Large Bank Conference Regulatory Update

1. Large Bank Conference Regulatory Update Loss-Sharing Agreementsand Related Accounting Topics Robert Warren FDIC Regional Accountant Atlanta Regional Office Division of Risk Management Supervision December 8, 2011

2. Loss-Sharing Agreements • When an acquiring institution has entered into a loss sharing agreement with the FDIC in connection with an acquisition of a failed financial institution: • The assets covered by the loss sharing agreements should be recorded in their respective balance sheet categories (i.e., loans, OREO, securities) • The loss sharing agreement should be valued and recorded separately on the face of the balance sheet or grouped within other assets if not material • Call Report: Schedule RC-F (All Other Assets), item 6.e. (FDIC loss-sharing indemnification assets)

3. Loss-Sharing Agreements • Accounting for the FDIC loss-sharing agreement is based on the guidance for indemnification assets in ASC Topic 805, Business Combinations • Initially measure the indemnification asset related to the assets covered by the loss-sharing agreement in a manner consistent with the initial measurement of the indemnified items • Covered loans and securities are measured at acquisition date fair value • Covered other real estate owned is measured at acquisition date fair value less cost to sell

4. Loss-Sharing Agreements • Indemnification asset is measured at acquisition date fair value • Fair value should reflect estimate of the amount and timing of the expected future cash flows to be received from the FDIC under the agreement • The assumptions used in estimating the fair value of the indemnification asset should be consistent with those used to estimate of the fair values of the covered assets • Retrospectively adjust provisional fair value estimates to appropriate acquisition date fair values to reflect new information about acquisition date facts and circumstances obtained during the measurement period

5. Loss-Sharing Agreements • Subsequent accounting for indemnification asset • Measure asset on the same basis as the covered assets • Approach is intended to reduce earnings volatility • Also assess asset for impairment • Covered loans – decrease in expected cash flows • Results in increase in expected cash flows from FDIC under loss-sharing agreement

6. Loss-Sharing Agreements • For a covered purchased credit-impaired (PCI) loan accounted for under ASC Subtopic 310-30 (former SOP 03-3) • Recognize a loan loss allowance and provision expense • Also reclassify portion of accretable yield to nonaccretable difference • Recognize increase in indemnification asset and noninterest income for reimbursable percentage of decrease in expected cash flows covered by FDIC • For a covered non-PCI loan accounted for under ASC Subtopic 310-20 (former FAS 91) • Same accounting as above, but without reclassification

7. Loss-Sharing Agreements • Covered loans – increase in expected cash flows • Results in decrease in expected cash flows from FDIC under loss-sharing agreement • For a covered PCI loan • Reduce post-acquisition loan loss allowance, if any • Reclassify portion of nonaccretable difference to accretable yield, which will be recognized prospectively as an adjustment of loan’s yield over its remaining life • For a covered non-PCI loan • Reduce post-acquisition loan loss allowance, if any • No other entry needed, which means that cash flow increase will be recognized prospectively in income

8. Loss-Sharing Agreements • Impact of decrease in expected cash flows from FDIC on indemnification asset – possible accounting alternatives • Recognize decrease as an impairment of indemnification asset and a charge to noninterest income/expense • Does not produce income statement symmetry with accounting for covered loan, i.e., “same basis” accounting not achieved OR

9. Loss-Sharing Agreements • Recognize decrease prospectively through reduction of undiscounted expected cash flows from FDIC, thereby reducing discount on indemnification asset and yield used to accrete discount over asset’s remaining life (i.e., no change in asset’s carrying amount) • Achieves income statement symmetry with accounting for covered loan • However, may result in a negative discount and negative yield (i.e., indemnification asset’s carrying amount exceeds undiscounted expected cash flows from FDIC)

10. Loss-Sharing Agreements • The allowance for loan losses should be determined without giving consideration to the loss sharing agreement (since the loss sharing agreement is separately accounted for and thus “gross” on the balance sheet) • The provision for loan losses may be net of changes in the amount receivable from the loss sharing agreement, with appropriate disclosure of the effects of the loss sharing agreement on the provision for loan losses • For Call Reports proposes, these amounts should be reported separately and not netted

11. Loss-Sharing Agreements • True-up Payments under Loss-Sharing Agreements (a/k/a “claw-back provision”) • Agreement may require acquiring institution to reimburse the FDIC when loss-sharing ends if FDIC’s initially estimated losses on covered assets are overstated and actual realized losses are less

12. Loss-Sharing Agreements

13. Loss-Sharing Agreements • True-up Payments (cont.) • Obligation for payment represents a form of contingent consideration under ASC Topic 805, Business Combinations • At initial recognition as of acquisition date, measure obligation at fair value • Fair value is part of consideration transferred by acquirer to acquire the failed institution, which reduces bargain purchase gain (or goodwill) • Report obligation as a liability • Do not net liability against indemnification asset • Subsequently measure obligation at fair value, with changes in fair value recognized in earnings

14. Loss-Sharing Agreements • No carryover of ALLL at acquisition • Do not recognize an ALLL for the contractual cash flows on the acquired loans that are deemed to be uncollectible at the acquisition date • Uncertainty about the future cash flows are included in their estimated acquisition-date fair values • Establish loan loss allowances for acquired held-for-investment loans in periods after the acquisition date • But only for losses incurred due to credit deterioration after acquisition

15. Loss-Sharing Agreements • Subsequent (Day 2) Loan Accounting: • ASC Subtopic 310-30, Loans and Debt Securities acquired with Deteriorated Credit Quality (SOP 03-3) • Purchased Credit Impaired (PCI) Loans • Subtopic 310-10, Receivables – Overall (FAS 114) • Subtopic 450-20, Contingencies – Loss Contingencies (FAS 5)

16. Purchased Credit Impaired Loans • ASC Subtopic 310-30, “Receivables − Loans and Debt Securities Acquired with Deteriorated Credit Quality” (formerly AICPA SOP 03-3) • Applies to “purchased credit impaired loans” (PCI loans), i.e., individual loans “with evidence of deterioration of credit quality since origination acquired by completion of a transfer for which it is probable, at acquisition, that the investor will be unable to collect all contractually required payments receivable”

17. Purchased Credit Impaired Loans • Aggregation under ASC Subtopic 310-30 • Investors may aggregate individual PCI loans acquired in same fiscal quarter that have common risk characteristics and account for them as a pool • Upon establishment of the pool, the pool becomes the unit of account • Purchase discount is not allocated to individual loans • All of the loans in the pool accrete at a single pool (composite) interest rate based on the cash flow projections for the pool • Impairment analysis is performed on the pool as a whole rather than for each individual loan

18. Purchased Credit Impaired Loans • Aggregation under ASC Subtopic 310-30 (cont.) • On an ongoing basis, investor should estimate cash flows expected to be collected on the loans in the pool over the life of the pool • If, upon evaluation, it is probable based on current information and events that investor is unable to collect all cash flows expected at acquisition on the loans in the pool,* the pool should be considered impaired and an allowance for post-acquisition credit losses should be established * Plus any additional cash flows expected to be collected on the loans in the pool arising from previous changes in estimate after acquisition

19. Purchased Credit Impaired Loans • Aggregation under ASC Subtopic 310-30 (cont.) • Once a pool is assembled, integrity of pool should be maintained • A loan should be removed from a pool only if the investor receives assets in satisfaction of the loan (e.g., though foreclosure) or the loan is sold or written off, and the loan should be removed at its carrying amount • Per ASU No. 2010-18, issued April 2010, a modification of a PCI loan accounted for within a pool does not result in the removal of the loan from the pool even if the modification would otherwise be considered a troubled debt restructuring

20. Purchased Credit Impaired Loans • Aggregation under ASC Subtopic 310-30 (cont.) • Investor must consider whether the modification of the PCI loan in the pool results in a change in cash flows expected to be collected on the loans in the pool over the life of the pool, i.e., impairment or additional impairment • PCI loans accounted for individually (i.e., not as part of a pool) under Subtopic 310-30 are subject to the troubled debt restructuring accounting provisions of Subtopic 310-40, “Receivables − Troubled Debt Restructurings by Creditors”

21. Purchased Credit Impaired Loans • Reporting PCI loans as past due or nonaccrual in the Call Report • PCI loan accounted for individually • When accrual of income is appropriate, determine delinquency status of loan in accordance with its contractual repayment terms • When accrual of income is not appropriate, place loan in − and report loan as being in − nonaccrual status

22. Purchased Credit Impaired Loans • Reporting PCI loans as past due or nonaccrual in the Call Report (cont.) • PCI loans accounted for on a pool basis • When accrual of income on pool is not appropriate, place entire pool in − and report entire pool as being in − nonaccrual status • When accrual of income on pool is appropriate, determine delinquency status of individual loans in the pool − and report individual loans in the pool as past due − in accordance with each loan’s contractual repayment terms • Do not report individual loans in the pool as nonaccrual

23. Adverse Classification of Assets Covered by LSA • Day 1 • Book Value at Failed Institution $100,000 • Credit Loss Estimate 20,000 • FV to Acquiring Institution (AI) $ 80,000 • AI Carrying Amt • At acquisition AI books an Indemnification Asset $ 16,000 • ($20,000 x 80%) • The AI does not book an allowance on Day 1. The uncertainty about the future cash flows on the acquired loan, including collectability concerns, was included in estimated acquisition-date FV • Day 2 • There has been further deterioration on the acquired loan. The AI does not expect to collect an additional $10,000 • At the time of the examination the bank has not accounted for the credit impairment in the allowance. Before considering the LSA, examiners would classify the loan as follows: Assume the Carrying Amt of Loan is $80,000 • Substandard $70,000 • Loss $10,000

24. Adverse Classification of Assets Covered by LSA • After considering LSA, examiners would show the following classified amounts: • Substandard $70,000 (20%) $14,000 • Loss $10,000 (20%) $ 2,000 • Entries required by Bank for Call Report • Indemnification Asset $8,000 • Other Operating Income $8,000 • (increase in FDIC receivable for additional $10,000 covered loss) • Provision Loan and Lease Losses $10,000 • Allowance for Loan Losses $10,000 • (provision expense/charge-off for additional impairment)

25. Best Practices • Fair Value evaluations by qualified, independent party • Accounting consultations from qualified, independent party • Internal Audit by qualified party • Procedures and systems for purchased impaired loans (ASC 310-30/SOP 3-03) • Written policies and procedures to account for: • losses on covered loans after acquisition • indemnification asset

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