Board's Martin Building (20th and C
Streets, N.W.) between 9 a.m. and 5 p.m. on weekdays.
FDIC: You may submit comments by any of the following methods:
Agency Web Site: http://www.fdic.gov/regulations/laws/federal/propose.html.
Follow instructions for submitting comments on
the Agency Web site.
E-mail: Comments@FDIC.gov.
Mail: Robert E. Feldman, Executive Secretary, Attention:
Comments, Federal Deposit Insurance Corporation, 550 17th Street, NW.,
Washington, DC 20429.
Hand Delivery/Courier: Guard station at the rear of the
550 17th Street Building (located on F Street) on business days between
7 a.m. and 5 p.m.
Instructions: All comments received will be posted without change
to http://www.fdic.gov/regulations/laws/federal/propose.html including
any personal information provided.
OTS: You may submit comments, identified by No. 2005-14, by any of
the following methods:
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
E-mail: regs.comments@ots.treas.gov. Please include No.
2005-14 in the subject line of the message, and include your name and
telephone number in the message.
Fax: (202) 906-6518.
Mail: Regulation Comments, Chief Counsel's Office, Office
of Thrift Supervision, 1700 G Street, NW., Washington, DC 20552,
Attention: No. 2005-14.
Hand Delivery/Courier: Guard's Desk, East Lobby Entrance,
1700 G Street, NW., from 9 a.m. to 4 p.m. on business days, Attention:
Regulation Comments, Chief Counsel's Office, Attention: No. 2005-14.
Instructions: All submissions received must include the agency name
and document number or Regulatory Information Number (RIN) for this
notice. All comments received will be posted without change to
http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1
, including any
personal information provided.
Docket: For access to the docket to read background documents or
comments received, go to http://www.ots.treas.gov/pagehtml.cfm?catNumber=67&an=1.
In addition, you may inspect comments
at the Public Reading Room, 1700 G Street, NW., by appointment. To make
an appointment for access, call (202) 906-5922, send an e-mail to
public.info@ots.treas.gov, or send a facsimile transmission to (202)
906-7755. (Prior notice identifying the materials you will be
requesting will assist us in serving you.) We schedule appointments on
business days between 10 a.m. and 4 p.m. In most cases, appointments
will be available the next business day following the date we receive a
request.
FOR FURTHER INFORMATION CONTACT:
OCC: Daniel Bailey, National Bank Examiner, Credit Risk Division,
(202) 874-5170, Office of the Comptroller of the Currency, 250 E
Street, SW., Washington, DC 20219.
Board: Robert Walker, Senior Supervisory Financial Analyst, Credit
Risk, (202) 452-3429, Division of Banking Supervision and Regulation,
Board of Governors of the Federal Reserve System. For the hearing
impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869, Board of Governors of the Federal Reserve System, 20th and C
Streets NW., Washington, DC 20551.
FDIC: Kenyon Kilber, Senior Examination Specialist, (202) 898-8935,
Division of Supervision and Consumer Protection, Federal Deposit
Insurance Corporation, 550 17th Street. NW., Washington, DC 20429.
OTS: William J. Magrini, Senior Project Manager, (202) 906-5744,
Supervision Policy, Office of Thrift Supervision, 1700 G Street, NW.,
Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
Background Information
The Uniform Agreement on the Classification of Assets and Appraisal
of Securities Held by Banks (current classification system \1\) was
originally issued in 1938. The current classification system was
revised in 1949, again in 1979,\2\ and most recently in 2004.
Separately in 1993, the agencies adopted a common definition of the
special mention rating. The current classification system is used by
both regulators and institutions to measure the level of credit risk in
commercial loan portfolios, benchmark credit risk across institutions,
assess the adequacy of an institution's capital and allowance for loan
and lease losses (ALLL), and evaluate an institution's ability to
accurately identify and evaluate the level of credit risk posed by
commercial exposures.
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\1\ The supervisory categories currently used by the agencies
are:
Special Mention: A ``special mention'' asset has potential
weaknesses that deserve management's close attention. If left
uncorrected, these potential weaknesses may result in deterioration
of the repayment prospects for the asset or in the institution's
credit position at some future date. Special mention assets are not
adversely classified and do not expose an institution to sufficient
risk to warrant adverse classification.
Substandard: A ``substandard'' asset is inadequately protected
by the current sound worth and paying capacity of the obligor or by
the collateral pledged, if any. Assets so classified must have a
well-defined weakness, or weaknesses that jeopardize the liquidation
of the debt. They are characterized by the distinct possibility that
the institution will sustain some loss if the deficiencies are not
corrected.
Doubtful: An asset classified ``doubtful'' has all the
weaknesses inherent in one classified substandard with the added
characteristic that the weaknesses make collection or liquidation in
full, on the basis of currently known facts, conditions, and values,
highly questionable and improbable.
Loss: An asset classified ``loss'' is considered uncollectible,
and of such little value that its continuance on the books is not
warranted. This classification does not mean that the asset has
absolutely no recovery or salvage value, but rather it is not
practical or desirable to defer writing off this basically worthless
asset event though partial recovery may be affected in the future.
\2\ The Federal Home Loan Bank Board, the predecessor of the
OTS, adopted the Uniform Agreement in 1987.
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The current classification system focuses primarily on borrower
weaknesses and the possibility of loss without specifying how factors
that mitigate the loss, such as collateral and guarantees, should be
considered in the
[[Page 15683]]
rating assignment. This has led to differing applications of the
current classification system by institutions and the agencies.
Under the current classification system, rating differences between
an institution and its supervisor commonly arise when, despite a
borrower's well-defined credit weaknesses, risk mitigants such as
collateral and the facility's structure reduce the institution's risk
of incurring a loss. The current classification system does not
adequately address how, when rating an asset, to reconcile the risk of
the borrower's default with the estimated loss severity of the
particular facility. As a result, the system dictates that transactions
with significantly different levels of expected loss receive the same
rating. This limits the effectiveness of the current classification
system in measuring an institution's credit risk exposure.
To address these limitations, the agencies are proposing a two-
dimensional rating framework (proposed framework) that considers a
borrower's capacity to meet its debt obligations separately from the
facility characteristics that influence loss severity. By
differentiating between these two factors, a more precise measure of an
institution's level of credit risk is achieved.
The proposal includes three borrower rating categories,
``marginal,'' ``weak'' and ``default.'' Facility ratings would be
required only for those borrowers rated default (i.e. borrowers with a
facility placed on nonaccrual or fully or partially charged off).
Typically, this is a very small proportion of all commercial exposures.
For borrowers not rated default, institutions would have the option of
assigning the facility ratings as discussed in the proposed framework.
The agencies believe that this flexibility will allow institutions
with both one-dimensional and two-dimensional internal risk rating
systems to adopt the proposed framework. Under the current
classification system, institutions with two-dimensional internal
credit rating systems have encountered problems translating their
internal ratings into the supervisory categories.
The agencies also propose to adopt common definitions for the
``criticized'' and ``classified'' asset quality benchmarks.
In this proposed framework, the agencies have sought to minimize
complexity and supervisory burden. The agencies believe that the
proposed framework attains these goals and that institutions of all
sizes will be able to apply the approach.
The proposed framework aligns the determination of a facility's
accrual status, partial charge-off and ALL treatment with the rating
assignment process. The current framework does not provide a link
between these important determinations and a facility's assignment to a
supervisory category. The proposed framework leverages off many
determinations and estimates management must already make to comply
with generally accepted accounting principles (GAAP). As a result,
financial institutions should benefit from a more efficient assessment
process and improved clarity.
This proposed framework, if adopted, would apply to all regulated
financial institutions and their operating subsidiaries supervised by
the agencies. Institutions will be provided transition time to become
familiar with the proposal and to implement the framework for their
commercial loan portfolios. In addition, the agencies will need to
review the existing classification guidance for specialized lending
activities, such as commercial real estate lending, to reflect the
proposed rating framework. The text of the proposed framework statement
follows below.
Uniform Agreement on the Classification of Commercial Credit Exposures
This agreement applies to the assessment of all commercial credit
exposures both on and off an institution's balance sheet. An
institution's management is encouraged to differentiate borrowers and
facilities beyond the requirements of this framework by developing its
own risk rating system. Institutions may incorporate this framework
into their internal risk rating systems or, alternatively, they may map
their internal rating system into the supervisory framework. Note that
this framework does not apply to commercial credit exposures in the
form of securities.
The framework is built upon two distinct ratings:
Borrower \3\ rating--rates the borrower's capacity to meet
financial obligations.
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\3\ Borrower means any obligor or counterparty in a credit
exposure, both on and off the balance sheet.
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Facility rating--rates a facility's estimated loss
severity.
When combined, these two ratings determine whether the exposure
will be a ``criticized'' or ``classified'' asset, as those asset
quality benchmarks are defined.
Borrower Ratings
Marginal
A ``marginal'' borrower exhibits material negative financial trends
due to company-specific or systemic conditions. If these potential
weaknesses are not mitigated, they threaten the borrower's capacity to
meet its debt obligations. Marginal borrowers still demonstrate
sufficient financial flexibility to react to and positively address the
root cause of the adverse financial trends without significant
deviations from their current business strategy. Their potential
weaknesses deserve institution management's close attention and warrant
enhanced monitoring.
A marginal borrower exhibits potential weaknesses, which may, if
not checked or corrected, negatively affect the borrower's financial
capacity and threaten its ability to fulfill its debt obligations.
The existence of adverse economic or market conditions that are
likely to affect the borrower's future financial capacity may support a
``marginal'' borrower rating. An adverse trend in the borrower's
operations or balance sheet, which has not reached a point where
default is likely, may warrant a ``marginal'' borrower rating. The
rating should also be used for borrowers that have made significant
progress in resolving their financial weaknesses but still exhibit
characteristics inconsistent with a ``pass'' rating.
Weak
A ``weak'' borrower does not possess the current sound worth and
payment capacity of a creditworthy borrower. Borrowers rated weak
exhibit well-defined credit weaknesses that jeopardize their continued
performance. The weaknesses are of a severity that the distinct
possibility of the borrower defaulting exists.
Borrowers included in this category are those with weaknesses that
are beyond the requirements of routine lender oversight. These
weaknesses affect the ability of the borrower to fulfill its
obligations. Weak borrowers exhibit adverse trends in their operations
or balance sheets of a severity that makes it questionable that they
will be able to fulfill their obligations, thus making default likely.
Illustrative adverse conditions that may warrant a borrower rating of
``weak'' include an insufficient level of cash flow compared to debt
service needs; a highly leveraged balance sheet; a loss of
[[Page 15684]]
access to the capital markets; adverse industry and/or economic
conditions that the borrower is poorly positioned to withstand; or a
substantial deterioration in the borrower's operating margins. A
``weak'' rating is inappropriate for any borrower that meets the
conditions described in the definition of a ``default'' rating.
Default
A borrower is rated ``default'' when one or more of the
institution's material \4\ credit exposures to the borrower satisfies
one of the following conditions:
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\4\ The materiality of credit exposures is measured relative to
the institution's overall exposure to the borrower. Charge-offs and
write-downs on material credit exposures include credit-related
write-downs on securities of distressed borrowers for other than
temporary impairment, as well as material write-downs on exposures
to distressed borrowers that are sold or transferred to held-for-
sale, the trading account, or other reporting categories.
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(1) the supervisory reporting definition of non-accrual,\5\ or
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\5\ An asset should be reported as being in nonaccrual status if
(1) it is being maintained on a cash basis because of deterioration
in the financial condition of the borrower, (2) payment in full of
principal and interest is not expected, or (3) principal or interest
has been in default for a period of 90 days or more unless the asset
is both well secured and in the process of collection.
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(2) the institution has made a full or partial charge-off or write-
down for credit-related reasons or determined that an exposure is
impaired for credit-related reasons.
Borrowers rated ``default'' may be upgraded if they have met their
contractual debt service requirements for six consecutive months and
their financial condition supports management's assessment that they
will recover their recorded book value(s) in full.
Facility Ratings
Facilities to borrowers with a rating of default must be further
differentiated based upon their estimated loss severity. The framework
contains additional applications of facility ratings; however,
institutions may choose not to utilize them. An institution can
estimate how severe losses may be for either individual loans or pooled
loans (provided the pooled transactions have similar risk
characteristics), mirroring the institution's allowance for loan and
lease losses (ALLL) methodologies. Institutions may use their ALLL
impairment analysis as a basis for their loss severity estimates.
The four facility ratings are:
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Loss severity category Loss severity estimate
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Remote Risk of Loss................... 0%.
Low................................... < =5% of recorded investment \6\.
Moderate.............................. >5% and <=30% of recorded
investment.
High.................................. >30% of recorded investment.
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\6\ Recorded investment means the exposure amount reported on the
financial institution's balance sheet per the Call Report or Thrift
Financial Report instructions.
Remote Risk of Loss
Management has the option to expand the use of the ``remote risk of
loss'' facility rating to borrowers rated ``marginal'' and ``weak.''
Facilities or portions of facilities that represent a remote risk of
loss include those secured by cash, marketable securities, commodities,
or livestock. In the event of the borrower's contractual default,
management must be capable of liquidating the collateral and applying
the funds against the facility's balance. The balance reflected in this
category should be adequately margined to reflect fluctuations in the
collateral's market price.
Loans for the purpose of financing production expenses associated
with agricultural crops may be rated ``remote risk of loss'' if
management can demonstrate that the loan will be self-liquidating at
the end of the production cycle. That is, based upon current estimates
of yields and market prices for the crops securing the loan, the
borrower should be expected to yield sufficient cash from the sale to
repay the loan in full.
Facilities guaranteed by the U.S. government or a government-
sponsored entity (GSE) that have a high investment grade external
rating might be included in this category. If the guaranty is
conditional, the ``remote risk of loss'' rating should be used only
when the institution can satisfy the conditions and qualify for payment
under the terms of the guaranty.
Asset-based lending facilities may be rated ``remote risk of loss''
only if certain criteria are met, as described below (see ``Treatment
of Asset-Based Lending Activities.'')
Low Loss Severity
The ``low loss severity'' rating applies to exposures to borrowers
rated default. Loss severity is estimated to be 5 percent or less of
the institution's recorded investment. Asset-based lending facilities
to Weak borrowers may be rated ``low loss severity'' only if certain
criteria are met, as described below (see ``Treatment of Asset-Based
Lending Activities.'')
Moderate Loss Severity
The ``moderate loss severity'' rating only applies to exposures to
borrowers rated default. Loss severity is estimated to be greater than
5 percent and at most 30 percent of the institution's recorded
investment. Recovery in full is not likely.
High Loss Severity
The ``high loss severity'' rating only applies to exposures to
borrowers rated default. Loss severity is estimated to be greater than
30 percent of the institution's recorded investment. Recovery in full
is not likely.
Loss
Assets rated ``loss'' are considered uncollectible and of such
little value that their continuance on the institution's balance sheet
is not warranted. This rating does not mean that the asset has
absolutely no recovery or salvage value (it may indeed have some
fractional future value), but rather that it is not practical or
desirable to defer writing off this basically worthless asset.
Portions of facilities rated ``low loss severity'' and ``moderate
loss severity'' must be rated loss when they satisfy this definition.
Entire facilities or portions thereof rated ``high loss severity'' must
be rated loss if they satisfy the definition. Balances rated loss are
charged off and netted from the facility's balance and the
institution's loss severity estimate must be updated to reflect the
uncertainty in collecting the remaining recorded investment.
A loss rating for an exposure does not imply that the institution
has no prospects to recover the amount charged off. However,
institutions should not maintain an asset or a portion thereof on their
balance sheet if realizing its value would require long-term litigation
or other lengthy recovery efforts. A facility should be partially rated
``loss'' if there is a remote prospect of collecting a portion of the
facility's balance. When the collectibility of the loan becomes highly
questionable, it should be charged off or written down to a balance
equal to a conservative estimate of its net realizable value under a
realistic workout strategy. When access to the collateral is impeded,
regardless of the collateral's value, the institution's management
should carefully consider whether the facility should remain a bankable
asset. Furthermore, institutions need to recognize losses in the period
in which the asset is identified as uncollectible.
[[Page 15685]]
Treatment of Asset-Based Lending Facilities
Institutions with asset-based lending (ABL) activities can utilize
the following facility ratings for qualifying exposures; however, this
treatment is not required. Some ABL facilities, including some debtor-
in-possession (DIP) loans, may be included in the ``remote risk of
loss'' category if they are well-secured by highly liquid collateral
and the institution exercises strong controls over the collateral and
the facility. ABL facilities secured by accounts receivable or other
collateral that readily generates sufficient cash to repay the loan may
be included in this category. In addition, the institution must have
dominion over the cash generated from the conversion of collateral,
prudent advance rates, strong monitoring controls, such as frequent
borrowing base audits, and the expertise to liquidate sufficient
collateral to repay the loan. Facilities that do not possess these
characteristics are excluded from the category.
ABL facilities and the lending institution must meet certain
characteristics for the exposure to be rated ``remote risk of loss.''
Convertibility
--Institution is able to liquidate the collateral within 90 days of
the borrower's contractual default.
--Collateral is readily convertible to cash.
Coverage
--Loan is substantially over-collateralized such that full recovery
of the exposure is expected.
--Collateral has been valued within 60 days.
Control
--Collateral is under the institution's control.
--Active lender management and credit administration can mitigate
all loss through disbursement practices and collateral controls.
For ABL facilities whose borrower is rated weak, management may
assign the ``low loss severity'' rating if the conditions set forth
below are satisfied:
Convertibility
--Institution is able to liquidate collateral within 180 days of
the borrower's contractual default.
--Substantial amount of the collateral is self-liquidating or
marketable.
Coverage
--Loss severity is estimated to be 5 percent or less.
--Collateral has been valued within 60 days.
Control
--Collateral is under the institution's control.
--Active lender management and credit administration can minimize
loss through disbursement practices and collateral controls.
The institution's ABL controls and capabilities are the same as
those described in the ``remote risk of loss'' description above. This
category simply lengthens the period it would likely take the
institution to liquidate the collateral from 90 days to 180 days and
increases the loss severity estimate from full recovery of the exposure
to 5 percent or less.
Commercial Credit Risk Benchmarks:
Criticized Assets = All loans to borrowers rated marginal,
excluding those facilities, or portions thereof, rated ``remote risk of
loss''
plus
ABL transactions to borrowers rated weak, if they satisfy the ``low
loss severity'' definition.
Classified Assets = All loans to borrowers rated default, excluding
those facilities, or portions thereof, rated ``remote risk of loss''
plus
All loans to borrowers rated weak, excluding those facilities, or
portions thereof, rated ``remote risk of loss'' and ABL transactions
rated ``low loss severity.''
When calculating a financial institution's criticized and
classified assets, the institution's recorded investment plus any
undrawn commitment that is reported on the institution's Call Report or
Thrift Financial Report is included in the total, excluding any
balances rated ``remote risk of loss.'' In the cases of lines of credit
with borrowing bases or any other contractual restrictions that prevent
the borrower from drawing on the entire committed amount, only the
amount outstanding and available under the facility is included--not
the full amount of the commitment. However, the lower amount should be
used only if it is management's intent and practice to exert the
institution's contractual rights to limit its exposure.
Framework Principles
The borrower ratings should be utilized for both improving and
deteriorating borrowers. Management should refresh ratings with
adequate frequency to avoid significant jumps across their internal
rating scale.
When a facility is unconditionally guaranteed, the guarantor's
rating can be substituted for that of the borrower to determine whether
a facility should be criticized or classified. If the guarantor does
not perform its obligations under the guarantee, the guarantor is rated
default and the facility is included in the institution's classified
assets.
Loss severity estimates must relate to the institution's recorded
investment, net of prior charge-offs, borrower payments, application of
collateral proceeds, or any other funds attributable to the facility.
Each loss severity estimate for borrowers rated default must
reflect the institution's estimate of the asset's net realizable value
or its estimate of projected future cash flows and the uncertainty of
their timing and amount. For this purpose, financial institutions may
use their impairment analysis for determining the adequacy of their
ALLL. Facilities may be analyzed individually or in a pool with similar
facilities.
The ``default'' borrower rating in no way implies that the borrower
has triggered an event of default as specified in the loan
agreement(s). The rating indicates only that management has placed one
or more of the borrower's facilities on non-accrual or recognized a
full or partial charge-off. Legal determinations and collection
strategies are the responsibility of management. If a borrower is rated
default, it does not imply that the lender must take any particular
action to collect from the borrower.
When management recognizes a partial charge-off, the loss severity
estimate and facility rating should be updated. For example, after a
facility is partly charged off, its loss severity may improve and
warrant a better rating.
Estimating loss severity for many exposures to defaulted borrowers
is difficult. If borrowers have filed for bankruptcy protection, there
is normally significant uncertainty regarding their intent and ability
to reorganize, to sell assets, to sell divisions, or, if it comes to
that, to liquidate the firm. In addition, there is considerable
uncertainty regarding the timing and amount of cash flows that these
various strategies will produce for creditors. As a result, the loss
severity estimates for facilities to borrowers rated default should be
conservative and based upon the most probable outcome given current
circumstances and the institution's loss experience on similar assets.
The financial institution should be able to credibly support recovery
rates on facilities in excess of the underlying collateral's net
realizable value. Supervisors will focus on estimates where institution
management has estimated recovery rates in excess of a loan's
collateral value. Market prices for a borrower's similar exposures are
one indication of a claim's intrinsic value. However, distressed debt
prices may not
[[Page 15686]]
be a realistic indication of value if trading volume is low compared to
the magnitude of the institution's exposure.
Split facility ratings should be used only when part of the
facility meets the criteria for the ``remote risk of loss'' category.
When a portion of a facility is rated ``remote risk of loss,''
management's loss severity estimate should only reflect the risk
associated with the remaining portion of the facility.
To eliminate the need for split facility ratings and further
simplify the framework, institutions have the option to disregard the
``remote risk of loss'' category for loans partially secured by
collateral that qualify for the treatment. In that case, the
institution would reflect the loss characteristics of the loan in its
entirety when estimating the loan's loss severity and slot the loan in
one of the three remaining facility ratings.
Because individually rating every borrower would be labor-intensive
and costly, institutions may use an alternative rating approach for
borrowers with an aggregate exposure below a specified threshold.
Examiners will evaluate the appropriateness of the alternative rating
approach and aggregate exposure threshold by considering factors such
as the size of the institution, the risk profile of the subject
exposures, and management's portfolio management capabilities.
The following chart summarizes the structure of the proposed
framework:
BILLING CODE 4810-33-P; 6210-01-P; 6714-01-P; 6720-01-P
Chart 1--Framework Overview
[GRAPHIC] [TIFF OMITTED] TN28MR05.018
Appendix A. Application of Framework
The following examples highlight how certain loan facilities
should be rated under the ``Uniform Agreement on the Assessment of
Commercial Credit Risk.''
Example 1. Marginal Borrower Rating
Credit Facility: $100 line of credit for working capital, $50
outstanding
Source of Repayment:
Primary: Cash flow from conversion of assets
Secondary: Security interest in all corporate assets
Collateral: Accounts receivable with a net book value of $70
from large hospitals, nursing care facilities, and other health care
providers. Receivables turn slowly, 120-150 days, but with a low
level of uncollectible accounts. No customer concentrations exceed 5
percent of sales. Modest inventory levels consist of products to
fill specific orders.
Situation: The borrower is a distributor of health care
products. Consolidation of health care providers in the firm's
market area has had a negative effect on its revenues,
profitability, and cash flow. The borrower's balance sheet exhibits
moderate leverage and liquidity. The firm is currently operating at
break-even. The firm has developed a new relationship with a
hospital chain that operates in adjacent markets to the firm's
traditional trade area. The new client is expected to increase sales
by 10 percent in the coming fiscal year. If this expectation
materializes, the borrower should return to profitability. Line
utilization has increased over the last fiscal year; however, the
remaining availability should provide sufficient liquidity during
this slow period.
Borrower Rating: The borrower has shown material negative
financial trends; however, it appears that there is sufficient
financial flexibility to positively address the cause of the
concerns without significant deviation from its original business
plan. Accordingly, the borrower is rated marginal.
The loan is included in criticized assets.
Example 2. Weak Borrower Rating
Credit Facility: $100 line of credit for working capital
purposes, $100 outstanding. Borrowing base equal to 70 percent of
eligible accounts receivable.
Sources of Repayment:
Primary: Cash flow from conversion of assets
Secondary: Security interest in all unencumbered corporate
assets
[[Page 15687]]
Situation: The borrower is a regional truck transportation firm.
A sustained increase in fuel prices over the last six months led to
operating losses. The borrower has been unable to increase prices to
offset the higher fuel prices.
The borrower's interest payments have been running 15 to 30 days
late over the last several months. Net cash flow from operations is
breakeven, but sufficient to meet lease payments on its truck fleet.
The borrower leases all of its trucks from the manufacturer's
leasing company. The line was recently fully drawn to pay
registration fees and insurance premiums for the fleet. The borrower
is moderately leveraged and has minimal levels of liquid assets.
Borrower continues to maintain its customer base and generate new
business, but pricing pressures are forcing it to run unprofitably.
The most recent borrowing base certificate indicates the
borrower is in compliance with the advance rate.
Borrower and
Facility rating: The borrower's unprofitable operations and lack
of liquidity constitute well-defined credit weaknesses. As a result,
the borrower is rated weak.
The loan is included in classified assets.
Example 3. Remote Risk of Loss Facility Rating
Credit Facilities: $100 line of credit to fund seasonal
fluctuations in cash flow
$100 mortgage for the acquisition of farmland
Sources of Repayment:
Primary: Cash flow from operations
Secondary: Security interest in collateral
Collateral: The line of credit is secured by livestock and crops
with a market value of $110. The mortgage is secured by a lien on
acreage valued at $75. A U.S. government agency guarantee was
obtained on the mortgage loan. The guarantee covers 75% of any
principal deficiency the institution suffers on the mortgage.
Situation: Borrower's financial information reflects the
negative effect of low commodity prices and a reduction in the value
of the livestock. The borrower does not have adequate sources of
liquidity to remain operating. Both loans have been placed on
nonaccrual since they are delinquent in excess of 90 days.
Institution management has completed a recent inspection of the
livestock and crops securing their loan. The borrower has placed its
operations up for sale, including all of the collateral securing
both loans. The farmland is under contract with a purchase price of
$75. Management expects to realize after selling expenses $100 from
the sale of livestock and crops and $70 from the sale of the
farmland. As a result, management expects to collect approximately
$20 (75% of $30) under the government guarantee. Management
estimates that the mortgage has impairment of $10 based on the fair
value of the collateral and the guarantee.
Borrower and Facility rating: The borrower is rated default
because the loans are on nonaccrual.
Because the line of credit is adequately collateralized by
marketable collateral, the facility is rated ``remote risk of
loss.'' The portion of the mortgage supported by the sale of the
property and proceeds from the government guarantee, $90, is also
considered ``remote risk of loss.'' The remaining $10 balance is
rated loss due to the collateral shortfall and the unlikely
prospects of collecting additional amounts.
The line of credit and the portion of the mortgage supported by
the government guarantee are included in pass assets.
Example 4. Rating Assignments for Multiple Loans to a Single Borrower
Credit Facilities: $100 mortgage for permanent financing of an
office building located at One Main Street.
$100 mortgage for permanent financing of an office building
located at One Central Avenue.
Sources of Repayment:
Primary: Rental income
Secondary:Sale of real estate
Collateral: Each loan is secured by a perfected first mortgage
on the financed property. The values of the Main Street and Central
Avenue properties are $85 and $110, respectively.
Situation: The borrower is a real estate holding company for the
two commercial office buildings. The Main Street building is not
performing well and is generating insufficient cash flow to maintain
the building, renovate vacant space for new tenants, and service the
debt. The borrower is more than 90 days delinquent on the building's
mortgage. Because the building's rents have declined and its vacancy
rate has increased, the fair market value of the troubled property
has declined to $85 from $120 at the time of loan origination.
Market conditions do not favor better performance of the Main Street
property in the short run. As a result, management has placed the
loan on nonaccrual.
The Central Avenue property is performing adequately, but is not
generating sufficient excess cash flow to meet the debt service
requirements of the first loan. The property is currently estimated
to be worth $110. Since the loan's primary source of repayment
remains adequate to service the debt, the credit remains on accrual
basis.
According to institution management's estimates, foreclosing on
the troubled Main Street building and selling it would realize $75,
net of brokerage fees and other selling expenses. However, the
institution is exploring other workout strategies exclusive of
foreclosure. These strategies may mitigate the amount of loss to the
institution. To be conservative, the institution bases its loss
severity estimate on the foreclosure scenario. If the Central Avenue
building continues to generate sufficient cash flow to service the
loan and maintains its fair market value, the institution does not
expect to incur any loss on the second loan. Therefore, management
assigns a 5 percent loss severity estimate to the facility, which is
equal to its impairment estimate for a pool of similar facilities
and borrowers.
Borrower and Facility Ratings: The borrower is rated default
because the one mortgage is on non-accrual.
The mortgage on the Main Street property is rated ``moderate
loss severity'' (>5% and <=30%) because management's estimate is a
25 percent loss severity. The mortgage on the Central Avenue
property is rated ``low loss severity'' (< =5%) because management's
estimate is a 5 percent loss severity.
Both facilities are included in classified assets.
Example 5. Loss Recognition
Credit Facility: $100 term loan
Source of Repayment:
Primary: Cash flow from business
Secondary: Security interest in collateral
Collateral: The institution has a blanket lien on all business
assets with an estimated value of $60.
Situation: The borrower is seriously delinquent on its loan
payments and has filed for bankruptcy protection. Because the
borrower's business prospects are poor, liquidation of collateral is
the only means by which the institution will receive repayment.
Management estimates net realizable value ranges between $50 and
$60. As a result, management charges off $40 and places the loan on
nonaccrual. Management also assigns a 10 percent loss severity
estimate to the remaining balance, which is equal to its impairment
estimate for a pool of similar facilities and borrowers.
Borrower and Facility Rating: Since the borrower's facility was
placed on nonaccrual and partially charged off, the borrower is
rated default.
After recognizing a loss in the amount of $40, the facility's
remaining balance is rated ``moderate loss severity'' (>5% and <30%)
because management's analysis indicates impairment of 10 percent of
the loan balance.
The loan is included in classified assets.
Example 6. Asset-Backed Loan
Credit Facility: $100 revolving credit facility, $50 outstanding
with $20 available under the borrowing base
Sources of Repayment:
Primary: Conversion of accounts receivable
Secondary: Liquidation of collateral
Collateral: Accounts receivable from companies with investment
grade external ratings.
Situation: The borrower manufactures patio furniture. Because
the prices of aluminum and other raw materials have increased, the
borrower's profit margin has compressed significantly. As a result,
the borrower's financial condition exhibits well-defined credit
weaknesses.
Despite the borrower's financial weakness, the financial
institution is well-positioned to recover its loan balance and
interest. The institution controls all cash receipts of the company
through a lock-box and applies excess funds daily against the loan
balance. The institution also controls the borrower's cash
disbursements. The facility has a borrowing base that allows the
borrower to draw 70 percent of eligible receivables. Eligibility is
based on restrictive requirements designed to exclude low-quality or
disputed receivables. Management monitors adherence to the
requirements by conducting periodic on-site audits of the borrower's
accounts receivable. Management estimates that the facility is not
impaired because the collateral is liquid and has ample coverage,
the account receivables
[[Page 15688]]
counterparties are highly creditworthy, and the institution's
management not only has tight controls on the loan but also has a
favorable track record of managing similar loans. In the event of
the borrower's contractual default, the institution's management
believes that it would recover sufficient cash to repay the loan
within 60 days.
Borrower and Facility Rating: The borrower is rated weak due to
its well-defined credit weaknesses.
The facility is rated ``remote risk of loss'' because of
institutional management's expertise; the facility's strong controls
and high quality; and the collateral's liquidity and ample coverage.
The facility is included in pass assets.
Example 7. Debtor-in-Possession
Credit Facility: $100 debtor-in-possession (DIP) facility, $70
outstanding with $10 available
$100 term loan
Sources of Repayment:
Primary: Cash flow from operations
Secondary: Liquidation of collateral
Collateral: The DIP facility is secured by receivables from
several investment grade companies and underwritten with a
conservative advance rate to protect against dilution risk.
The term loan is secured by equipment.
Situation: The borrower has filed for Chapter 11 bankruptcy
protection because the recall of one of the company's products has
precipitated a substantial decline in sales. The product liability
litigation resulted in substantial legal expenses and settlements.
Because collecting the term loan in full is very unlikely, the
financial institution's management placed the term loan on
nonaccrual prior to the borrower's bankruptcy filing. Management
estimates the institution will collect 70 percent to 80 percent on
their secured claim under the borrower's bankruptcy reorganization
plan. Based on this estimate, management charges off $20 and
estimates impairment of $10 for the remaining balance. The DIP
facility repaid the pre-petition asset-based line of credit.
Management has expertise in asset-based lending and strong controls
over the activity.
Borrower and Facility Rating: The borrower is rated default
since one of its facilities was placed on nonaccrual.
The DIP facility is rated ``remote risk of loss'' not only
because it is secured by high-quality receivables with ample
coverage, but also because the financial institution's management
has performed frequent borrowing-base audits and has strong controls
over cash disbursements and collections. The term loan is rated
``moderate loss severity'' (>5% and <=30%) because management's
impairment estimate for the remaining loan balance falls within this
range.
The DIP facility is included in pass assets.
The term loan is included in classified assets.
Request for Comment
The agencies request comments on all aspects of the proposed
policy statement. In addition, the agencies also are asking for
comment on a number of issues affecting the policy and will consider
the answers before developing the final policy statement. In
particular, your comments are needed on the following issues:
1. The agencies intend to implement this framework for all sizes
of institutions. Could your institution implement the approach?
2. If not, please provide the reasons.
3. What types of implementation expenses would financial
institutions likely incur? The agencies welcome financial data
supporting the estimated cost of implementing the framework.
4. Which provisions of this proposal, if any, are likely to
generate significant training and systems programming costs?
5. Are the examples clear and the resultant ratings reasonable?
6. Would additional parts of the framework benefit from
illustrative examples?
7. Is the proposed treatment of guarantors reasonable?
Please provide any other information that the agencies should
consider in determining the final policy statement, including the
optimal implementation date for the proposed changes.
Dated: March 17, 2005.
Julie L. Williams,
Acting Comptroller of the Currency.
Board of Governors of the Federal Reserve System, March 21,
2005.
Jennifer J. Johnson,
Secretary of the Board.
Federal Deposit Insurance Corporation.
By order of the Board of Directors.
Dated at Washington, DC, this 18th day of March, 2005.
Robert E. Feldman,
Executive Secretary.
Dated: March 18, 2005.
By the Office of Thrift Supervision.
James E. Gilleran,
Director.
[FR Doc. 05-5982 Filed 3-25-05; 8:45 am]
BILLING CODE 4810-33-C
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