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Appeals of Material Supervisory Determinations: Guidelines & Decisions

SARC-99-04 (August 9, 1999)

Your appeal of a material supervisory determination was decided by the Supervision Appeals Review Committee (Committee) of the Federal Deposit Insurance Corporation (FDIC) on July 13, 1999. The Committee considered your appeal of various determinations of the September 21, 1998, FDIC Safety and Soundness examination. After careful review, the Committee concluded that the examination determinations relating to adverse classification of the entire “Finance Company” (X) loan portfolio, methodology and adequacy of the Allowance for Loan and Lease Losses, earnings, and capital are appropriate. The Committee’s findings on these issues are presented below along with an explanation of the reason for the decision.

Adverse Classification Loan Portfolio
The Committee concluded that the adverse classification of X’s entire loan portfolio is appropriate for the reasons noted below.

The X loan portfolio exhibits characteristics similar to the type of loans defined as subprime loans in the March 1999 Federal Financial Institutions Examination Council (FFIEC) financial institution letter (FIL) titled Interagency Guidelines on Subprime Lending. The FIL defines subprime lending, in part, “as extending credit to borrowers who exhibit characteristics indicating a significantly higher risk of default than traditional bank lending customers. Risk of default may be measured by traditional credit risk measures (credit/repayment history, debt to income levels, etc.) or by alternative measures such as credit scores.” Due to their higher risk, subprime loans command higher interest rates and loan fees than those offered to standard risk borrowers. Although insured depository institutions have traditionally avoided lending to customers with poor credit histories, in recent years a number of lenders have extended their risk selection standards to such borrowers. The federal banking agencies have been monitoring, and continue to monitor, this development.

A number of financial institutions have experienced losses attributable to ill-advised or poorly structured subprime lending programs. Further, an economic downturn will tend to adversely affect subprime borrowers earlier and more severely than standard-risk borrowers. This has brought greater supervisory attention to subprime lending and the ability of insured depository institutions to manage the unique risks associated with this activity.

Since acquisition of the loans in 1994, the FDIC has gained considerable knowledge of the portfolio. This knowledge includes a better understanding of the type of borrowers that comprise the portfolio, the risks inherent in your lending activity, history of portfolio losses, and the bank’s risk management program. X customer base encompasses borrowers who generally have limited credit histories or credit histories with derogatory information. Many loans are renewed with only minimum payment history, some with only partial payments made or interest-only payments being made, resulting in no principal reduction. The bank’s renewal policy results in many loans returning to current status, which allows for loan problems to be understated. Unsecured loans coupled with inordinately high interest rates and substantial loan fees are also major characteristics of X’s portfolio. Typically, annual percentage rates (APRs) are 80+ percent, and at times, exceed 100 percent. When interest only is paid, coupled with a 10 percent loan origination fee each time a loan is renewed, a borrower may very well pay in excess of 100 percent of the principal owed. All of these characteristics are attributes of a subprime loan.

Movement of X’s portfolio from Special Mention to adverse classification of the entire portfolio is the result of several factors. Charge-offs have been increasing on a yearly basis since acquisition of the finance company. Twenty-four percent of the portfolio was charged-off in 1998, a dramatic increase from the 15.5 percent that was charged-off in 1995. The portfolio has averaged a 20 percent charge-off rate over the past three years. Additionally, loans 31 to 89 days past due tend to migrate to 90 days past due, necessitating a charge-off. Further demonstrating the risk profile of the portfolio is the assessment of exorbitant interest rates.

In summary, the loan portfolio is adversely classified because of the borrowers’ higher risk of default characteristics, the absence of collateral, and the increasingly high historical loss experience associated with the loan pool. Regulatory classifications used for retail credit are Substandard, Doubtful, and Loss. The less severe classification category, Substandard, is defined as, “As asset 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.” X’s loans less than 30 days past due possess well-defined weaknesses that jeopardize liquidation of the debt, therefore, appropriately receiving adverse classification.

Adequacy of the Allowance of the Allowance For Loan and Lease Losses
The Committee concluded that the methodology used to determine an appropriate level for the Allowance for Loan and Lease Losses (ALLL) conforms to interagency policy guidance. The Committee also agreed with the recommendation to provide an additional $400,000 provision to replenish the ALLL to a minimum acceptable level. Reasons for these conclusions are noted below.

The Interagency Policy Statement on the Allowance for Loan and Lease Losses (Policy Statement), dated December 21, 1993, establishes supervisory policy with respect to the ALLL. The Policy Statement states that federally insured depository institutions must maintain an ALLL at a level that is adequate to absorb estimated credit losses. For pools of loans (such as the X portfolio), estimated credit losses should reflect consideration of the institution’s historical net charge-off rate on pools of similar loans, adjusted for changes in trends, conditions, and other relevant factors that affect loan repayment.

As a point of reference, on March 4, 1999, the FFIEC issued the Interagency Guidelines on Subprime Lending (Interagency Guidance). The Interagency Guidance states that ALLL models driven by the volume and severity of historical losses experienced during an economic expansion may have little relevance in an economic downturn, particularly in the subprime market. The Interagency Guidance further states that management should ensure that models used to estimate credit losses allow for fluctuations in the economic cycle and are adjusted to account for other unexpected events.

The methodology utilized at the September 21, 1998, examination reflects consideration of the institution’s historical net charge-off rate, adjusted for changes in trends, conditions, and other relevant factors that affect loan repayment. The use of a three-year average net loan loss reserve factor is appropriate given the consistent increase in charge-offs, as well as the significantly higher charge-offs in more recent years. Further, the application of an additional reserve factor to those loans not adversely classified Doubtful or Loss appropriately accounts for estimated credit losses that may occur as a result of a downturn in the economy.

The Committee concluded that earnings performance is less than satisfactory for the reasons noted below.

The earnings of a bank are the initial safeguard against the risk of engaging in the business of banking. Earnings, therefore, represent a bank’s first line of defense against capital depletion resulting from losses related to a decline in asset value.

Although the bank has reported positive earnings for the past three years, earnings are overstated due to the need for an additional $400,000 provision to the ALLL. The additional provision expense is necessary to absorb estimated credit losses associated with X’s subprime loan portfolio. Once this provision is reflected in the bank’s 1998 financial statements, the institution will reflect a net operating loss of $189,000 for the year.

In summary, excessive credit risk in the institution’s subprime loan portfolio contributed to an inadequate ALLL and an adjusted net operating loss for 1998. Earnings are insufficient to support operations and maintain appropriate capital and ALLL levels. The establishment of sufficient earnings and ALLL levels would provide for adequate capital support and minimize the risk to the institution.

The Committee concludes that a minimum of $900,000 in additional capital is needed to support the risks associated with X’s subprime loan portfolio. The minimum required capital injection includes a 20 percent Tier 1 Leverage Capital requirement for X’s subprime loan portfolio. The following are reasons for our conclusion.

As a point of reference, the FFIEC issued Interagency Guidelines on Subprime Lending (Interagency Guidance) on March 4, 1999. The Interagency Guidance states that subprime lending presents greater risks for financial institutions and the deposit insurance funds. As such, the level of capital that institutions need to support this activity should be commensurate with the additional risks incurred. Institutions should determine how much additional capital they need to offset the risk taken in their subprime lending activities and document the methodology used to determine this amount. The Interagency Guidance also states that in light of the higher risks associated with this type of lending, the agencies may impose higher minimum capital requirements on institutions engaged in subprime lending.

The $900,000 capital injection requested in the September 21, 1998, Report of Examination is appropriate in light of the seriousness of the supervisory concerns identified. The overall financial condition of the institution is poor, having deteriorated significantly as a result of weaknesses associated with the subprime lending program. A concentration of unsecured subprime loans (representing 808 percent of Tier 1 Capital) poses excessive risk to the institution. Asset quality is poor, and the institution’s capital level does not support the high degree of risk in the subprime loan portfolio. Given the borrowers’ limited ability to repay the debts, the absence of collateral, the liberal renewal practices that mask past-due status, and the high level of net loan losses, the entire X loan portfolio is adversely classified. The volume of Substandard and Doubtful loans, representing 247 percent of total capital, is inordinately high as a result of the adverse classification of the X portfolio. Earnings do not represent a source of capital augmentation given an inadequate ALLL and an additional needed provision expense. Also, dividends during 1998 represented 95 percent of net income, further restricting capital augmentation. Each of these items indicates a higher risk profile that warrants maintenance of capital at levels well above required regulatory minimums.

Additional support for the required capital injection derives from industry data obtained from the FDIC’s Division of Insurance (DOI). The DOI data indicates that the institution’s consolidated net loan losses for 1997 and 1998 have ranked within the top six institutions in the industry for the highest net loan losses. The data also shows that the institution’s quarterly net loan loss ratio has been among the most volatile in the industry. Finally, the data indicates that the average capital ratio of publicly traded subprime portfolio lenders is 20.8 percent, a stark contrast from the capital levels maintained by the bank. Accordingly, the use of a 20 percent Tier 1 Leverage Capital ratio for the subprime loan portfolio is prudent.

These determinations constitute the final decision of the FDIC.

By direction of the Supervision Appeals Review Committee of the FDIC.