real estate loans effective date july 1997 section 3100 estate loans effective date july 1997...

Real Estate LoansEffective date July 1997 Section 3100.1

Real estate lending is a major function of somebranches. However, the composition of realestate loan portfolios will vary from branch tobranch because of differences in strategic direc-tion, asset size, lending experience, market con-ditions, and location. This section of the manualdeals with the permanent financing of residentialand commercial real estate. Also included in thissection are discussions on real estate appraisalsand environmental liability. Real estate construc-tion lending is discussed separately in the fol-lowing section of this manual.

Due to the differences in individual statebanking laws, this section of the manual pro-vides a general overview of the supervisory andregulatory requirements for a safe and soundreal estate lending program. For information onlending limitations and restrictions, refer to theapplicable banking laws and regulations thatgovern federally-insured and state-licensedbranches.

REAL ESTATE LENDING POLICY

The branch’s real estate lending policy is abroad statement of the standards, guidelines, andlimitations that senior branch management andlending officers are expected to adhere to in theprocess of making a real estate loan. The main-tenance of prudent written lending policies,effective internal systems and controls, andthorough loan documentation is essential to thebranch’s management of the real estate lendingfunction.

The policies governing a branch’s real estatelending activities must include prudent under-writing standards that are periodically reviewedby head office management and clearly commu-nicated to the branch’s management and lendingstaff. The branch should also have credit riskcontrol procedures that include, for example,prudent internal limits on exposure and aneffective credit review and problem loan identi-fication process. The complexity and scope ofthese policies and procedures should be appro-priate to the size of the branch and the nature ofthe branch’s activities, and should be consistentwith prudent banking practices and relevantregulatory requirements. As part of the analysisof a branch’s real estate loan portfolio, examin-ers should review lending policies, loan admin-

istration procedures, and credit risk control pro-cedures as well as the branch’s compliance withits policy.

On March 19, 1993, a uniform rule on realestate lending by insured depository institutionspromulgated by the federal banking agenciesbecame effective. Although the rule does notdirectly apply to uninsured branches, it shouldbe used as a general supervisory guide whenreviewing loan portfolios, procedures, and prac-tices at all branches. The rule requires eachinsured depository institution to adopt and main-tain comprehensive written real estate lendingpolicies that are consistent with safe and soundbanking practices, are appropriate to the size ofthe institution, and the nature and scope of itsoperations. The policies must establish loan-to-value limits; loan administration procedures;portfolio diversification standards; and documen-tation, approval, and reporting requirements.The policies adopted by the branch shouldreflect consideration of the Interagency Guide-lines for Real Estate Lending Policies estab-lished by the federal banking agencies. In addi-tion to the requirements of the uniform rule, abranch’s real estate lending policy should includeprincipal amortization terms acceptable for eachtype of real estate loan that the branch under-writes. Branch management should also ensurethat loans are granted with the reasonableexpectation that the borrowers will be able andwilling to meet the repayment terms. Any loanthat does not follow this principle should beregarded as an unsound banking practice, regard-less of the collateral value and favorable ratio ofcollateral value to the outstanding loan. Whilethere is no single lending policy appropriate forall branches, there are basic elements that abranch should consider in formulating its policy,including:

• Allocation of funds (i.e., maximum exposure)for real estate lending;

• Definition of acceptable loans that the branchwould consider making and the minimumterms that are acceptable to the branch (i.e.,amortization rates and cash flow coverageratio by loan type);

• Geographic area in which the branch willconsider lending;

• Minimum standards for credit analysis andloan documentation, including real estateappraisal and evaluation policies;

Branch and Agency Examination Manual September 1997

• Minimum credit criteria that a borrower mustmeet for the credit to be considered by thebranch;

• Maximum loan amounts and loan maturitiesthat can be extended on a given property type;

• Maximum aggregate loan amounts that maybe extended for a given category of real estateloans and for all other real estate loans;

• Required pricing structure for each type ofloan;

• Definition of lending authorities and loanapproval process;

• Structure and procedures for administratingthe disbursement and servicing of the branch’sreal estate loan portfolio;

• System for monitoring troubled loans;• Regular review of procedures and practices to

ensure compliance with the branch’s lendingpolicy and safe and sound lending practices;and

• Procedures for originating and purchasingloans with loan-to-value ratios in excess ofthose limits discussed in the InteragencyGuidelines for Real Estate Lending Policies,based on the support provided by other creditfactors.

REAL ESTATE LENDINGACTIVITY AND RISKS

Real estate lending falls into two broad catego-ries: short-term financing (i.e., constructionloans) and permanent financing (e.g., a 30-yearresidential mortgage or 10-year balloon mort-gage on an existing commercial office building).Each type of lending carries with it uniqueunderwriting risks and common risks associatedwith any type of lending. In all cases, the branchshould understand the credit risks and structureof the proposed transaction, even if it is not theoriginating lender. This policy includes, at aminimum, evaluating the financial strength ofthe borrower to repay the debt and the value ofthe underlying real estate collateral.

Permanent financing, as the name implies, islong-term in nature and presents a funding riskbecause a branch’s source of funds is generallyof a shorter maturity. Accordingly, branch man-agement should be aware of the source forfunding this lending activity. While matchingthe maturity structures of assets to liabilities isparticularly important for a branch’s overallloan portfolio management, the importance of

this task is even more evident in real estatelending activity. Many institutions reduce theirfunding risk by entering into loan participationsand sales with other institutions and asset secu-ritization transactions.1

For a detailed discussion on short-term financ-ing, see the manual section on Real EstateConstruction Loans.

UNSOUND LENDING PRACTICES

Some institutions have adversely affected theirfinancial condition and performance by grantingloans based on ill-conceived real estate projects.Apart from losses due to unforeseen economicdownturns, these losses have generally been theresult of poor or lax underwriting standards andimproper management of the institution’s over-all real estate loan portfolio.

A principal indication of an unsound lendingpractice is an improper relationship between theloan amount and the market value of the prop-erty; for example, a high loan-to-value ratio inrelation to normal lending practice for a similartype of property. Other unsafe and unsoundlending practices include the failure of theinstitution to examine the borrower’s debt ser-vice ability, or inappropriate loan structure suchas capitalizing interest on a term loan, notrequiring principal amortization, or ‘‘ever-green’’ lending—i.e. extending a short-term loanfor long-term purposes. For a commercial realestate loan, sound underwriting practices arecritical to the detection of problems in theproject’s plans, such as unrealistic incomeassumptions, substandard project design, poten-tial construction problems, and a poor marketingplan that will affect the feasibility of the project.

REAL ESTATE LOAN PORTFOLIOCONCENTRATION RISK

A branch should have in place effective internalpolicies, systems, and controls to monitor andmanage its real estate loan portfolio risk. Anindication of improper management of a branch’sportfolio is an excessive concentration in loans

1. See the section on Asset Securitization for additionalinformation, including information on mortgage-backed secu-rities (MBSs), collateralized mortgage obligations (CMOs),and real estate mortgage investment conduits (REMICS).

3100.1 Real Estate Loans

September 1997 Branch and Agency Examination Manual

to one borrower or related borrowers, in onetype of real estate loan, or in a geographiclocation outside the branch’s designated tradearea. In the case of a branch, examiners shouldbase their initial review of asset concentrationson the total assets of the branch. (See the CreditRisk Management section for further informa-tion on branch concentrations.)

In identifying loan concentrations, commer-cial real estate loans and residential real estateloans should be viewed separately when theirperformance is not subject to similar economicor financial risks. However, groups or classes ofreal estate loans should be viewed as concentra-tions when there are significant common char-acteristics and the loans are affected by similaradverse economic, financial, or business devel-opments. Institutions with asset concentrationsshould have effective internal policies, systems,and controls in place to monitor and manage thisrisk.

Concentrations that involve excessive orundue risks require close scrutiny by the branchand head office management, and should bereduced over a reasonable period of time. Toreduce this risk, the branch should develop aprudent plan and institute strong underwritingstandards and loan administration to control therisks associated with new loans.

LOAN ADMINISTRATION ANDSERVICING

Real estate loan administration is responsible forcertain aspects of loan monitoring. While theadministration may be segregated by propertytype, such as residential or commercial realestate loans, the functions of the servicingdepartment may be divided into the followingcategories (although the organization will varyamong institutions):

Loan closing and disbursement—preparing thelegal documents verifying the transaction,recording the appropriate documents in the pub-lic land records, and disbursing funds in accor-dance with the loan agreement.

Payment processing—collecting and applyingthe loan payments.

Escrow administration—collecting insurancepremiums and property taxes from the borrower

and remitting the funds to the insurance com-pany and taxing authority.

Collateral administration—maintaining docu-ments to reflect the status of the branch’s lien onthe collateral (i.e., mortgage/deed of trust andtitle policy/attorney’s opinion), the value of thecollateral (i.e., real estate appraisal or evaluationand verification of senior lien, if in existence),and the protection of the collateral (i.e., hazard/liability insurance and tax payments).

Loan pay-offs—determining the pay-off amount,preparing the borrower release or assumptiondocuments, confirming the receipt of funds, andrecording the appropriate lien-release docu-ments in the public land records.

Collections and foreclosure—monitoring the pay-ment performance of the borrower and pursuingcollection of past-due amounts in accordancewith branch policy on delinquencies.

Claims processing—seeking recoveries ondefaulted loans that are covered by a govern-ment guarantee or insurance program or a pri-vate mortgage insurance company.

The branch should have adequate proceduresto ensure segregation of duties for disbursal andreceipt of funds control purposes. Additionally,the procedures should address the need fordocument control because of the importance ofthe timely recording of the branch’s securityinterests in the public land records.

Some institutions provide various levels ofloan services for other institutions, which mayrange from the distribution of payments receivedto the ultimate collection of the debt throughforeclosure. In such cases, the branch will havethe additional responsibility of remitting fundson a timely basis to the other institutions, inaccordance with a servicing agreement. Theservicing agreement sets forth the servicer’sduties, reporting requirements, time frame forremitting funds, and fee structure. If one insti-tution relies upon another institution for servic-ing, the branch should have adequate controland audit procedures to verify the performanceof the servicer (also see the manual section onAsset Securitization). For residential loans soldinto the secondary mortgage market for whichthe branch has retained servicing, the FederalNational Mortgage Association (FNMA), theFederal Home Loan Mortgage Corporation

Real Estate Loans 3100.1


(FHLMC), and the Government National Mort-gage Corporation (GNMA) have specific stan-dards to which the branch (i.e., seller/servicer)must adhere. Failure to meet these standards canresult in the termination of the servicingagreement.

ASSESSMENT OF THEBORROWER

While the value of the real estate collateral is animportant component of the loan approval pro-cess, the branch should not place undue relianceupon the collateral value in lieu of an adequateassessment of the borrower’s ability to repay theloan. These assessment factors will differdepending upon the purpose of the loan, such assingle family residential loans compared toincome producing commercial property loansand commercial or residential development loans(referred to as ‘‘commercial real estate lend-ing’’). The loan documentation must adequatelysupport the branch’s assessment of the borrowerand contain the appropriate legal documentationto protect the branch’s interests.

Single Family Residential Loans

Some branches make single family residentialloans, typically to branch employees. As withother such loans, the branch should evaluate theapplicant’s creditworthiness and determinewhether the individual has the ability to meetmonthly mortgage payments and meet all otherobligations and expenses associated with homeownership. This process includes an assessmentof the applicant’s income, liquid assets, employ-ment history, credit history, and existing obliga-tions.2 The branch should also consider theavailability of private mortgage insurance, agovernment guarantee, or a government insur-ance program, such as loans through the FHA-insured or VA-guaranteed programs, in assess-ing the credit risk of a loan applicant.

If a branch delegates the loan originationfunction to a third party, the branch should haveadequate controls to ensure that its loan policiesand procedures are being followed. The controlsshould include a review of the third party’squalifications; a written agreement between thebranch and the third-party originator to set forththe responsibilities of the third party as an agentfor the branch; a periodic review of the thirdparty’s operations to ensure that the branch’spolicies and procedures are being followed; anddevelopment of quality controls to ensure thatloans originated by the third party meet thebranch’s lending standards and those of thesecondary mortgage market, if the branch expectsto sell the mortgages.

Secondary Residential MortgageMarket

In the secondary market, a branch (the primarymortgage originator) sells all or a portion of itsinterest in residential mortgages to other finan-cial institutions (investors). Thus, the secondarymortgage market provides an avenue for abranch to liquidate a long-term asset, as the needfor funds arises. The majority of the secondarymortgage market activity is supported by threegovernment-related or controlled institutions:FNMA,3 FHLMC,4 and GNMA5. These entitieswere created or sponsored by the federal gov-ernment to encourage the financing and construc-tion of residential housing. FNMA, FHLMC,and GNMA have specific underwriting stan-dards and loan documentation requirements formortgages, which they purchase or guarantee.

2. There are restrictions on the information that federally-insured branches can request. The Federal Reserve’s Regula-tion B, Equal Credit Opportunity (12 CFR 202), details theinformation that may and may not be requested on a loanapplication and provides a model form for a residentialmortgage transaction; and Regulation Z, Truth in Lending (12CFR 226), describes the disclosure requirements to the poten-tial borrower on the cost of financing.

3. Although FNMA was originally created in 1938 as anorganization within the federal government, it became afederally chartered, stockholder corporation in 1968, whensome of its functions were placed under the newly createdGNMA. Financial institutions can either sell mortgagesdirectly to FNMA or pool mortgages for placement in aFNMA-guaranteed mortgage-backed security.

4. FHLMC was sponsored by the Federal Home LoanBank Board and its members in 1970. Its primary purpose isto provide a secondary market for conventional mortgagesoriginated by thrifts.

5. GNMA, a government agency under the Department ofHousing and Urban Development (HUD), was created in 1968when FNMA became a private corporation. It has severalfunctions to assist in government housing programs, such asmanaging and liquidating loans acquired by the government.In the secondary market, GNMA acts as a guarantor ofmortgage-backed securities for pools of loans originated andsecuritized by financial institutions.



Generally, financial institutions enter into eithera mandatory or a standby commitment agree-ment with these entities, wherein the financialinstitution agrees to sell loans according tocertain delivery schedules, terms, and perfor-mance penalties.

Commercial Real Estate Loans

As with other types of lending activities, theextent of commercial real estate lending activityshould be contingent upon the lender’s expertiseand the branch’s experience. In considering anapplication for a commercial real estate loan, abranch should understand the relationship of theactual borrower to the project being financed.The form of business ownership varies forcommercial real estate projects and can affectthe financial resources available for the comple-tion of the project and the management andrepayment of the loan.

Information on past and current projects con-structed, rented, or managed by the potentialborrower can help the branch assess the borrow-er’s experience and the likelihood of the pro-posed project’s success. For development andconstruction projects, the branch should closelyreview the project’s feasibility study. The studyshould provide sensitivity and risk analyses ofthe potential impact of changes in key economicvariables, such as interest rates, vacancy rates,or operating expenses. The branch should alsoconduct credit checks of the borrower and of allprincipals involved in the transaction to verifyrelationships with contractors, suppliers, andbusiness associates.

Finally, the branch should assess the borrow-er’s financial strength to determine if the prin-cipals of the project have the necessary workingcapital and financial resources to support theproject until it reaches stabilization. As with anytype of lending on income-producing proper-ties,6 the branch should quantify the degree ofprotection from the borrower’s (or collateral’s)cash flow, the value of the underlying collateral,and any guarantees or other collateral that maybe available as a source of loan repayment.

ASSESSMENT OF THE REALESTATE COLLATERAL

Branches should obtain an appraisal or evalua-tion, as required by any applicable federal orstate laws or regulations, for all real estate-related financial transactions, before making thefinal credit or other decision. (Refer to the RealEstate Appraisals and Evaluations part of thissection for additional information.) The appraisalsection explains the standards for appraisals,indicates which transactions should have anappraisal or an evaluation, provides guidelineson qualifications for an appraiser and evaluator,provides guidance on evaluations, and describesthe three appraisal approaches for a CompleteAppraisal.

Management is responsible for determiningwhether the assumptions and conclusions of theappraisal or evaluation are reasonable. In addi-tion, management’s rationale for accepting andrelying upon the appraisal or evaluation shouldbe documented in writing. In assessing theunderwriting risks, management should recon-sider any assumptions used by an appraiser thatreflect overly optimistic or pessimistic values. Ifmanagement, after its review of the appraisal orevaluation, determines that there are unsubstan-tiated assumptions, the branch may request theappraiser or evaluator to provide a more detailedjustification of the assumptions or obtain a newappraisal or evaluation.

Single Family Residential Loans

The assessment of the residential property’smarket value is critical to the branch’s estimateof loan-to-value ratio. This assessment providesthe branch with an estimate of the borrower’sequity in the property and the branch’s potentialcredit risk, if the borrower should default on theloan. While transactions under $250,000 maynot require an appraisal, a branch is expected toperform an appropriate evaluation of the under-lying real estate collateral. Additionally, statelaws for appraisals may differ from federalregulatory or internal requirements.

Commercial Real Estate Loans

Due to the variety of uses and the complexity ofmost commercial projects, there is no uniformly

6. Income-producing commercial properties include rentalapartments, retail properties, office buildings, warehouses, andhotels.



accepted format for valuing commercial proper-ties as there is for valuing one-to-four familyresidential properties. A branch relies uponoutside appraisers or, in some instances, in-houseexpertise to prepare appraisals. For the mostpart, appraisals on commercial real estateprojects are presented in a narrative format withsupporting schedules. As the complexity of acommercial project increases, the detail of theappraisal report or evaluation should alsoincrease to fully support the analysis.

When estimating the value of income-producing real estate, the appraiser generallyrelies on the income approach to valuation to agreater degree than on the comparable salesapproach or the cost approach. The incomeapproach converts all expected future net oper-ating income into present value terms usingdifferent analytical methods. One method, knownas the direct capitalization method, estimates thepresent value of a property by discounting itsstabilized net operating income at an appropriatecapitalization rate (commonly referred to as acap rate). Stabilized net operating income is thenet cash flow derived from a property whenmarket conditions are stable and no unusualpatterns of future rents and occupancy areexpected. To approximate stabilized net operat-ing income, the appraiser or branch may need toadjust the current net operating income of aproperty either up or down to reflect currentmarket conditions. The direct capitalizationmethod is appropriate only for use in valuingstabilized properties.

Another method, known as the discountedcash flow method, requires the discounting ofexpected future cash flows, at an appropriatediscount rate, to determine the net present valueof a property. This method is appropriate for usein estimating the values of new properties thathave not yet stabilized or for troubled propertiesthat are experiencing fluctuations in income.

The discount rates and cap rates, used inestimating property values, should reflect rea-sonable expectations about the rate of return thatinvestors and lenders require under normal,orderly, and sustainable market conditions. Theappraiser’s analysis and assumptions should sup-port the discount and cap rates used in theappraisal. The appraiser should not use exagger-ated, imprudent, or unsustainably high orlow discount rates, cap rates, or incomeprojections.

In assessing the reasonableness of the factsand assumptions associated with the valuation

of commercial real estate, the branch shouldconsider:

• Current and projected vacancy and absorptionrates;

• Lease renewal trends and anticipated rents;• Volume and trends in past due leases;• The project’s feasibility study and market

survey to determine support for the assump-tions concerning future supply and demandfactors;

• Effective rental rates or sale prices (taking intoaccount all concessions);

• Net operating income of the property com-pared to budget projections; and,

• Discount rates and direct capitalization rates.

Because the income approach is generallyrelied upon to a greater degree than the othermethods, with specific emphasis on arriving atstabilized values, the branch must use judgmentin determining the time it will take for a prop-erty to achieve stabilized occupancy and rentalrates. The analysis of collateral values shouldnot be based on a simple projection of currentlevels of net operating income if markets aredepressed or reflect speculative pressures butcan be expected over a reasonable period of timeto return to normal (stabilized) conditions.

The capacity of a property to generate cashflow to service a loan is evaluated on the basis ofrents (or sales), expenses, and rates of occu-pancy that are reasonably estimated to beachieved over time. The determination of thelevel of stabilized occupancy, rental rates, andnet operating income should be based on ananalysis of current and reasonably expectedmarket conditions, taking into consideration his-torical levels, when appropriate.

EARLY INDICATIONS OFTROUBLED COMMERCIAL REALESTATE LOANS

Market Related

To evaluate the collectibility of their commer-cial real estate portfolio, branches should bealert for economic indicators of weakness intheir real estate markets and for indicators ofactual or potential problems in the individualcommercial real estate projects. Available indi-cators, which may be useful in evaluating the



condition of the local real estate market, includepermits for and the value of new construction,absorption rates, employment trends, vacancyrates, and tenant lease incentives. Weaknessesdisclosed by these types of statistics may signifythat a real estate market is experiencing difficul-ties that may cause cash flow problems forindividual real estate projects, declining realestate values and ultimately, troubled real estateloans.

Project Related

Characteristics of potential or actual difficultiesin commercial real estate projects may include:

• An excess supply of similar projects underconstruction in the same trade area;

• The lack of a sound feasibility study oranalysis that reflects current and reasonablyanticipated market conditions;

• Changes in concept or plan (for example, acondominium project converted to an apart-ment project because of unfavorable marketconditions);

• Rent concessions or sales discounts, resultingin cash flow below the level projected in theoriginal feasibility study, appraisal orevaluation;

• Concessions on finishing tenant space, mov-ing expenses, and lease buyouts;

• Slow leasing or lack of sustained sales activityand increasing sales cancellations that mayreduce the project’s income potential, result-ing in protracted repayment or default on theloan;

• Delinquent lease payments from major tenants;• Land values that assume future rezoning;• Tax arrearages; and,• Environmental hazards and liability for cleanup.

As the problems associated with a commer-cial real estate loan become more pronounced,the borrower/guarantor may experience a reduc-tion in cash flow to service related debts, whichcould result in delinquent interest and principalpayments.

While some real estate loans become troubledbecause of a general downturn in the market,others become troubled because the loans wereoriginated on an unsound or a liberal basis.Common examples of unsound loans include:

• Loans with little or no borrower equity;

• Loans on speculative, undeveloped propertywhere the borrower’s only source of repay-ment is the sale of the developed property;

• Loans based on land values that have beendriven up by rapid turnover of ownership butwithout any corresponding improvements tothe property or supportable income projec-tions to justify an increase in value;

• Additional advances to service an existingloan without evidence that the loan will berepaid in full;

• Loans to borrowers with no developmentplans or noncurrent development plans;

• Renewals, extensions, and refinancings thatlack credible support for full repayment fromreliable sources and that do not have a reason-able repayment schedule7;

• Evergreen loans—short-term, interest-onlyloans that are renewed annually with no pro-vision for repayment. Although structured as ashort-term loan, these loans are intended forlong-term purposes such as for the acquisitionor development of real estate;

• Loans that continue to capitalize interest afterconstruction is completed because of slowerthan anticipated lease-up;

• Loans with no meaningful principal amortiza-tion, instead relying on price appreciation andthe sale of property for repayment; and,

• Loans that are funded before zoning isobtained, water rights acquired, or an environ-mental study is performed.

EXAMINER REVIEW OFCOLLATERAL VALUE

The focus of an examiner’s review of a realestate loan is on the ability of the loan to berepaid. The principal factors that bear on thisreview are the income-producing potential ofthe underlying collateral and the borrower’swillingness and ability to repay the loan fromother resources, if necessary, and according toexisting loan terms. In evaluating the overallrisk associated with a real estate loan, examinersshould consider a number of factors, including

7. As discussed more fully in the section on Asset QualityClassifications, the refinancing or renewing of loans to soundborrowers would not result in a supervisory classification orcriticism unless well-defined weaknesses exist that jeopardizerepayment of the loans. Consistent with sound bankingpractices, institutions should work in an appropriate andconstructive manner with borrowers who may be experiencingtemporary difficulties.



the borrower’s character, overall financial con-dition and resources, and payment history; theprospects for support from any financiallyresponsible guarantors; and the nature and degreeof protection provided by the cash flow andvalue of the underlying collateral.8 As the bor-rower’s and guarantor’s ability to repay atroubled real estate loan decreases, the impor-tance of the collateral value of the loan increasescommensurately.

An examiner’s analysis of the collateral valueis based on the branch’s most recent appraisal orevaluation and includes a review of the majorfacts, assumptions and approaches used by theappraiser (including any comments made bymanagement on the value rendered by theappraiser). This review and any resulting adjust-ments to value are solely for purposes of anexaminer’s analysis and classification of a creditand do not involve actual adjustments to anappraisal or evaluation.

Examiners should not make adjustments toappraisal or evaluation assumptions for creditanalysis purposes based on worst-case scenariosthat are unlikely to occur. For example, exam-iners should not necessarily assume that a build-ing will become vacant just because an existingtenant, who is renting at a rate above today’smarket rate, may vacate the property when thecurrent lease expires. On the other hand, anadjustment to value may be appropriate forcredit analysis purposes when the valuationassumes renewal at the above-market rate, unlessthat rate is a reasonable estimate of the expectedmarket rate at the time of renewal.

Assumptions should be given a reasonableamount of deference when recently made byqualified appraisers or qualified evaluators andwhen consistent with the discussion above.Examiners should not challenge the underlyingassumptions, including discount rates and caprates used in appraisals or evaluations, thatdiffer only in a limited way from norms thatwould generally be associated with the propertyunder review. However, the estimated value ofthe underlying collateral may be adjusted for

credit analysis purposes when the examiner canestablish that underlying facts or assumptionsareinappropriate and can support alternativeassumptions.

CLASSIFICATION GUIDELINES

As with other types of loans, real estate loansthat are adequately protected by the currentsound worth and debt service capacity of theborrower, guarantor, or the underlying collateralgenerally are not classified. In analyzing loans,the examiner should focus on the ability of theborrower, guarantor, or the collateral to providethe necessary cash flow to adequately servicethe loan. However, the fact that the underlyingcollateral value equals or exceeds the currentloan balance, does not preclude the loan fromclassification if other factors jeopardize therepayment ability of the borrower, such as thelack of credible financial support for full repay-ment from reliable sources.

Similarly, loans to sound borrowers that arerefinanced or renewed according to prudentunderwriting standards, including loans to cred-itworthy commercial or residential real estatedevelopers, should not be classified or catego-rized as special mention, unless well-definedweaknesses exist that jeopardize repayment. Abranch should not be criticized for working withborrowers whose loans are classified or catego-rized as special mention, as long as the branchhas a well-conceived and effective workout planfor such borrowers and effective internal con-trols to manage the level of these loans.

In evaluating real estate credits for possibleclassification, examiners should apply the stan-dard classification definitions as set forth in theClassification of Credits section of the manual.In determining the appropriate classification,examiners should consider all important infor-mation regarding repayment prospects, includ-ing information on the borrower’s creditworthi-ness, the value of and cash flow provided by allcollateral supporting the loan, and any supportprovided by financially responsible guarantors.

The loan’s performance history to date isimportant and must be considered by the exam-iner. As a general principle, a performing realestate loan should not be automatically classi-fied or charged off solely because the value ofthe underlying collateral has declined to anamount that is less than the loan balance. How-ever, it would be appropriate to classify a

8. The primary basis for the review and classification of theloan should be the original source of repayment and theborrower’s intent and ability to fulfill the obligation withoutrelying on third-party guarantees. However, examiners shouldalso consider the support provided by any guarantees whendetermining the appropriate classification treatment for atroubled loan. The treatment of guarantees in the classificationprocess is discussed in the Asset Quality Classificationssection of this manual.



performing loan when well-defined weaknessesexist that jeopardize repayment, such as the lackof credible support for full repayment fromreliable sources.9

These classification guidelines apply to indi-vidual credits, even if portions or segments ofthe industry to which the borrower belongs areexperiencing financial difficulties. The evalua-tion of each credit should be based upon thefundamental characteristics affecting the collect-ibility of the particular credit. The problemsbroadly associated with some sectors or seg-ments of an industry, such as certain commercialreal estate markets, should not lead to overlypessimistic assessments of particular credits inthe same industry that are not affected by theproblems of the troubled sectors.

Troubled Project-DependentCommercial Real Estate Loans

The following guidelines for classifying atroubled commercial real estate loan apply whenthe repayment of the debt will be providedsolely by the underlying real estate collateraland there are no other available and reliablesources of repayment. As a general principle, fora troubled project-dependent commercial realestate loan, any portion of the loan balance thatexceeds the amount that is adequately securedby the value of the collateral and that can beclearly identified as uncollectible, should beclassified ‘‘loss.’’ The portion of the loan bal-ance that is adequately secured by the value ofthe collateral should generally be classified noworse than substandard. The amount of the loanbalance in excess of the value of the collateral,or portions thereof, should be classified doubtfulwhen the potential for full loss may be mitigatedby the outcome of certain pending events orwhen loss is expected, but the amount of the losscannot be reasonably determined. If warrantedby the underlying circumstances, an examinermay use a doubtful classification on the entireloan balance. However, this methodology wouldoccur infrequently.

Partially Charged-Off Loans

An evaluation based upon consideration of allrelevant factors may indicate that a credit haswell-defined weaknesses that jeopardize collec-tion in full, although a portion of the loan maybe reasonably certain of collection. When acharge-off has been taken in an amount suffi-cient to ensure that the remaining recordedbalance of the loan (1) is being serviced (basedupon reliable sources) and (2) is reasonablyassured of collection, classification of the remain-ing recorded balance may not be appropriate.Classification would be appropriate when well-defined weaknesses continue to be present in theremaining recorded balance. In such cases, theremaining recorded balance would generally beclassified no more severely than substandard.

A more severe classification than substandardfor the remaining recorded balance would beappropriate, however, if the loss exposure can-not be reasonably determined; for example,where significant risk exposures are perceived,such as in the case of bankruptcy situations orloans collateralized by properties subject toenvironmental hazards. In addition, classifica-tion of the remaining recorded balance moreseverely than substandard would be appropriatewhen sources of repayment are consideredunreliable.

Formally Restructured Loans

The classification treatment previously dis-cussed for a partially charged-off loan wouldalso generally be appropriate for a formallyrestructured loan, when partial charge-offs havebeen taken. For a formally restructured loan, thefocus of the examiner’s analysis is on the abilityof the borrower to repay the loan in accordancewith its modified terms. Classification of aformally restructured loan would be appropriateif, after the restructuring, well-defined weak-nesses exist that jeopardize the orderly repay-ment of the loan in accordance with reasonablemodified terms.10 Troubled commercial realestate loans, whose terms have been restruc-tured, should be identified in the institution’s

9. Another issue that arises in the review of commercialreal estate loans is its accrual or nonaccrual treatment forreporting purposes. The federal banking agencies, under theauspices of the FFIEC, have provided guidance on nonaccrualstatus in the instructions for the Report of Assets andLiabilities (call report) and in related supervisory guidance ofthe banking regulatory agencies. This guidance is summarizedin the Credit Risk Management section of this manual.

10. An example of a restructured commercial real estateloan that does not have reasonable modified terms would be a‘‘cash flow’’ mortgage, which requires interest payments onlywhen the underlying collateral generates cash flow but pro-vides no substantive benefits to the lending institution.



internal credit review system and closely moni-tored by management.

REAL ESTATE APPRAISALS ANDEVALUATIONS

Bank regulators have a long-standing policy onreal estate appraisals that emphasizes the impor-tance of sound appraisal policies and proce-dures. In December 1987, the federal bankingagencies jointly adopted supervisory guidelinesfor real estate appraisal policies and reviewprocedures (which were revised in September1992). With the passage of Title XI of theFinancial Institutions Reform, Recovery andEnforcement Act (FIRREA) of 1989, in August1990, the federal banking agencies adoptedregulations regarding the performance and utili-zation of appraisals by federally regulated finan-cial institutions.

The intent of Title XI of FIRREA is to protectfederal financial and public policy interests inreal estate-related financial transactions requir-ing the services of an appraiser. Title XI requiresthat real estate appraisals be performed in writ-ing in accordance with uniform standards and byindividuals with demonstrated competency andwhose professional conduct is subject to effec-tive supervision. In this regard, Title XI requiredeach state to establish a program for certifyingand licensing real estate appraisers, who arequalified to perform appraisals in connectionwith federally-related transactions (which aredefined later in this section). Additionally, TitleXI designated the Appraisal Foundation, a non-profit appraisal industry group, as the authorityfor establishing qualifications criteria forappraiser certification and standards for theperformance of an appraisal. However, Title XIleft to the states the authority to establish quali-fication standards for licensing. Title XI estab-lished the Appraisal Subcommittee of the Fed-eral Financial Institutions Examination Councilto monitor the requirements established to meetthe intent of Title XI.

Applicability of Title XI of FIRREAto Branches

The requirements of the appraisal regulationsadopted by each of the federal banking agencies

pursuant to Title XI of FIRREA are discussed inthe remainder of this section. The appraisalregulations are directly applicable only to FDIC-insured branches. In uninsured branches, exam-iners may use the regulations as general super-visory guidance when reviewing appraisalpractices. As such, while an examiner inan uninsured branch may not cite the branch asbeing in violation of law or regulation forappraisal practices not consistent with the stan-dards set forth in Title XI and the implementingappraisal regulations, the examiner may criticizesuch practices in the report of examination ifconsidered appropriate from a risk managementbasis.

Effective Date

Appraisals performed in connection withfederally-related transactions after the effectivedate of August 9, 1990, are to comply with theregulations. Appraisals for real estate-relatedfinancial transactions entered into before August9, 1990, do not have to comply with the regu-lations. However, the branch would have had toadhere to the Federal Reserve Board’s supervi-sory guidelines, issued in 1987, for such realestate appraisals. Transactions are deemed tohave been entered into and a loan is deemed tohave been originated if there was a bindingcommitment to perform, before the effectivedate.

The requirement to use a state-certified or-licensed appraiser had a separate effective dateof no later than December 31, 1992. However,states had the flexibility to adopt an earlierimplementation date regarding state require-ments that an appraiser be certified or licensedto perform an appraisal within their state. Finan-cial institutions doing business in a state that hadan effective date for mandatory use of certifiedor licensed appraiser earlier than the federally-mandated effective date would have had to abideby any state laws in this regard.

Branch Appraisal and EvaluationPolicy

Branch and head office management is respon-sible for adopting policies and procedures that



establish effective real estate appraisal and evalu-ation programs for the branch. Analyzing realestate collateral at a loan’s inception and over itslife requires a sufficient understanding ofappraisals and evaluations to fully assess creditrisk. While the appraisal plays an important rolein the loan approval process, undue relianceshould not be placed upon the collateral value inlieu of an adequate assessment of the borrower’srepayment ability. However, when a creditbecomes troubled, the primary source of repay-ment often shifts from the borrower’s capacityto repay to the value of the collateral. For thesereasons, it is important that branches have soundappraisal policies and procedures as a method ofcontrolling risk.

Appraisal and Evaluation Programs

The appraisal and evaluation programs of abranch should be tailored to the branch’s size,location, and the nature of its real estate marketand attendant real estate-related activity. Suchprograms should establish prudent standards andprocedures that ensure written appraisals orevaluations are obtained and analyzed for realestate-related financial transactions before thebranch makes its final credit decision.

The branch’s appraisal and evaluation pro-grams should also establish the manner in whichit selects, evaluates, and monitors individualswho perform real estate appraisals or evalua-tions. The key elements of the branch’s pro-grams should ensure that individuals possess therequisite expertise to satisfactorily complete theassignment, hold the proper state certification orlicense, if applicable, and are capable of render-ing a high quality, written appraisal or evaluation.

Compliance Procedures

To ensure the branch’s compliance with appli-cable supervisory guidelines, the branch shouldhave established regulatory compliance proce-dures for all appraisals and evaluations. Addi-tionally, a branch should critique selectedappraisals and evaluations for adequacy andrelevance of the data before making final creditdecisions. The critique should consider theappropriateness of the methods and approachesused, and assess the reasonableness of the analy-

ses, opinions, and conclusions. The branchshould maintain formal documentation or evi-dence of the critique to support the compliancereview. An individual performing critiques,either an employee of the branch or an outsideconsultant, should have real estate-related train-ing or experience and be independent of thetransaction. The individual may not change theestimate of value of the appraisal or evaluationas a result of a critique.

Reappraisals and Reevaluations

The program should also include a process fordetermining when a reappraisal and reevaluationis required on a prior transaction. In thesesituations, the original appraisal or evaluationwill have become unreliable, e.g., the useful lifeof the appraisal or evaluation has ended andfurther circumstances dictate that the collateralshould be reappraised or reevaluated. The indi-vidual who makes this determination shouldhave real estate-related training or experience.

The decision to obtain a reappraisal orreevaluation will depend upon the condition andquality of a credit or investment and the sound-ness of the underlying collateral. The volatilityof the local real estate market should also beconsidered in determining the need for a reap-praisal or reevaluation. In certain situations,such as loan workouts, loan renewals, loanrestructurings, or problem credits or invest-ments, the need for a reappraisal or reevaluationshould receive particularly close attention. In allcases, the information sources and analysesrelied upon must sufficiently support a branch’sdetermination of whether a reappraisal orreevaluation is required. Reappraisals shouldconform with appraisal regulations, and reevalu-ations should conform with applicable supervi-sory guidelines.

A reappraisal would not be required when aninstitution advances funds to protect its interestin a property, such as to repair damaged prop-erty, because these funds should be used torestore the damaged property to its originalcondition. If a loan workout involves modifica-tion of the terms and conditions of an existingcredit, including acceptances of new or addi-tional real estate collateral, which facilitates theorderly collection of the credit or reduces theinstitution’s risk of loss, a reappraisal or reevalu-ation may be prudent, even if it is obtained afterthe modification occurs.



FEDERALLY-RELATEDFINANCIAL TRANSACTIONS

A federally-related transaction is defined inTitle XI as a real estate-related financial trans-action that a federal financial institution’s regu-latory agency engages in, contracts for, or regu-lates and that requires the services of anappraiser. Title XI further defines a real estate-related financial transaction as any transactioninvolving the sale, lease, purchase, investmen-tin, or exchange of real property, includinginterests in property or the financing thereof; therefinancing of real property or interests in realproperty; or the use of real property or interestsin property as security for a loan or investment,including mortgage-backed securities.

The federal banking agencies recognize thatnot all real estate-related financial transactionsrequire the services of a certified or licensedappraiser and, therefore, would not be consid-ered federally-related transactions. While thesetransactions do not require a certified or licensedappraisal, an evaluation of the underlying col-lateral is required under existing supervisoryguidelines.

Transaction Value

The transaction value is defined as the amountof the loan or extension of credit under consid-eration. For a pool of loans or a mortgage-backed security, the transaction value is theamount of each individual loan. In determiningtransaction value, the senior and junior debt areconsidered separate transactions under theappraisal rule. However, a series of relatedtransactions will be considered one transactionif it seems that an institution is attempting toavoid the appraisal requirement by structuringthe transactions below the appraisal threshold.

Transactions Not Requiring theServices of a Licensed or CertifiedAppraiser

Currently, the categories of transactions notrequiring the services of an appraiser includetransactions where:

• The transaction value is $250,000 or less;• A lien on real property has been taken as

collateral, solely through an abundance ofcaution and, as a consequence, the terms ofthe transaction have not been made morefavorable than the terms would have been inthe absence of a lien;

• The transaction is not secured by real estate;• A lien on real estate has been taken for

purposes other than the real estate’s value;• The transaction is a business loan that has a

transaction value of $1 million or less and isnot dependent on the sale of, or rental incomederived from, real estate as the primary sourceof repayment;

• A lease of real estate is entered into, unless thelease is the economic equivalent of a purchaseor sale of the leased real estate;

• The transaction involves the purchase, sale,investment in, exchange of, or extension ofcredit secured by a loan or interest in a loan,pooled loans, or interests in real property,including mortgage-backed securities, andeach loan or interest in a loan, pooled loan, orreal property interest met the Board’s regula-tory requirements for appraisals at the time oforigination;

• The transaction is wholly or partially insuredor guaranteed by a U.S. government agency orU.S. government- sponsored agency;

• The transaction either qualifies for sale to aU.S. government agency or U.S. government-sponsored agency, or involves a residentialreal estate transaction in which the appraisalconforms to the Federal National MortgageAssociation or Federal Home Loan MortgageCorporation appraisal standards applicable tothat category of real estate; or

• There is a subsequent transaction resultingfrom a maturing extension of credit, providedthat:— The borrower has performed satisfactorily,

according to the original terms;— No new monies have been advanced, other

than as previously agreed;— The credit standing of the borrower has

not deteriorated; and— There has been no obvious and material

deterioration in market conditions or physi-cal aspects of the property, which wouldthreaten the branch’s collateral protection;or

— A branch purchases a loan or interest in aloan, pooled loans, or interests in realproperty, including mortgage-backed secu-rities, provided that the appraisal preparedfor each pooled loan or real property



interest met the requirements of theappraisal regulation.

When a real estate-related financial transac-tion does not require a certified or licensedappraiser, the U.S. regulator may still require anappropriate evaluation of the real property thatis consistent with the guidelines for real estateappraisal and evaluation programs.

Obtaining an Appraisal

The branch or its agent is responsible for engag-ing the appraiser and must have sufficient timeto analyze the appraisal as part of the decisionprocess to enter into the transaction. A branchmay not accept an appraisal prepared for apotential borrower as the appraisal for a feder-ally related transaction. However, an appraisalprepared for one federally-regulated financialinstitution may be used by the branch, so long asthe branch has established procedures for review-ing appraisals, the review indicates that theappraisal meets the regulation, and the review isdocumented in writing.

When to Obtain an Appraisal

The branch should obtain the appraisal in suffi-cient time to be analyzed before the branchmakes its final credit or other decision. In certaincircumstances, when a branch acts to prudentlyprotect its interest by modifying the terms andconditions of an existing extension of credit tofacilitate orderly collection and thereby reduceits risk of loss, an appraisal or evaluation may beobtained after the branch makes its decisionconcerning the extension of credit.

The determination of when a federally-relatedtransaction has occurred may be difficult todefine in existing credits or in established lend-ing arrangements. A new federally-related trans-action is generally considered to have occurredwhen there is a potential change in the branch’sexposure to risk. This includes, but is not limitedto the following situations.

Phased Developments—The appraisal of an ear-lier phase cannot be used for a new phase.However, if the original appraisal was preparedfor all phases of the project, the branch may usethe project appraisal, provided that the appraisal

is still valid at the time the branch extends theadditional credit for the new phase.

Cross-Collateralization—In cases where mul-tiple loans are secured by separate parcels ofreal estate and are collateralized by the realestate pledged to other loans, the branch wouldnot necessarily be required to reappraise all realestate collateral if an extension or renewal isgranted on one of the loans. However, if thebranch is relying on the excess collateral of theother loans to support the loan in question, thebranch would have to have a valid appraisal onall real estate collateral.

Loan Assumptions—If a new borrower is substi-tuted for the original borrower and the originalborrower is released from any future obligationon the loan, the branch would be required tohave a valid appraisal.

Loan Restructuring and Workouts—A branchwould have to have a valid appraisal if thetransaction is a refinancing.

Foreclosures—At the time title to foreclosedreal estate passes to the branch, a branch needsto have a valid appraisal. It is recommended thatthe individual who performed the appraisal forthe original credit decision should normally notperform the appraisal for this subsequenttransaction.

Sale of Other Real Estate Owned (OREO)—Abranch is required to have a valid appraisalwhen the sale occurs. The appraisal prepared forthe foreclosure may be used, if that appraisalremains valid.

Useful Life of Appraisals orEvaluations

The useful life of an appraisal or evaluation willvary depending upon the circumstances sur-rounding the property and the marketplace.When deciding if an appraisal or evaluation maybe used for a subsequent transaction, a branchshould determine if there has been any materialchange to the underlying assumptions, whichwould affect the original estimate of value.

Examples of factors that could cause materialchanges to reported values include the passageof time; the volatility of the local market; the



availability of financing; the inventory of com-peting properties; new improvements to, or lackof maintenance of, the subject or competing,surrounding properties; change in zoning; orenvironmental contamination. The branch shoulddocument its information sources and analysesused to determine that an existing appraisal orevaluation remains valid and that the branch willuse that appraisal or evaluation in a subsequenttransaction.

Updated Appraisal

An updated appraisal is currently not acceptableas an appraisal under the Board of Governors’regulation. However, a branch may use anupdated appraisal in the following cases:

• To evaluate real estate when a federally-related transaction has not occurred; or

• To assess the useful life of an appraisal.

APPRAISAL REQUIREMENTS

The objective of an appraisal is to communicatethe appraiser’s reasoning and conclusions in alogical manner so that the reader is led to theappraiser’s estimation of market value. Thecontents of appraisals should conform to thestandards of the Board’s appraisal regulation, ifapplicable, and the Uniform Standards of Pro-fessional Appraisal Practice (USPAP), promul-gated by the Appraisal Standards Board of theAppraisal Foundation. The actual form, length,and content of appraisal reports may vary,depending on the type of property beingappraised and the nature of the assignment.Standard forms completed in compliance withthe rule and USPAP are also acceptable.

Appraisal Options

A branch may engage an appraiser to performeither a Complete or Limited Appraisal. Whenperforming a Complete Appraisal assignment,an appraisal must comply with all USPAP stan-dards without departing from any bindingrequirements and specific guidelines when esti-mating market value. When performing a Lim-ited Appraisal, the appraiser elects to invoke the

Departure Provision which allows the appraiserto depart, under limited conditions, from stan-dards identified as specific guidelines. For exam-ple, in a Limited Appraisal, the appraiser mightnot utilize all three approaches to value. Depar-ture from standards designed as binding require-ments is not permitted.

A branch and appraiser must concur that useof the Departure Provision is appropriate for thetransaction before the appraiser commences theappraisal assignment. The appraiser must ensurethat the resulting appraisal report will not mis-lead the branch or agency or other intendedusers of the appraisal report. The banking regu-lators do not prohibit the use of a LimitedAppraisal for a federally related transaction, butthe bank regulators believe that branches shouldbe cautious in their use of a Limited Appraisalbecause it will be less thorough than a CompleteAppraisal.

Complete and Limited Appraisal assignmentsmay be reported in three different report for-mats: a Self-Contained Report, a SummaryReport, or a Restricted Report. The major dif-ference among these three reports relates to thedegree of detail presented in the report by theappraiser. The Self-Contained Appraisal Reportprovides the most detail, while the SummaryAppraisal Report presents the information in acondensed manner. The Restricted Report pro-vides a capsulized report with the supportingdetails maintained in the appraiser’s files.

The banking agencies believe that theRestricted Report format will not be appropriateto underwrite a significant number of federallyrelated transactions due to the lack of sufficientsupporting information and analysis in theappraisal report. However, it might be appropri-ate to use this type of appraisal report forongoing collateral monitoring of a branch’s realestate transactions and under other circum-stances when a branch’s program requires anevaluation.

Moreover, since a branch is responsible forselecting the appropriate appraisal report tosupport its underwriting decisions, its programshould identify the type of appraisal report thatwill be appropriate for various lending transac-tions. The branch’s program should consider therisk, size, and complexity of the individual loanand the supporting collateral when determiningthe level of appraisal development and the typeof report format that will be ordered. Whenordering an appraisal report, institutions maywant to consider the benefits of a written



engagement letter that outlines the branch’sexpectations and delineated each party’s respon-sibilities, especially for large, complex, or out-of-area properties.

Appraisal Standards

Title XI mandated that the minimum standardsfor Complete appraisals performed in connec-tion with federally-related transactions are stan-dards set forth in USPAP together with any otherstandards that the federal banking agencies deemnecessary. In summary, an appraisal must:

• Be performed by a qualified, independent staffor fee-paid appraiser, selected by the branch,who is competent and knowledgeable of rel-evant markets. The appraiser must also holdthe proper state certification or license asrequired under the appraisal regulations. Anindependent appraisal is one in which theappraiser is not participating in the adminis-tration of the credit or in the approval of thetransaction and has no interest, financial orotherwise, in the property;

• Result in a market value that is defined as themost probable price that a property shouldbring in a competitive and open market underall conditions requisite to a fair sale, assumingthe buyer and seller are both acting prudentlyand knowledgeably and the price is not affectedby any undue stimulus;

• State the market value in terms of the cashequivalent value, which reflects the value ofthe property without the influence of specialor creative financing or seller concessions;

• Follow a reasonable valuation method, whichaddresses cost, income, and direct sales com-parison approaches to determine market value,unless the appraiser fully explains and docu-ments the elimination of an approach;

• Support the current valuation of the realestate. All assumptions and projections shouldbe supportable by current market conditionsand expectations of current market trends. Inthe case of income property, the capitalizationrate, discount rate, net income and/or lossprojections, cash flow, financing terms, andabsorption rate should be reasonable and sup-portable by current market conditions;

• Document and explain how the discount andcapitalization rates used in generating presentvalue estimates were derived;

• Render the ‘‘as is’’ value, which reflects thevalue of the property in its current physicalcondition and subject to the zoning in effect asof the appraisal date. Appropriate deductionsand discounts should be made for proposeddevelopment projects to reflect holding costs,marketing expenses, and entrepreneurial profit,which are based on stabilized occupancy forcommercial projects or a retail sales programfor residential projects;

• Report the sales history on the appraisedproperty for one year for 1–to–4 family resi-dential properties and three years for all othertypes of properties;

• Address a proposed project’s marketabilityand feasibility prospects. Studies prepared bya party other than the appraiser must beverified to the extent assumptions are utilized.The appraiser’s acceptance or rejection of thethird party study and its impact on value mustbe fully explained;

• State the marketing period for the appraisedproperty, the effective date of the appraisal,and the date the appraisal was rendered;

• Include a legal description of the subjectproperty;

• Identify and separately value any personalproperty, fixtures, and intangible items that arenot real property but are included in theappraisal, and discuss the impact of theirinclusion or exclusion on the estimate ofmarket value of the real property;

• Contain an appraiser’s certification statementin which the appraiser attests to the accuracyof the data, the disclosure of assumptions, andindependence from the transaction; stateswhether an inspection of the property wasmade; discloses any professional assistancereceived from another appraiser; and certifiesthat a fee, contingent on the value rendered,was not received; and

• The appraisal regulations and USPAP providea complete listing of the appraisal standards.

Appraisal Valuation Approaches

There are three basic approaches used in apprais-ing the market value of real estate in a CompleteAppraisal:

• Cost Approach;• Market Data or Direct Comparable Sales

Approach; and• Capitalization of Income Approach.



All three approaches have particular meritsdepending upon the type of real estate beingappraised. For single family residential property,the cost and comparable sales approaches aremost frequently used because the common useof the property is the personal residence of theowner. However, if a single family residentialproperty is intended to be used as a rentalproperty, the appraiser would have to considerthe income approach and the cost and compa-rable sales approaches. For special use commer-cial properties, the appraiser may have difficultyin obtaining sales data on comparable propertiesand may have to base the value estimate on thecost and capitalization of income approach. If anapproach is not used in the appraisal, theappraiser should disclose the reason the approachwas not used and whether this affects the valueestimate.

Value Correlation

The three value estimates—cost, market, andincome—must be evaluated by the appraiser andcorrelated into a final value estimate based onthe appraiser’s judgment. Correlation does notimply averaging the value estimates obtained byusing the three different approaches. Wherethese value estimates are relatively close together,correlating them and setting the final marketvalue estimate presents no special problem. It isin situations where widely divergent values areobtained by using the three appraisal approachesthat judgment must be exercised in analyzingthe results and determining the estimate ofmarket value.

Cost Approach

In the cost approach to value estimation, theappraiser obtains a preliminary indication ofvalue by adding the estimated depreciatedreproduction cost of the improvements to theestimated land value. This approach is based onthe assumption that the reproduction cost is theupper limit of value and that a newly con-structed building would have functional andmechanical advantages over an existing build-ing. The appraiser would evaluate any deprecia-tion, i.e., disadvantages or deficiencies of theexisting building in relation to a new structure.

The cost approach consists of four basicsteps: (1) estimate the value of the land as

though vacant; (2) estimate the current cost ofreproducing the existing improvements;(3) estimate depreciation and deduct from thereproduction cost estimate; and (4) add theestimate of land value and the depreciatedreproduction cost of improvements to determinethe value estimate.

Market Data or Direct SalesComparison Approach

The essence of this approach is to determine theprice at which similar properties have sold forrecently on the local market. Through an appro-priate adjustment for differences in the subjectproperty and the selected comparable properties,the appraiser estimates the market value of thesubject property based on the sales price of thecomparable properties. The market approach tovalue estimation is essential in nearly everyappraisal of real property and is based on thefollowing assumptions:

• Market value is the highest price for which aproperty is deemed most likely to sell in acompetitive market;

• A reasonable time is allowed for exposure ofthe property in the open market;

• Payment is to be made in cash or on termsreasonably equivalent to cash or on typicalfinancing terms available at the time of theappraisal;

• Both the buyer and seller are typically moti-vated and the price is not affected by unduestimulus; and

• Both buyer and seller act prudently and knowl-edgeably and have reasonable knowledge ofthe various uses to which the property may beput.

The application of this approach produces anestimate of value of a property by comparing itwith similar properties that have been soldrecently. The process used in determining thedegree of comparability of two or more proper-ties involves judgment as to their similarity withrespect to age, location, condition, construction,layout, and equipment. The sales price or listprice of those properties deemed most compa-rable tend to set the range in which the value ofthe subject property lies.



Capitalization of Income Approach

The income approach estimates the project’sexpected income over time converted to anestimate of its present value. The incomeapproach typically is used to determine themarket value of income producing properties,such as office buildings, apartment complexes,hotels, and shopping centers. In the incomeapproach, the appraiser can use several differentcapitalization or discounted cash flow tech-niques to arrive at a market value. These tech-niques include band-of-investments method,mortgage equity method, annuity method, andland residual technique. The use of a particulartechnique will depend upon whether there isproject financing, whether there are long-termleases with fixed level payments and whetherthe value is being rendered for a component ofthe project, such as land or buildings.

The accuracy of this method depends on theappraiser’s skill in estimating the anticipatedfuture net income of the property and in select-ing the appropriate capitalization rate andmethod. The following data are assembled andanalyzed to determine potential net income andvalue:

• Rent schedules and the percentage of occu-pancy for the subject property and for compa-rable properties for the current year and sev-eral preceding years. This information providesgross rental data and the trend of rentals andoccupancy, which are then analyzed by theappraiser to estimate the gross income theproperty should produce;

• Expense data, such as taxes, insurance, andoperating costs being paid from revenuesderived from the subject property and bycomparable properties. Historical trends inthese expense items are also determined;

• Time frame for achieving a ‘‘stabilized’’ ornormal occupancy and rent levels (also referredto as holding period); and

• An appropriate capitalization rate and valua-tion technique are selected and applied to netincome to establish a value estimate.

Basically, the income approach converts allexpected future net operating income into presentvalue terms. When market conditions are stableand no unusual patterns of future rents andoccupancy rates are expected, the direct capitali-zation method is used to value income proper-

ties. This method calculates the value of aproperty by dividing an estimate of its ‘‘stabi-lized’’ annual income by a factor called a ‘‘cap’’rate. Stabilized income generally is defined asthe yearly net operating income produced by theproperty at normal occupancy and rental rates; itmay be adjusted upward or downward fromtoday’s actual market conditions. The ‘‘cap’’rate—usually defined for each property type in amarket area—is viewed by some analysts as therequired rate of return stated in terms of currentincome.

The use of this technique assumes that eitherthe stabilized income or the ‘‘cap’’ rate usedaccurately captures all relevant characteristics ofthe property relating to its risk and incomepotential. If the same risk factors, required rateof return, financing arrangements, and incomeprojections are used, explicit discounting anddirect capitalization will yield the same results.

For special use properties, new projects, ortroubled properties, the discounted cash flow(net present value) method is the more typicalapproach to analyzing a property’s value. In thismethod, a time frame for achieving a ‘‘stabi-lized,’’ or normal occupancy and rent level, isprojected. Each year’s net operating incomeduring that period is discounted to arrive at thepresent value of expected future cash flows. Theproperty’s anticipated sales value at the end ofthe period until stabilization (its terminal orreversion value) is then estimated. The reversionvalue represents the capitalization of all futureincome streams of the property after the pro-jected occupancy level is achieved. The terminalor reversion value is then discounted to itspresent value and added to the discounted incomestream to arrive at the total present market valueof the property.

Most importantly, the analysis should be basedon the ability of the project to generate incomeover time based upon reasonable and support-able assumptions. Additionally, the discount rateshould reflect reasonable expectations about therate of return that investors require under nor-mal, orderly, and sustainable market conditions.For further discussion, refer to the section of thismanual on Real Estate Loans.

Other Definitions of Value

An appraisal for a federally-related transactionmust reflect a market value as defined in the



regulations. The regulations also require that,for development projects, the appraisal containthe ‘‘as is’’ value as of the date of the appraisal.However, there are other definitions of valuethat are encountered in appraising and evaluat-ing real estate transactions. These include:

Fair Value.This term is an accounting term thatis generally defined as the amount, in cash orcash equivalent value or other consideration,that a real estate parcel would yield in a currentsale between a willing buyer and a willing seller(i.e., selling price), that is, other than in a forcedor liquidation sale. According to accountingliterature, fair value is generally used in valuingassets in troubled debt restructuring, quasi-reorganizations, nonmonetary transactions, andbusiness combinations accounted for by thepurchase method. An accountant generallydefines fair value as market value; however,depending on the circumstances, these valuesmay not be the same for a particular property.

Investment Value.This term is based on the dataand assumptions that meet the criteria andobjectives of a particular investor for a specificproperty or project. The investor’s criteria andobjectives are often substantially different thanparticipants in a broader market. Thus, invest-ment value can be significantly higher thanmarket value in certain circumstances and shouldnot be used in credit analysis decisions.

Liquidation Value.This term assumes that thereis little or no current demand for the propertyand that the property needs to be disposed ofquickly, resulting in the owner sacrificing poten-tial property appreciation for an immediate sale.

Going-Concern Value.This term is based on thevalue of a business entity rather than the valueof just the real estate. The valuation is based onthe existing operations of the business that has aproven operating record with the assumptionthat the business will continue to operate.

Assessed Value.This term represents the valueon which a taxing authority bases its assess-ment. The assessed value and market value maydiffer considerably due to tax assessment laws,timing of reassessments, and tax exemptionsallowed on properties or portions of a property.

Net Realizable Value (NRV).This term is recog-nized under generally accepted accounting prin-

ciples (GAAP) as ‘‘the estimated selling price inthe ordinary course of business less estimatedcosts of completion (to the stage of completionassumed in determining the selling price), hold-ing, and disposal.’’ The NRV is generally usedto evaluate the carrying amount of assets beingheld for disposition and properties representingcollateral. While the market value or futureselling price are generally used as the basis forthe NRV calculation, the NRV also reflects thecurrent owner’s costs to complete the projectand to hold and dispose of the property. For thisreason, the NRV will generally be less than themarket value.

The appraiser should state the definition ofvalue reported in the appraisal, and, for federally-related transactions, the value must meet themarket value definition as defined in the regu-lations. This value is the most probable pricethat a property should bring in a competitive andopen market under all conditions requisite to afair sale, assuming the buyer and seller are bothacting prudently and knowledgeably and theprice is not affected by undue stimulus. Otherpresentations of value, in addition to marketvalue, are allowed and may be included in theappraisal at the request of the branch.

EVALUATION REQUIREMENTS

The appraisal regulations identify certain realestate-related financial transactions that do notrequire the services of an appraiser (i.e., do notneed an appraisal). In the context of Title XI ofFIRREA, an appraisal means the kind of spe-cialized opinion as to the value of real estatecontaining certain formal elements recognizedby appraisal industry practices and standards.For transactions that do not require an appraisalby a licensed or certified appraiser under theappraisal regulations, the branch should estab-lish an evaluation program and perform anappropriate evaluation of the real estate for thesetransactions as a prudent banking practice. Theevaluation should result in a determination ofvalue that will assist the branch in assessing thesoundness of the transaction and that will pro-tect the branch’s interest in the transaction.Further, the evaluation need not meet all of thedetailed requirements of an appraisal as set forthin the appraisal regulations.

Bank regulators’ appraisal regulations allowan institution to use an appropriate evaluation of



real estate rather than an appraisal when thetransaction:

• Has a value of $250,000 or less;• Is a business loan of $1,000,000 or less, and

the transaction is not dependent on the sale of,or rental income derived from, real estate asthe primary source of repayment; or

• Involves an existing extension of credit at thelending branch, provided that: (i) there hasbeen no obvious and material change in themarket conditions or physical aspects of theproperty that threaten the adequacy of thebranch’s real estate collateral protection afterthe transaction, even with the advancement ofnew monies; or (ii) there is no advancement ofnew monies other than funds necessary tocover reasonable closing costs.

The branch is not precluded from obtainingan appraisal that conforms to the regulation forany real estate-related financial transaction. If abranch makes loans that may be sold into thesecondary market at a later date, the branch mayneed to ensure that they meet the secondarymortgage market requirements.

Form and Content of Evaluations

The documentation for evaluations should fullysupport the estimate of value and include suffi-cient information to understand the evaluator’sanalysis and assumptions. There is no require-ment that the evaluator use a particular form orvaluation approach but the analysis should beapplicable to the type of property and fullyexplain the value rendered.

An evaluation, at a minimum, should:

• Be written;• Include the preparer’s name, address, and

signature, and the effective date of theevaluation;

• Describe the real estate collateral, its condi-tion, its current and projected use;

• Describe the source(s) of information used inthe analysis;

• Describe the analysis and supporting informa-tion; and

• Provide an estimate of the real estate’s marketvalue, with any limiting conditions.

An individual who conducts an evaluationshould have real estate-related training or expe-

rience relevant to the type of property but doesnot have to be a state-licensed or -certifiedappraiser. Prudent practices generally requirethat, as the branch’s exposure in a real estate-related financial transaction increases, a moredetailed evaluation should be performed, whe-ther or not specifically subject to appraisalregulations.

An evaluation for a transaction that needs amore detailed analysis should fully describe theproperty and discuss its use, especially fornonresidential property. An evaluation reportshould include calculations, supporting assump-tions, and, if utilized, a discussion of compa-rable sales. Documentation should be sufficientto allow an institution to understand the analy-sis, assumptions, and conclusions. An institu-tion’s own real estate loan portfolio experienceand value estimates prepared for recent loans oncomparable properties might provide a basis forevaluations.

An evaluation for a transaction that requires aless detailed analysis may be based upon infor-mation, such as comparable property salesinformation from sales data services, for exam-ple, the multiple listing service or current taxassessed value in appropriate situations. Further,the branch’s own real estate loan portfolioexperience and value estimates, which wereprepared for recent loans on comparable prop-erties where appraisals meeting the requirementsof the regulation were obtained, may be used.Regardless of the method, the branch must docu-ment its analysis and findings in the loan file.

Letter Updates

A branch may use letter updates to an appraisalas an evaluation even though such updates donot conform to the appraisal regulations andwould not be acceptable for the initial creditdecision for federally-related transactions. Forexample, an existing appraisal for a first mort-gage might be updated for a subsequent homeequity line of credit where the extension ofcredit is below the threshold amount.

QUALIFICATIONS CRITERIA FORAPPRAISERS AND EVALUATORS

The accuracy of an appraisal or evaluationdepends on the competence and integrity of the



individual performing the appraisal or evalua-tion and the expertise of the appraiser or evalu-ator at developing and interpreting pertinentdata for the subject property. Appraisers andevaluators should have adequate training, expe-rience, and knowledge of the local real estatemarket to make sound judgments concerning thevalue of a particular property. The level oftraining, experience, and knowledge should becommensurate with the type and complexity ofthe property to be valued. Additionally, apprais-ers and evaluators should be independent of thecredit decision, have no interest in the propertybeing appraised, and have no affiliations orassociations with the potential borrower.

Appraiser Qualifications

Under Title XI of FIRREA, two classificationsof appraisers were identified to be used infederally-related transactions: ‘‘state-certifiedappraiser’’ and ‘‘state-licensed appraiser.’’ For acertified appraiser, Title XI contemplated thatthe states would adopt similar standards forcertification based on the qualification criteria ofthe Appraiser Qualifications Board of theAppraisal Foundation. These standards set forthminimum educational, testing, experience, andcontinuing education requirements. For a licensedappraiser, the states have some latitude in estab-lishing qualification standards provided that thecriteria are adequate to protect federal financialand public policy interests.

The Appraisal Subcommittee of the FFIEC isresponsible for monitoring the states for com-pliance with Title XI. The federal bankingagencies also have the authority to imposeadditional certification and licensing require-ments to those adopted by a given state.

Selection of an Appraiser

In selecting an appraiser for an appraisal assign-ment, a branch is expected to consider whetherthe individual holds the proper state certificationor license and has the appropriate experienceand educational background to complete theassignment. Financial institutions may notexclude a qualified appraiser from considerationfor an appraisal assignment solely because theappraiser lacks membership in a particularappraisal organization or does not hold a par-

ticular designation from an appraisal associa-tion, organization, or society.

In that regard, branches should treat allappraisers fairly and equitably in determiningwhether to use the services of a particularappraiser. Generally, financial institutions haveestablished procedures for selecting appraisersand maintaining an approved appraiser list. Thepractice of pre-approving appraisers for on-goingappraisal work and maintaining an approvedappraiser list is acceptable as long as all apprais-ers are required to follow the same approvalprocess. However, a branch that requires apprais-ers who are not members of a particular appraisalorganization to formally apply, pay an applica-tion fee, and submit samples of previousappraisal reports for review—but does not haveidentical requirements for appraisers who aremembers of certain appraisal organizations—would be viewed as having a questionableselection process.

APPRAISALS PERFORMED BYCERTIFIED OR LICENSEDAPPRAISERS

In summary, a federally-insured branch isrequired to use a Certified Appraiser for:

• All federally-related transactions over$1 million;

• Nonresidential federally-related transactionsof $250,000 or more; and

• Complex residential federally-related transac-tions of $250,000 or more.

A federally-insured branch is required to usea Licensed Appraiser for:

• All other federally-related transactions overthe $250,000 transaction value not requiringthe services of a certified appraiser. These alsomay be performed by a certified appraiser.

Some of the states have adopted otherappraiser designations, which may cause confu-sion on whether a particular appraiser holds theappropriate designation for a given appraisalassignment. Additionally, some states have useddesignations such as ‘‘certified residential’’appraiser and ‘‘certified general’’ appraiser,which leads to further confusion. Other stateshave no specified license designation but have



used the term ‘‘certified residential’’ based onthe standards for licensing. For this reason, thebranch needs to understand (1) the qualificationscriteria set forth by the state appraiser regulatorybody and (2) whether these standards are equiva-lent to the federal designations as accepted bythe Appraisal Subcommittee.

Other Appraiser Designations

The Appraisal Subcommittee recognized twoother appraiser designations: certified residentialappraiser and transitional license. For the certi-fied residential appraiser, the minimum qualifi-cation standards are those established by theAppraiser Qualifications Board for ‘‘certifiedresidential real estate appraiser.’’ Under theappraisal regulations, a certified residentialappraiser would be permitted to appraise realestate in connection with a federally-relatedtransaction designated for a ‘‘certified’’ appraiseras long as the individual is competent for theparticular appraisal assignment.

The Appraisal Subcommittee and the federalbanking agencies also recognized a transitionallicense, which allowed a state to issue a licenseto an appraiser provided that the individual hadpassed an examination and had satisfied eitherthe education or experience requirement. Atransitional licensed appraiser was permitted toappraise real estate collateral in connection witha federally-related transaction as if licensed. Thetransitionally-licensed appraiser was expectedto complete the missing requirement within aset time frame or the license would expire.The recognition of a transitional license wasbelieved to be necessary to ease the initialproblems and inefficiencies resulting from theestablishment of a new regulatory program. TheAppraisal Subcommittee advised the states thatthe use of the transitional license should bephased out over time once the appraiser regula-tory program is fully established. As a result, theuse of the transitional license and the applicabletime frame varies from state to state.

Qualifications of Individuals WhoCan Perform Evaluations

Evaluations can be performed by a competentperson who has experience in real estate-related

activities, including but not limited to apprais-als, real estate lending experience, real estateconsulting, and real estate sales. An individualperforming an evaluation need not be licensedor certified. The branch’s evaluation proceduresshould have established standards for selectingqualified individuals to perform evaluations andconfirming their qualifications and indepen-dence to perform an evaluation for a particulartransaction.

Supervisory Policy and Evaluations

A branch’s appraisal and evaluation policies andprocedures should be reviewed as part of theexamination of its overall real estate-relatedactivities to ensure compliance with regulations,if a federally-insured branch, and to evaluaterisk management techniques as appropriate. Thisprocess would include a review of the proce-dures for selecting an appraiser for a particularappraisal assignment and confirming that theappraiser is qualified, independent, and licensed/certified to undertake the assignment. If a branchmaintains a list of qualified real estate appraisersacceptable for the branch’s use, the examinershould ascertain whether senior management ofthe branch has periodically reviewed andapproved the list.

When analyzing individual credits, examinersshould analyze appraisals or evaluations to deter-mine that the methods, assumptions, findings,and conclusions are reasonable and in compli-ance with any applicable appraisal regulationsand supervisory guidelines. Examiners shouldnot challenge the underlying assumptions, includ-ing discount rates and capitalization rates usedin appraisals, that differ only in a limited wayfrom norms that would generally be associatedwith the property under review. Additionally, anexaminer is not bound to accept the results ofthe appraisal or evaluation, regardless of whethera new appraisal or evaluation was requestedduring the examination. If an examiner con-cludes that an appraisal or evaluation is deficientfor any reason, that fact will be taken intoaccount in reaching a judgment on the quality ofthe credit.

When the examiner can establish that theunderlying facts or assumptions are inappropri-ate and can support alternative assumptions, theexaminer may adjust the estimated value of theproperty for credit analysis purposes. It is



important to emphasize that an examiner’s over-all analysis and classification of a credit may bebased upon other credit or underwriting stan-dards, even if the loan is secured by realproperty whose value is supported by anappraisal or evaluation. Further discussion onthe examiner’s assessment of value for loanclassification can be found in sections in thismanual on Classification of Credits.

Significant failures to meet applicable stan-dards and procedures as outlined previouslyshould be criticized and corrective action shouldbe required. Furthermore, inadequate appraisaland evaluation procedures may be considered anunsafe and unsound banking practice if thefailure to accurately reflect the value of assets ona timely basis misrepresents the branch’s finan-cial condition. In this situation, formal correc-tive measures will be pursued as appropriate.

The appraisal regulation and guidelines requirethat federally-insured financial institutions usethe services of qualified, independent, certifiedor licensed appraisers to perform appraisals. Abranch that knowingly uses the services of anindividual to perform an appraisal in connectionwith a federally-related transaction who is notproperly certified or licensed is in violation ofSection 1120(a)(1) of Title XI of FIRREA. Anyaction of a state-certified or -licensed appraiserthat is contrary to the purpose of Title XI shouldbe reported to the branch’s appropriate federaland/or state regulators for referral to the stateappraiser regulatory agency for investigation.

ENVIRONMENTAL LIABILITY

In connection with any real estate lending activ-ity, a branch and its legal entity, the foreignbanking organization, may be subject to liabilityassociated with the clean-up of hazardous sub-stance contamination pursuant to the Compre-hensive Environmental Response, Compensa-tion and Liability Act (CERCLA), the federalsuperfund statute. CERCLA was enacted inresponse to the growing problem of improperhandling and disposal of hazardous substances.CERCLA authorizes the Environmental Protec-tion Agency (EPA) to clean up hazardous wastesites and to recover costs associated with theclean up from entities specified in the statute.The superfund statute is the primary federal lawdealing with hazardous substance contamina-tion. However, there are numerous other federal

and state statutes that establish environmentalliability that could place banking organiza-tions at risk. For example, underground storagetanks are also covered by separate federallegislation.11

While the superfund statute was enacted in1980, it has been only since the mid-1980s thatcourt actions have resulted in some bankingorganizations being held liable for the clean-upof hazardous substance contamination. Theseearly court decisions had a wide array of inter-pretations as to whether banking organizationsare owners or operators of contaminated facili-ties and thereby liable under the superfundstatute for clean-up costs. These decisions led touncertainty on the part of banking organizationsas to how best to protect themselves fromenvironmental liability.

The relevant provisions of CERCLA, theso-called ‘‘superfund’’ statute as it pertains tobanking organizations indicate which persons orentities are subject to liability for clean-up costsof hazardous substance contamination. Theseinclude ‘‘the owner and operator of a vessel or afacility, (or) any person who at the time ofdisposal of any hazardous substance owned oroperated any facility at which such hazardoussubstances were disposed.’’12 A person or entitythat transports or arranges to transport hazard-ous substances can also be held liable forcleaning up contamination under the superfundstatute.

The liability imposed by the superfund statuteis strict liability, which means the governmentdoes not have to prove that the owners oroperators had knowledge of or caused the haz-ardous substance contamination. Moreover, lia-bility is joint and several, which allows thegovernment to seek recovery of the entire costof the clean up from any individual party that isliable for those clean-up costs under CERCLA.In this connection, CERCLA does not limit thebringing of such actions to the EPA but permitssuch actions to be brought by third parties.

CERCLA provides a secured creditor exemp-tion in the definition of ‘‘owner and operator’’by stating that these terms do not include ‘‘aperson, who, without participating in the man-agement of a vessel or facility, holds indicia ofownership primarily to protect his security inter-

11. Resource Conservation and Recovery Act of 1987(RCRA).

12. CERCLA, Section 107(a).



est in the vessel or facility.’’13 However, thisexception has not provided banking organiza-tions with an effective ‘‘safe harbor’’ becauseearly court decisions worked to limit the appli-cation of this exemption. Specifically, courtsheld that actions by lenders to protect theirsecurity interests may result in the bankingorganization ‘‘participating in the management’’of a vessel or facility, thereby voiding theexemption. Additionally, once the title to aforeclosed property passes to the banking orga-nization, courts held that the exemption nolonger applies and that the banking organizationis liable under the superfund statute as an‘‘owner’’ of the property. Under some circum-stances, CERCLA may exempt landowners whoacquire property without the knowledge of pre-existing conditions (the so-called ‘‘innocent land-owner defense’’). However, the courts applied astringent standard to qualify for this defense.Because little guidance is provided by the stat-ute as to what constitutes the appropriate timingand degree of ‘‘due diligence’’ to successfullyemploy this defense, banking organizationsshould exercise caution before relying on it.

Overview of Environmental Hazards

Environmental risk can be characterized asadverse consequences resulting from havinggenerated or handled hazardous substances orotherwise having been associated with the after-math of subsequent contamination. The follow-ing discussion highlights some common envi-ronmental hazards but by no means covers allenvironmental hazards.

Hazardous substance contamination is mostoften associated with industrial or manufactur-ing processes that involve chemicals or solventsin the manufacturing process or as waste prod-ucts. For years, these types of hazardous sub-stances were disposed of in land fills or justdumped on industrial sites. Hazardous sub-stances are also found in many other lines ofbusiness. The following examples demonstratethe diverse sources of potential hazardous sub-stance contamination, which should be of con-cern to banking organizations.

• Farmers and ranchers (use of fuel, fertilizers,herbicides, insecticides, and feedlot runoff).

• Dry cleaners (various cleaning solvents).• Service station and convenience store opera-

tors (underground storage tanks).• Fertilizer and chemical dealers and applicators

(storage and transportation of chemicals).• Lawn care businesses (application of lawn

chemicals).• Trucking firms (local and long haul transport-

ers of hazardous substances, such as fuel orchemicals).

• The real estate industry has taken the brunt ofthe adverse affects of hazardous waste con-tamination. In addition to having land con-taminated with toxic substances, constructionmethods for major construction projects, suchas commercial buildings, have utilized mate-rials that have been subsequently determinedto be hazardous resulting in significant declinesin their value. For example, asbestos wascommonly used in commercial constructionfrom the 1950s to the late 1970s. Asbestoswas found to be a health hazard and now mustmeet certain federal and, in many instances,state requirements for costly removal or abate-ment (enclosing or otherwise sealing off).

• Another common source of hazardous sub-stance contamination is underground storagetanks. Leaks in these tanks not only contami-nate the surrounding ground but often flowinto ground water and travel far away from theoriginal contamination site. As contaminationspreads to other sites, clean-up costs escalate.

Impact on Banking Organization

Banking organizations may encounter lossesarising from environmental liability in severalways. The greatest risk to banks resulting fromthe superfund statute and other environmentalliability statutes is the possibility of being heldsolely liable for costly environmental clean ups,such as hazardous substance contamination. If abank is found to be a responsible party underCERCLA, it may find itself responsible forcleaning up a contaminated site at a cost that farexceeds any outstanding loan balance. This riskof loss results from an interpretation of thesuperfund statute as providing for joint andseveral liability. Any responsible party, includ-ing a branch and the foreign banking organiza-tion or FBO, as the branch’s legal entity, couldbe forced to pay the full cost of any clean up. Ofcourse, the branch or FBO may attempt to13. CERCLA, Section 101(20)(A).



recover such costs from the borrower, or fromthe owner, if different than the borrower, pro-vided that the borrower or owner continues inexistence and is solvent. Banking organizationsmay be held liable for the clean up of hazardoussubstance contaminations in situations where it:

• Takes title to property pursuant to foreclosure;• Involves the banking organization’s personnel

or contractors engaged by the bank in day-to-day management of the facility;

• Takes actions designed to make the contami-nated property salable, possibly resulting infurther contamination;

• Acts in a fiduciary capacity, including man-agement involvement in the day-to-day opera-tions of industrial or commercial concerns andpurchasing or selling contaminated property;

• Owns or acquires (by merger or acquisition),subsidiaries involved in activities that mightresult in a finding of environmental liability;or

• Owns or acquires, for future expansion, prem-ises that have been previously contaminatedby hazardous substances. For example, sitecontamination at a branch office where aservice station with underground storage tanksonce operated. Premises or other real estateowned could also be contaminated by asbestosrequiring costly clean up or abatement.

A more common situation encountered bybanking organizations has been where real prop-erty collateral is found to be contaminated byhazardous substances. The value of contami-nated real property collateral can decline dra-matically depending on the degree of contami-nation. As the projected clean-up costs increase,the borrower may not be able to provide thenecessary funds to remove contaminated mate-rials. In making its determination whether toforeclose, the lender must estimate the potentialclean-up costs. In many cases, this estimatedcost has been found to be well in excess of theoutstanding loan balance and the lender haselected to abandon its security interest in theproperty and write-off the loan. This situationoccurs, regardless of the fact that the superfundstatute provides a secured creditor exemption.Some courts have not extended this exemptionto situations where lenders have taken title to aproperty pursuant to foreclosure. These rulingshave been based on a strict reading of the statutethat provides the exemption to ‘‘security inter-ests’’ only.

Risk of credit losses can also arise where thecredit quality of individual borrowers (opera-tors, generators, or transporters of hazardoussubstances) deteriorates markedly as a result ofbeing required to clean up hazardous substancecontamination. Banking organizations must beaware that significant clean-up costs borne bythe borrower could threaten the borrower’s sol-vency and jeopardize the lender’s ultimate col-lection of outstanding loans to that borrowerregardless of the fact that no real propertycollateral is involved. Therefore, ultimate col-lection of loans to fund operations or to acquiremanufacturing or transportation equipmentcan be jeopardized by the borrower’s generatingor handling of hazardous substances in animproper manner. Further, some bankruptcycourts have required clean up of hazardoussubstance contamination before distribution of adebtor’s estate to secured creditors.

Borrowers may have existing subsidiaries ormay be involved in merger and acquisitionactivity that may place the borrower at risk forthe activities of others that result in environmen-tal liability. Some courts have held that for thepurposes of determining liability under thesuperfund statute, the corporate veil may notprotect parent companies that participate in theday-to-day operations of their subsidiaries fromenvironmental liability and court imposedclean-up costs. Additionally, borrowers can beheld liable for contamination that occurred beforethey owned or used real estate.

Protection Against EnvironmentalLiability

Lenders have numerous ways to identify andminimize their exposure to environmental liabil-ity. Because environmental liability is relativelyrecent, procedures used to safeguard againstsuch liability are evolving. Generally, however,banking organizations should have in placeadequate safeguards and controls to limit theirexposure to potential environmental liability.Loan policies and procedures should addressmethods for identifying potential environmentalproblems relating to credit requests and existingloans. The loan policy should describe anappropriate degree of due diligence investiga-tion required for credit requests. Borrowers inhigh-risk industries or localities should be held



to a more stringent due diligence investigationthan borrowers in low-risk industries or localities.

In addition to establishing procedures forgranting credit, procedures should be developedand applied to portfolio analysis, credit moni-toring, loan workout situations, and—beforetaking title to real property—foreclosures. Banksmay avoid or mitigate potential environmentalliability by having sound policies and proce-dures designed to identify, assess, and controlenvironmental liability.

At the same time, banking organizations mustbe careful that any lending policies and proce-dures, especially those undertaken to assess andcontrol environmental liability, cannot be con-strued as taking an active role in participating inthe management or day-to-day operations of theborrower’s business. Activities that could beconsidered active participation in the manage-ment of the borrower’s business and thereforesubject the banking organization to potentialliability, include but are not limited to:

• Having branch or FBO employees serve asmembers of the borrower’s board of directorsor actively participating in board decisions;

• Assisting in day-to-day management andoperating decisions; or

• Actively determining management changes.

These considerations are especially importantwhen the banking organization is activelyinvolved in loan workouts or debt restructuring.

The first step in identifying and minimizingenvironmental risk is for banks to performenvironmental reviews. Such reviews may beperformed by loan officers or others and typi-cally identify past practices and uses of thefacility and property, evaluate regulatory com-pliance, if applicable, and identify potentialfuture problems. This review is accomplishedby interviewing persons familiar with past andpresent uses of the facility and property, review-ing relevant records and documents, and visitingand inspecting the site.

Where the environmental review reveals pos-sible hazardous substance contamination, anenvironmental assessment or audit may berequired. Environmental assessments are madeby personnel trained in identifying potentialenvironmental hazards and provide a more thor-ough review and inspection of the facility andproperty. Environmental audits differ markedlyfrom environmental assessments in that indepen-dent environmental engineers are employed to

investigate, in greater detail, those factors listedpreviously and actually test for hazardous sub-stance contamination. Such testing might requirecollecting and analyzing air samples, surfacesoil samples, and subsurface soil samples anddrilling wells to sample ground water.

Other measures used by some banking orga-nizations to assist in identifying and minimizingenvironmental liability include obtaining indem-nities from borrowers for any clean-up costsincurred by the bank and including affirmativecovenants in loan agreements (and attendantdefault provisions) requiring the borrower tocomply with all applicable environmental regu-lations. Although these measures may providesome aid in identifying and minimizing poten-tial environmental liability, they are not a sub-stitute for environmental reviews, assessments,and audits because their effectiveness is depen-dent upon the financial strength of the borrower.

The foregoing discussion provides generalguidance on environmental liability. Because ofcontinuing legal and regulatory changes andcourt decisions in this area, all policies, prac-tices, and procedures should be periodicallyreviewed by legal counsel to ensure that they areadequate and up-to-date.

Conclusion

Potential environmental liability can touch on agreat number of loans to borrowers in manyindustries or localities. Moreover, nonlendingactivities and affiliations can lead to environ-mental liability depending upon the nature ofthese activities and the degree of participationthat the banking organization, whether domesticor foreign, exercises in its U.S. operations.Such liability can result in losses arising fromhazardous substance contamination becausebanking organizations are held directly liable forcostly court ordered clean ups. Additionally, thebanking organization’s ability to collect theloans it makes may be hampered by significantdeclines in collateral value or the inability of aborrower to meet debt payments, after payingfor costly clean-ups of hazardous substancecontamination.

Banking organizations must understand thenature of environmental liability arising fromhazardous substance contamination. Addition-ally, they should take prudential steps to identifyand minimize their potential environmental lia-



bility. Indeed, the common thread to environ-mental liability is the existence of hazardous

substances, not types of borrowers, lines ofbusiness, or real property.



Real Estate LoansExamination ObjectivesEffective date July 1997 Section 3100.2

1. To determine if policies, practices, proce-dures, and internal controls regarding realestate lending activities and appraisals areadequate.

2. To determine if branch officers are operatingin conformance with established guidelines.

3. To evaluate the portfolio for collateral suffi-ciency, performance, credit quality, andcollectibility.

4. To determine that appraisals performed inconnection with federally-related transac-tions comply with the minimum standards of

the appraisal regulations and the UniformStandards of Professional Appraisal Practice.

5. To determine whether adequate safeguardsand controls have been established to limitexposure to potential environmental liability.

6. To determine compliance with applicablelaws and regulations.

7. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawsor regulations have been noted.

Branch and Agency Examination Manual September 1997Page 1

Real Estate LoansExamination ProceduresEffective date July 1997 Section 3100.3

Refer to the Credit Risk Management examina-tion procedures for general procedures to assessthe risk of real estate lending activities. How-ever, if the branch engages in significant realestate lending activities, and additional informa-tion is needed, the examiner should perform thefollowing examination procedures.

1. If selected for implementation, complete orupdate the Internal Control Questionnaire.

2. Determine if deficiencies noted at previousexaminations and internal/external auditshave been adequately addressed bymanagement.

3. Review the following information forselected real estate loans:a. Determine the primary source of repay-

ment and evaluate its adequacy.b. Assess the quality of any secondary col-

lateral afforded by the loan guarantors orpartners.

c. Compare collateral values to outstandingdebt and determine whether the loan’sLTV ratio is in excess of the suggestedsupervisory LTV limits.

d. Assess the adequacy of the appraisal orevaluation.

e. Determine if the loan complies withbranch policy.

f. Identify deficiencies in the loan’s creditfiles or the collateral records.

g. Review the borrower’s compliance withloan covenants, and paymentperformance.

h. Determine if any problems exist thatmay jeopardize the repayment of theloan.

i. If the loan was classified during thepreceding examination and has subse-quently been paid off, determine thesource of funds for repayment (e.g.another loan, a sale to another institution,or repossession of the property.)

j. If the loan is to a firm or to individualswho provided professional services tothe branch, such as attorneys, accoun-tants, or appraisers, determine if theborrower received preferential treatment.

4. Evaluate the branch’s real estate lendingactivities, taking into account the followingitems:

a. The adequacy of the policies, proce-dures, and internal controls.

b. The adherence to policies and proce-dures, and accuracy and completeness ofthe branch’s records.

c. The competency of management andloan officers.

d. The adequacy of systems to monitor bothfavorable and adverse trends in the over-all real estate industry.

e. The quality of the real estate loan port-folio, including the level and trends ofclassified and criticized loans, and delin-quent and nonaccrual loans. Ascertain ifmanagement is aware of the causes ofexisting problems.

f. Loans lacking current and completefinancial information or documentation.Address deficiencies related to items suchas appraisals, feasibility studies, theenvironmental impact study, takeoutcommitment, title policy, deeds of trust,and mortgage notes.

g. Compliance with laws, regulations, andapplicable regulatory policy.

h. Independent verification of collateralvalues.

APPRAISALS

5. Review the branch’s appraisal and evalua-tion program, making sure it includes guide-lines for obtaining appraisals from thirdparty appraisers and evaluating appraisalsin-house.

6. Evaluate the adequacy and integrity ofthe appraisal and evaluation process,considering:a. The appropriateness of the methods,

assumptions, and techniques used, andcompliance with interagency real estateappraisal and evaluation guidelines.

b. Other appraisal deficiencies such as:• Misrepresentation of data,• Inadequate analysis,• Use of dissimilar comparables,• Underestimation of factors, such as

construction cost, construction period,lease-up period, and rent concessions,


• Use of best case assumptions for theincome approach, or

• Overly optimistic assumptions, such asa high absorption rate in an overbuiltmarket.


7. Determine if policies, procedures, and othersafeguards and controls have been estab-lished to avoid or mitigate potential envi-ronmental liability.

8. Determine whether appropriate periodicanalysis of potential environmental liabilityis conducted.

9. Review loan agreements to determine ifwarranties, representations, and indemnifi-cations have been included in loan agree-ments designed to protect the branch fromlosses stemming from hazardous substancecontamination. (Although such provisionsprovide some protection for the lender,these agreements are not binding against thegovernment or third parties. Such contrac-tual protections are only as secure as theborrower’s financial strength.)

10. Update workpapers with any informationthat will facilitate future examinations.

3100.3 Real Estate Loans: Examination Procedures

September 1997 Branch and Agency Examination ManualPage 2

Real Estate LoansInternal Control QuestionnaireEffective date July 1997 Section 3100.4

Refer to the Credit Risk Management InternalControl Questionnaire, section 3010.4, for ageneral review of the branch’s internal controls,policies, practices, and procedures. If the branchengages in significant real estate lending activi-ties, and additional information is needed, theexaminer should complete the following ICQ.For audit procedures, refer to the Credit RiskManagement section 3010.5.

1. Has branch and head office managementadopted written real estate lending policiesthat define:a. Target market?b. Acceptable collateral?c. Prudent, clear, and measurable underwrit-

ing standards for each type of propertysuch as:• Maximum loan amount and maturity?• Repayment terms?• Pricing structure?• Loan-to-value (LTV) limits?

d. Approval procedures and authority limits?e. Loan administration procedures that

include documentation, disbursement,collateral inspection, collection, and loanreview?

f. Minimum loan documentation standards,such as minimum frequency and type offinancial information required for eachcategory of real estate loan?

g. Appraisals and evaluations?h. Reporting requirements to the head office

relative to loan portfolio monitoring,including items such as compliance withlending policies and procedures, delin-quency trends, and problem loans?

2. Are policies and procedures appropriate tothe size and sophistication of the branch,and are they reviewed annually to ensurethey are compatible with changing marketconditions?

3. Has someone been assigned the responsibil-ity for maintaining the document files?

4. Are notes and other original documentsproperly safeguarded?

5. Is a tickler system or a check sheet used toensure that required documents are receivedand on file?

6. Are loan files reviewed after closing todetermine if all documents are properly

drawn, executed, recorded, and filed withinthe loan files?

7. Is there a procedure for monitoring escrowaccounts to determine that private mortgageinsurance premiums and hazard insurancepremiums are current?

8. Do hazard insurance policies include a losspayable clause to the branch?

9. Are escrow accounts reviewed at least annu-ally to determine if monthly deposits willcover anticipated disbursements?

10. Are disbursements for taxes and insurancesupported by records showing the natureand purpose of the disbursement?

11. Does the branch have adequate collectionprocedures to monitor delinquencies andpursue foreclosure?

12. Are ‘‘in-substance foreclosure’’ propertiesappropriately identified?

13. Are properties to which the branch hasobtained title appropriately transferred toother real estate owned (OREO)? Refer tothe Other Real Estate Owned section in thismanual for requirements.

APPRAISALS AND EVALUATIONS

14. Do appraisal policies include:a. Guidelines for selecting, evaluating, and

monitoring the individuals performingappraisals or evaluations, whether thirdparty or in-house?

b. Procedures for when to obtain appraisalsand evaluations on new loans, as well asreappraisals or reevaluations on existingloans?

c. Review procedures to determine thatappraisals and evaluations comply withsupervisory guidelines?

15. If appropriate, does the appraisal meet theminimum standards of the appraisal regula-tions and the Uniform Standards of Profes-sional Appraisal Practice, including:a. Purpose?b. Market value?c. Effective date?d. Marketing period?e. Sales history of subject property?


f. Reflect the valuation using the cost,income, and comparable salesapproaches?

g. Evaluate and correlate the threeapproaches into a final value estimate,based on the appraiser’s judgment?

h. Explain why an approach is inappropri-ate and not used in the appraisal?

i. Fully support the assumptions and thevalue rendered through adequatedocumentation?

16. Are staff appraisers independent of the lend-ing, investment, and collection functions?

17. Are fee appraisers engaged directly by thebranch and do they have no direct or indi-rect interest, financial or otherwise, in theproperty or transaction?

18. Are fee appraisers paid the same fee whetheror not the loan is granted?

19. If the transaction is outside the local geo-graphic market of the branch, does thebranch engage an appraiser with knowledgeof the market where the real estate collateralis located?


20. Do loan applicants provide information onenvironmental matters pertaining to theirbusiness facilities?

21. If the branch acquires a loan, either bypurchase or participation, does it ensure that

adequate due diligence regarding environ-mental risk matters has been performed bythe lead lender?

22. Do loans receive a Phase I EnvironmentalRisk Report if the collateral is deemed tohave a higher environmental risk potentialthan other types of real property?

23. Has senior management designated a spe-cific ‘‘environmental risk analyst’’ whoreceives special training on environmentalrisk?

24. Are potential environmental problems notedin an environmental risk report consideredby senior management prior to loan approval?

25. Are procedures established for reviewingcollateral prior to foreclosure to ensureenvironmental risk has been addressed?

26. Are training programs conducted so thatlending personnel are aware of environmen-tal liability issues and are able to identifyborrowers with potential problems?

CONCLUSION

27. Is the information covered by this ICQadequate for evaluating internal controls inthis area? If not, indicate any additionalexamination procedures deemed necessary.

28. Based on the information gathered, evaluatethe internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).

3100.4 Real Estate Loans: Internal Control Questionnaire


Real Estate Construction LoansEffective date July 1997 Section 3110.1

INTRODUCTION

A construction loan is used to finance theconstruction of a particular project within aspecified period of time and is funded by super-vised disbursements of a predetermined amountover the construction period. When properlycontrolled, a branch can promote commercial orresidential development through its constructionlending as well as receive significant profits overa relatively short time frame.

Inasmuch as construction lending is a form ofinterim financing, loan repayment is contingentupon the borrower either obtaining permanentfinancing or finding a buyer with sufficient fundsto purchase the completed project. Becausemany borrowers anticipate retaining ownershipafter construction, the cost and availability offunds from permanent financing is a primaryfactor to be considered by the branch in assess-ing the risk of a construction loan.

A construction loan is generally secured by afirst mortgage or deed of trust on the land andimprovements, which is often backed by apurchase agreement from a financially soundinvestor or by a takeout financing agreementfrom a responsible permanent lender. A long-term mortgage loan (permanent financing) istypically obtained prior to or simultaneous withthe construction loan and is made to refinancethe short-term construction loan. Additionally,the bank may require a borrower to providesecondary collateral in the form of a juniorinterest in another real estate project or a per-sonal guarantee.

LENDING POLICY

Banks can limit the risk inherent in constructionlending by establishing policies that specifythe type and extent of branch involvement.The branch’s lending policies should reflectprudent lending standards and set forth pricingguidelines, limits on loan-to-value ratios anddebt-coverage ratios, and yield requirements.Such policies should also address proceduresrelative to controlling disbursements in a man-ner that is commensurate with the constructionprogress.

Lending Limits

A branch should establish well-controlled con-struction lending limits that are within theacceptable standards of state banking regula-tions. State banking statutes governing construc-tion lending may contain minimum standards ofprudence without specifying actual loan terms.

The branch’s internal limits should not exceedthe supervisory loan-to-value (LTV) limits setforth in the Interagency Guidelines for RealEstate Lending Policies, as required by section304 of the Federal Deposit Insurance Corpora-tion Improvement Act of 1991 and included asappendix C of the Federal Reserve’s Regula-tion H. These guidelines, and the accompanyingLTV limits, are discussed in the Real EstateLoans section of this manual. Generally, theLTV ratio should not exceed the followingsupervisory guidance limits:

• 65 percent for raw land loans;• 75 percent for land development and improved

land loans;• 80 percent for commercial, multifamily, and

other nonresidential construction loans; and• 85 percent for one- to four-family residential

construction loans.

The foregoing limits apply only to domesticbanks, not to FBOs; however, these guidelinesare provided for reference.

For loans that fund multiple phases of thesame real estate project, the appropriate LTVlimit is the supervisory LTV limit applicable tothe final phase of the project.

Lending Risks

Construction loans are vulnerable to a widevariety of risks. Critical to the evaluation of anyconstruction loan is the analysis of the project’sfeasibility study to ascertain the developer’srisk, which affects the lender’s risk. The majorportion of the risk is attributable to the need tocomplete a project within specified cost andtime limits. Examples of difficulties that mayarise include:

• Completion of a project after takeout dates,which voids permanent funding commitments.


• Cost overruns, which may exceed takeoutcommitments or sale prices.

• The possibility that the completed project willbe an economic failure.

• The diversion of progress payments resultingin nonpayment of material bills orsubcontractors.

• A financial collapse of or the failure of thecontractors, subcontractors, or suppliers toperform before the completion date.

• Increased material or labor costs.• The destruction of improvements from unex-

pected natural causes.• An improper or lax monitoring of funds

advanced by the branch.

TYPES OF CONSTRUCTIONLOANS

The basic types of construction loans are unse-cured front money, land development, residen-tial construction, and commercial constructionloans. It is not uncommon for a branch toprovide the acquisition, development, and con-struction loans for a particular project.

Unsecured Front Money Loans

Front money loans are considered very risky andshould not be undertaken unless the branch hasthe expertise to evaluate the credit risk. Theseloans may represent working capital advances toa borrower who may be engaged in a new andunproven venture. The funds may be used toacquire or develop a building site, eliminate titleimpediments, pay architect or standby fees, andmeet minimum working capital requirementsestablished by construction lenders. Becauserepayment often comes from the first drawagainst construction financing, many construc-tion loan agreements prohibit the use of the firstadvance to repay nonconstruction costs. Unse-cured front money loans used as a developer’sequity investment in a project or to cover initialcost overruns are symptomatic of an undercapi-talized or possibly an inexperienced or ineptbuilder.

Land Development Loans

Land development or off-site improvement loansare intended to be secured-purchase loans or

unsecured advances to creditworthy borrowers.A development loan involves the purchase ofland and lot development in anticipation offurther construction or sale of the property. Inaddition to funding the acquisition of the land, adevelopment loan may be used to fund thepreparation of the land for future construction,including the grading of land, installation ofutilities, and construction of streets.

Effective administration of a land develop-ment loan begins with a plan defining each stepof the development. The development planshould incorporate cost budgets, including legalexpenses for building and zoning permits, envi-ronmental impact statements, costs of installingutilities, and all other projected costs of thedevelopment. Branch management’s review ofthe plan and related cost breakdowns shouldprovide the basis for determining the size, terms,and restrictions for the development loan. Referto the subsection below on the assessment ofreal estate collateral for further discussion.

The LTV ratio should provide for sufficientmargin to protect the branch from unforeseenevents (such as unplanned expenses) that wouldotherwise jeopardize the branch’s collateral posi-tion or repayment prospects. If the loan involvesthe periodic development and sale of portions ofthe property under lien, each separately identi-fiable section of the project should be indepen-dently appraised and any collateral should bereleased in a manner that maintains a reasonablemargin. The repayment program should be struc-tured to follow the sales or development pro-gram. Control over development loans can bebest established when the branch finances boththe development and the construction or salephases of the project.

In the case of an unsecured land developmentloan, it is essential to analyze the borrower’sfinancial statements to determine the source ofloan repayment. In establishing the repaymentprogram, the branch should review sales projec-tions to ensure that they are not overly optimis-tic. Additionally, branches should avoid grant-ing loans to illiquid borrowers or guarantorswho provide the primary support for a borrower(project).

Residential Construction Loans

Residential construction loans are made eitheron a speculative basis, where homes are built to

3110.1 Real Estate Construction Loans


be sold later in the general market, or for aspecific buyer with prearranged permanentfinancing. Loans financing residential projectsthat do not have prearranged home buyer financ-ing are usually limited to a predetermined num-ber of speculative homes, which are permitted toget the project started. It is important to ensurethat the home buyer has arranged permanentfinancing before the branch finances the con-struction; otherwise, the branch may find itselfwithout a source of repayment. Constructionloans without permanent takeout commitmentsgenerally should be aggregated to determinewhether a concentration of credit exists, that is,in those situations when the amount exceeds thedesignated percentage of total assets. For furtherguidance in this area, examiners should consultwith their respective agencies.

Proposals to finance speculative constructionprojects should be evaluated according to pre-determined policies that are compatible with theinstitution’s size, the technical competence of itsmanagement, and the housing needs of its ser-vice area. The prospective borrower’s reputa-tion, experience, and financial condition shouldalso be reviewed to assess the likelihood ofcompleting the proposed project. Until theproject is completed, the actual value of the realestate is questionable. Thus, the marketability ofthe project should be substantiated in a feasibil-ity study, reflecting a realistic assessment ofcurrent favorable and unfavorable local housingmarket conditions. As in any real estate loan, thebranch must also obtain an appraisal or evalua-tion for the project. The appraisal or evaluationand the feasibility study are important tools tobe used by lenders in evaluating project risks.For projects located out of area, the lender maylack market expertise, which makes evaluatingthe reasonableness of the marketing plan andfeasibility study more difficult, and thereforemakes the loan inherently riskier.

A branch dealing with speculative buildersshould have control procedures tailored to theindividual project. A predetermined limit on thenumber of unsold units to be financed at any onetime should be included in the loan agreement toavoid overextending the builder’s capacity. Theconstruction lender should receive currentinspection reports indicating the project’sprogress. In some instances, the constructionlender is also the permanent mortgagor. Loanson larger residential construction projects areusually negotiated with prearranged permanentfinancing as part of the construction loan.

Commercial Construction Loans

A branch’s commercial construction lendingactivity can encompass a wide range ofprojects—apartments, condominiums, officebuildings, shopping centers, and hotels—witheach requiring a special set of skills and exper-tise to successfully manage, construct, andmarket.

Commercial construction loan agreementsshould normally require the borrower to have aprecommitted extended-term loan to ‘‘takeout’’the construction lender. Takeout financing agree-ments, however, are usually voidable if construc-tion is not completed by the final funding date,if the project does not receive occupancy per-mits, or if the preleasing or occupancy rate doesnot meet an agreed-upon level. A branch canalso enter into an ‘‘open-end’’ construction loanwhere there is no precommitted source to repaythe construction loan. Such loans pose an addedrisk because the branch may be forced intoproviding permanent financing, oftentimes indistressed situations. In evaluating this risk, thebranch should consider whether the completedproject will be able to attract extended-termfinancing, supported by the projected net oper-ating income.

The risk of commercial construction requiresa complete assessment of the real estate collat-eral, borrower’s financial resources, source ofthe extended-term financing, and constructionplans. As in any real estate loan, the branch mustobtain an appraisal or evaluation of the realestate in accordance with the Federal Reserve’sRegulation H. Additionally, the borrower shouldprovide a feasibility study for the project thatdetails the project’s marketing plan, as well asan analysis of the supply-and-demand factorsaffecting the projected absorption rate. For anopen-end construction loan, the feasibility studyis particularly important to the branch’s assess-ment of the credit because the repayment of theloan becomes increasingly dependent on thesales program or leasing of the project.

The branch also needs to assess the borrow-er’s development expertise, that is, whether theborrower can complete the project within budgetand according to the construction plans. Thefinancial risk of the project is contingent on theborrower’s development expertise because thesource of the extended-term loan may be predi-cated upon a set date for project completion.

Real Estate Construction Loans 3110.1


Until the project is completed, the actual valueof the real estate is questionable.

A branch may reduce its financial risk byfunding the construction loan after the borrowerhas funded its share of the project equity (forexample, by paying for the feasibility study andland acquisition and development costs). Analternative approach would require the borrowerto inject its own funds into the project atagreed-upon intervals during the project’s man-agement, construction, and marketing phases tocoincide with the construction lender’s contri-butions. In larger projects, equity injections canbe provided by equity partners or joint ventures.These can take the form of equity syndications,with contributions injected in the project inphases. A branch should assess the likelihood ofthe syndication being able to raise the necessaryequity.

BRANCH ASSESSMENT OF THEBORROWER

The term ‘‘borrower’’ can refer to different typesof entities. These forms can range from an entitywhose sole asset is the project being financed toan entity that has other assets available tosupport the debt in addition to the project beingfinanced (a multi-asset entity).

Although the value of the real estate collateralis an important component of the loan approvalprocess, the branch should not place unduereliance on the collateral value in lieu of anadequate analysis of the borrower’s ability torepay the loan. The analytical factors differdepending on the purpose of the loan, such asresidential construction versus the various typesof commercial construction loans.

The branch’s analysis is contained in itsdocumentation files, which should include back-ground information on the borrower and partner/guarantor concerning their character and credithistory, expertise, and financial statements (pref-erably audited) for the most recent fiscal years.Background information regarding a borrower’sand partner’s/guarantor’s character and credithistory is based upon their work experience andprevious repayment practices, both relative totrade creditors and financial institutions. Thedocumentation files should indicate whether theborrower has demonstrated the ability to suc-cessfully complete the type of project to beundertaken. The financial statements should be

analyzed to ensure that the loan can be repaid inthe event that a takeout does not occur.

The degree of analysis depends on whetherthe borrower is a single-asset entity or a multi-asset entity. A loan to a single-asset entity isoften predicated upon the strength of the partners/guarantors. Accordingly, understanding theirfinancial strength, which frequently is made upof various partnership interests, is key to assess-ing the project’s strength. In this example, itwould be necessary to obtain financial informa-tion on the partner’s/guarantor’s other projects,even those not financed by the branch, to under-stand their overall financial condition. This isnecessary because other unsuccessful projectsmay cause financial trouble for the partner/guarantor, despite a successful sales program bythe branch’s borrower. Issues to be considered,in addition to those raised in the precedingparagraph, include the vacancy rates of thevarious projects, break-even points, and rentrolls.

A loan to a multi-asset entity has similarcharacteristics to those found in the single-assetentity, in that it is necessary to evaluate all of theassets contained therein to ascertain the actualfinancial strength. In both cases, assessment ofthe project under construction would includepreleasing requirements. For a loan with atakeout commitment, the financial strength andreputation of the permanent lender should beanalyzed. For a loan without a takeout commit-ment, or one where the construction lenderprovides the permanent financing for its con-struction loan, the long-term risks also need tobe evaluated. Refer to the Real Estate Loanssection in this manual, on the branch’s assess-ment of the borrower, for additional factors to beconsidered.

In instances where approval for the loan ispredicated upon the strength of entities otherthan the borrower (partner/guarantor), the branchshould obtain information on their financialcondition, income, liquidity, cash flow, contin-gent liabilities, and any other relevant factorsthat exist to demonstrate their financial capacityto fulfill the obligation in the event that theborrower defaults.

Partners/guarantors generally have invest-ments in other projects included as assets ontheir financial statements. The value of theseinvestments frequently represents the partner’s/guarantor’s own estimate of the investment’sworth, as opposed to a value based upon theinvestment’s financial statements. As a result, it



is necessary to obtain detailed financial state-ments for each investment to understand thepartner’s/guarantor’s complete financial pictureand capacity to support the loan. The statementsshould include detailed current and accuratecash flow information since cash flow is oftenthe source of repayment.

It is also important to consider the numberand amount of the guarantees currently extendedby a partner/guarantor to determine if they havethe financial capacity to fulfill the contingentclaims that exist. Furthermore, the branch shouldreview the prior performance of the partner/guarantor to voluntarily honor the guarantee aswell as the marketability of the assets collater-alizing the guarantee. Since the guarantee can belimited to development and construction phasesof a project, the branch should closely monitorthe project before issuing a release to the partner/guarantor.

BRANCH ASSESSMENT OF REALESTATE COLLATERAL

Branches should obtain an appraisal or evalua-tion, as appropriate, for all real estate-relatedfinancial transactions prior to making the finalcredit or other decision. Refer to the Real EstateAppraisals and Evaluations section of thismanual for a description of the related require-ments a branch must satisfy for real estate-related financial transactions. The appraisal sec-tion explains the standards for appraisals,indicates which transactions require an appraisalor an evaluation, states qualifications necessaryfor an appraiser and evaluator, provides guid-ance on evaluations, and describes the threeappraisal methods.

The appraisal or evaluation techniques usedto value a proposed construction project areessentially the same as those used for othertypes of real estate. The aggregate principalamount of the loan should be based on anappraisal or evaluation that provides, at a mini-mum, the ‘‘as is’’ market value of the property.Additionally, the branch will normally requestthe appraiser to report the ‘‘as completed’’value. Projections should be accompanied by afeasibility study explaining the effect of pro-jected property improvements on the marketvalue of the land. The feasibility study may be aseparate report or incorporated into the appraisalreport. If the appraiser uses the feasibility study,

the appraiser’s acceptance or rejection of thestudy and its effect on the value should be fullyexplained in the appraisal.

Management is responsible for reviewing thereasonableness of the appraisal’s or evaluation’sassumptions and conclusions. Also, manage-ment’s rationale in accepting and relying uponthe appraisal or evaluation should be docu-mented in writing and made a part of loandocumentation. In assessing the underwritingrisks, management should reconsider anyassumptions used by an appraiser that reflectoverly optimistic or pessimistic values. If man-agement, after its review of the appraisal orevaluation, determines that there are unsubstan-tiated assumptions, the branch may request theappraiser or evaluator to provide a more detailedjustification of the assumptions or obtain a newappraisal or evaluation. Since the approval ofthe loan is based upon the value of the projectafter the construction is completed, insofar asthe value component of the loan-to-value ratio isconcerned, it is important for the branch toclosely monitor the project’s progress and valueduring the construction period. Refer to the RealEstate Loans section of the manual for addi-tional information relative to the real estatecollateral assessment.

LOAN DOCUMENTATION

The loan documentation should provide infor-mation on the essential details of the loantransaction, the security interest in the real estatecollateral, and the takeout loan commitment, ifany. The necessary documentation before thestart of construction generally includes:

• Financial and background information on theborrower to substantiate the borrower’s exper-tise and financial strength to complete theproject.

• The construction loan agreement, which setsforth the rights and obligations of the lenderand borrower, conditions for advancing funds,and events of default. In some states, theagreement must be cited in either the deed oftrust or the mortgage.

• A recorded mortgage or deed of trust, whichcan be used to foreclose and to obtain title tothe collateral.

• A title insurance binder or policy, usuallyissued by a recognized title insurance com-



pany or, in some states, an attorney’s opinion.The title should be updated with each advanceof funds to provide additional collateral pro-tection.

• Insurance policies and proof of payment asevidence that the builder has adequate andenforceable coverage for liability, fire andother hazards, and vandalism and maliciousmischief losses.

• An appropriate appraisal or evaluation show-ing the value of the land and improvements todate or, possibly, a master appraisal based onspecifications for a multi-phase development.

• Project plans, a feasibility study, and a con-struction budget showing the developmentplans, project costs, marketing plans, andequity contributions. A detailed cost break-down of land and ‘‘hard’’ construction costs,as well as indirect or ‘‘soft’’ costs for con-struction loan interest, organizational andadministrative cost, and architectural, engi-neering, and legal fees should be included.

• Property surveys, easements, an environmen-tal impact report, and soil reports that indicateconstruction is feasible on the selected devel-opment site. The branch should also obtain thearchitect’s certification of the plan’s compli-ance with all applicable building codes andzoning, environmental protection, and othergovernment regulations, as well as the engi-neer’s report on compliance with buildingcodes and standards. If internal expertise isnot available, a branch may need to retain anindependent construction expert to reviewthese documents to assess the reasonablenessand appropriateness of the construction plansand costs.

• The takeout commitment from the permanentlender, if applicable, and the terms of the loan.The branch should verify the financial strengthof the permanent lender to fund the takeoutcommitment.

• A completion or performance bond signed bythe borrower that guarantees that the borrowerwill apply the loan proceeds to the projectbeing financed.

• An owners’ affidavit or a borrowing resolutionempowering the borrower or its representativeto enter into the loan agreement.

• Evidence that property taxes have been paid todate.

These documents furnish evidence that thelending officer is obtaining the information nec-

essary for processing and servicing the loan andprotect the branch in the event of default.

Documentation for ResidentialConstruction Loans on Subdivisions

The documents mentioned above are usuallyavailable for residential construction loans onsubdivisions (tracts). Documentation of tractloans frequently includes a master note in thegross amount of the entire project, and a masterdeed of trust covering all of the land involved inthe project. In addition to an appraisal or evalu-ation for each type of house to be constructed,the branch should also obtain a master appraisalincluding a feasibility study for the entire devel-opment. The feasibility study compares theprojected demand for housing against the antici-pated supply of housing in the market area of theproposed tract development. This analysis shouldindicate whether there will be sufficient demandfor the developer’s homes given the project’slocation, type of homes, and unit sales price.

Documentation for TakeoutCommitment

Most construction lenders require the developerto have an arrangement for permanent financingfor each house to be constructed. Exceptionsinclude model homes, typically one for eachstyle of home offered, and a limited number ofhousing starts ahead of sales (speculative build-ing). The starts ahead of sales, however, containadditional risk. If the branch finances too manyhouses without purchase contracts, and housingsales decline rapidly, it may have to foreclose onthe unsold houses and sell them for less thantheir loan value. A takeout of this type is usuallyan arrangement between the developer and apermanent mortgage lender, but constructionlenders may also finance the permanentmortgages.

The essential information required for a com-mercial real estate takeout to proceed includesthe floor and ceiling rental rates and minimumoccupancy requirements; details of the projectbeing financed; expiration date; standby feerequirement; assignment of rents; and, gener-ally, a requirement that the construction loan befully disbursed and not in any way be in defaultat the time settlement occurs.



The commitment agreement, referred to as abuy/sell contract or a tri-party agreement, issigned by the borrower, the construction lender,and the permanent lender. The purpose of thisagreement is to permit the permanent lender tobuy the loan directly from the constructionlender upon completion of the construction,with the stipulation that all contingencies havebeen satisfied. Examples of contingencies includeproject completion by the required date, cleartitle to the property, and minimum lease-uprequirements. A commitment agreement alsoprotects the construction lender against unfore-seen possibilities, such as the death of a princi-pal, before the permanent loan documents aresigned.

LOAN ADMINISTRATION

The branch and the borrower must effectivelycooperate as partners if controls relative toconstruction progress are to be maintained. Theloan agreement specifies the performance ofeach party during the entire course of construc-tion. Any changes in construction plans shouldbe approved by both the construction lender andthe takeout lender. Construction changes canresult in increased costs, which may not neces-sarily increase the market value of the com-pleted project. On the other hand, a decrease incosts may not indicate a savings but may sug-gest the use of lesser quality materials or work-manship, which could affect the marketability ofthe project.

Disbursement of Loan Funds

Loan funds are generally disbursed througheither a stage payment plan or a progress pay-ment plan. Regardless of the method of dis-bursement, the amount of each constructiondraw should be commensurate with the improve-ments made to date. Funds should not beadvanced unless they are used in the projectbeing financed and as stipulated in the drawrequest. Therefore, the construction lender mustmonitor the funds being disbursed and must beassured, at every stage of construction, thatsufficient funds are available to complete theproject.

Stage Payment Plan

The stage payment plan, which is normallyapplied to residential and smaller commercialconstruction loans, uses a pre-established sched-ule for fixed disbursements to the borrower atthe end of each specified stage of construction.The amount of the draw is usually based uponthe stage of development because residentialhousing projects normally consist of houses invarious stages of construction. Nevertheless,loan agreements involving tract financing typi-cally restrict further advances in the event of anaccumulation of completed and unsold houses.Disbursements are made when construction hasreached the agreed-upon stages, verified by anactual inspection of the property. These typi-cally include advances at the conclusion ofvarious stages of construction, such as the foun-dation, exterior framing, the roof, interior fin-ishing, and completion of the house. The finalpayment is made after the legally stipulated lienperiod for mechanic’s liens has lapsed.

Disbursement programs of this type are usu-ally required for each house constructed within atract development. As each house is completedand sold, the branch makes a partial releaserelative to that particular house covered by itsmaster deed of trust. The amount of the releaseis set forth in the loan agreement, which speci-fies the agreed-upon release price for each housesold with any excess over the net sales proceedsremitted to the borrower.

Progress Payment Plan

The progress payment plan is normally used forcommercial projects. Under a progress paymentsystem, funds are released as the borrowercompletes certain phases of construction asagreed upon in the loan agreement. Normally,the branch retains a percentage of the funds as ahold-back (or retainage) to cover project costoverruns or outstanding bills from suppliers orsubcontractors. Hold-backs occur when adeveloper/contractor uses a number of subcon-tractors and maintains possession of a portion ofthe amounts owed to the subcontractors duringthe construction period. This is done to ensurethat the subcontractors finish their work beforereceiving the final amount owed. Accordingly,the construction lender holds back the same



funds from the developer/contractor to avert therisk of their misapplication or misappropriation.

The borrower presents a request for paymentfrom the branch in the form of a ‘‘constructiondraw’’ request or ‘‘certification for payment,’’which sets forth the funding request by construc-tion phase and cost category for work that hasbeen completed. This request should be accom-panied by receipts for the completed work(material and labor) for which payment is beingrequested. The borrower also certifies that theconditions of the loan agreement have beenmet—that all requested funds have been used inthe subject project and that suppliers and sub-contractors have been paid. Additionally, thesubcontractors and suppliers should provide thebranch with lien waivers covering the workcompleted for which payment has been received.Upon review of the draw request and indepen-dent confirmation on the progress of work, thebranch will disburse funds for construction costsincurred, less the hold-back. The percentage ofthe loan funds retained are released when anotice of the project’s completion has been filed,and after the stipulated period has elapsed underwhich subcontractors or suppliers can file a lien.

Monitoring Progress of Constructionand Loan Draws

It is critical that a branch has appropriate pro-cedures and an adequate tracking system tomonitor payments to ensure that the fundsrequested are appropriate for the given stage ofdevelopment. The monitoring occurs throughphysical inspections of the project once it hasstarted. The results of the inspections are thendocumented in the inspection reports, which arekept in the appropriate file. Depending on thecomplexity of the project, the inspection reportscan be completed either by the lender or by anindependent construction consulting firm, thelatter generally staffed by architects and engi-neers. The reports address both the quantity andthe quality of the work for which funds arebeing requested. They also verify that the plansare being followed and that the construction isproceeding on schedule and within budget.

The branch must be accurately informed ofthe progress to date in order to monitor the loan.It is also important that the branch ascertainwhether draws are being taken in accordancewith the predetermined disbursement schedule.

Before any draw amount is disbursed, however,the branch must obtain verification of continuedtitle insurance. Generally, this means verifyingthat no liens have been filed against the title ofthe project since the previous draw. The titleinsurance insuring the construction lender’smortgage or lien is then increased to include thenew draw, which results in an increase in thetitle insurance commensurate with the disburse-ment of funds. The lender frequently examinestitle to the property securing the constructionloan to also be certain that the borrower is notpledging it for other borrowings and to be surethat mechanic’s liens are not being filed forunpaid bills. When the project is not proceedingas anticipated, that fact should be reflected in theinspection reports.

Another important component in the processis the ongoing monitoring of general economicfactors that will affect the marketing and sellingof the residential or commercial properties andaffect their success upon completion of theproject.

Monitoring Residential Projects

An inventory list is maintained for each tract orphase of the project. The inventory list shouldshow each lot number, the style of house, therelease price, the sale price, and the loan bal-ance. The list should be posted daily withadvances and payments indicating the balanceadvanced for each house, date completed, datesold, and date paid, and should age the builder’sinventory by listing the older houses completedand unsold.

Inspections (usually monthly) during thecourse of construction of each house should bedocumented in progress reports. The progressreport should indicate the project’s activity dur-ing the previous month, reflecting the number ofhomes under construction, the number com-pleted, and the number sold. The monthly reportshould indicate whether advances are beingmade in compliance with the loan agreement.

Monitoring Commercial Projects

To have an effective control over its commercialconstruction loan program, the branch musthave an established loan administration processthat continually monitors each project. The pro-



cess should include monthly reporting on thework completed, the cost to date, the cost tocomplete, construction deadlines, and loan fundsremaining. Any changes in construction plansshould be documented and reviewed by theconstruction consulting firm and should beapproved by the branch and takeout lender. Asignificant number of change orders may indi-cate poor planning or project design, or prob-lems in construction, and should be tracked andreflected in the project’s budget. Soft costs suchas advertising and promotional expenses nor-mally are not funded until the marketing of theproject has started.

Final Repayment

Before the final draw is made, the constructionloan should be in a condition to be converted toa permanent loan. Usually the final draw includespayment of the hold-back stipulated in the loanagreement and is used to pay all remaining bills.The branch should obtain full waivers of liens(releases) from all contractors, subcontractors,and suppliers before the loan is released and thehold-back is disbursed. The branch should alsoobtain a final inspection report to confirm theproject is completed and meets the buildingspecifications, including confirmation of the cer-tificate of occupancy from the governing build-ing authority.

Sources of permanent funding for commercialprojects vary greatly, depending upon the typeof project. For condominium projects, the con-struction lender may also be providing thefunding for marketing the individual units andwould be releasing the loan on a unit-by-unitbasis similar to a residential development con-struction loan. If there is a pre-committed take-out lender, the new lender could purchase theconstruction loan documents and assume thesecurity interest from the construction lender. Ifthe project is being purchased for cash, thebranch would release its lien and cancel thenote.

Additionally, as the commercial project isleased, the lender should ensure that the branch’sposition is protected in the event that extended-term funding is not obtained. The branch mayrequire tenants to enter into subordination,attornment, and nondisturbance agreements,which protect the branch’s interests in the leaseby providing for the assumption of the land-

lord’s position by the branch in the event theborrower declares bankruptcy. Furthermore, toensure that the branch has full knowledge of allprovisions of the lease agreements, tenantsshould be required to sign an estoppel certifica-tion.

In some cases, the takeout lender may onlypay off a portion of the construction loan becausea conditional requirement for full funding hasnot been met, such as the project not attaining acertain level of occupancy. The constructionlender would then have a second mortgage onthe remaining balance of the construction loan.When the conditions of the takeout loan are met,the construction lender is repaid in full and thelien is released.

Interest Reserves

A construction loan is generally an interest-onlyloan because of the fact that cash flow is notavailable from most projects until they arecompleted. The borrower’s interest expense istherefore borrowed from the construction lenderas part of the construction loan for the purposeof ‘‘paying’’ the lender interest on the ‘‘portion’’of the loan used for actual construction. Thefunds advanced to pay the interest are includedas part of the typical monthly draw. As a result,the balance due to the lender increases with eachdraw by the full amount of construction costs,plus the interest that is borrowed.

The borrower’s interest cost is determined bythe amount of credit extended and the length oftime needed to complete the project. This inter-est cost is referred to as an interest reserve. Thisperiod of time should be evaluated for reason-ableness relative to the project being financed.In larger projects, cash flow may be generatedprior to the project’s completion. In such cases,any income from the project should be appliedto debt service before there is a draw on theinterest reserve. The lender should closely moni-tor the lease-up of the project to ensure that theproject’s net income is being applied to debtservice and not diverted to the borrower as areturn of the developer’s capital or for use in thedeveloper’s other projects.

Loan Default

The inherent exposure in construction financingis that the full value of the collateral is not



realized until the project is completed. In defaultsituations the branch must consider the alterna-tives available to recover its advances. Forincomplete projects, the branch must decidewhether it is more advantageous to complete theproject or to sell on an ‘‘as is’’ basis. The variousmechanic’s and materialmen’s liens, tax liens,and other judgments that arise in such cases aredistressing to even the most seasoned lender.Due to these factors, the construction lendermay not be in the preferred position indicated bydocuments in the file. Therefore, the lendershould take every precaution to minimize anythird-party claim on the collateral. Because lawsregarding the priority of certain liens may varyamong states, the branch should take the neces-sary steps to ensure that its lien is recorded priorto the commencement of work or the delivery ofmaterials and supplies.

Signs of Problems

To detect signs of a borrower’s financial prob-lems, the branch should review the borrower’sfinancial statements on a periodic (quarterly)basis, assessing the liquidity, debt level, andcash flow. The degree of information the finan-cial statements provide the branch, insofar asunderstanding the borrower’s financial condi-tion is concerned, depends primarily on whetherthe borrower is a single-asset entity or a multi-asset entity.

The financial statements of a single-assetentity only reflect the project being constructed;therefore, they are of a more limited use thanstatements of multi-asset entities. Nevertheless,one issue that is of importance to financialstatements of both entities relates to monitoringchanges in accounts and trade payables. Moni-toring these payables in a detailed manner helpsthe branch to determine if trade payables arepaid late or if there are any unpaid bills. In theevent of problems, a branch might choose toeither contact the payables directly or request anadditional credit check on the borrower. Anothersource of information indicating borrower prob-lems is local publications that list lawsuits orjudgments that have been filed or entered againstthe borrower. Additionally, the branch shouldalso verify that the borrower is making its taxpayments on time.

In a multi-asset entity, on the other hand,more potential problems could arise due to the

greater number of assets (projects/properties)that make up the borrower. As a result, it isnecessary to obtain detailed financial statementsof each of the assets (projects/properties) andthe consolidating financial statements, as well asthe consolidated financial statements. This isimportant because each kind of statement canprovide significant insight into problems thatcould adversely affect the borrower’s overallfinancial condition.

Assessing the financial condition of the multi-asset entity includes evaluating the major sourcesof cash and determining whether cash flow isdependent on income generated from completedprojects, the sale of real estate, or infusion ofoutside capital. Additionally, the branch shouldalso review the borrower’s account receivablesfor the appropriateness of intercompany trans-actions and to guard against diversion of funds.

Depending upon the structure of the loan, itmay also be desirable to obtain a partner’s/guarantor’s financial statements on a periodicbasis. In such cases it is important to obtaindetailed current and accurate financial state-ments that include cash flow information on aproject-by-project basis.

Slow unit sales, or excessive inventory rela-tive to sales, indicate the borrower may havedifficulty repaying the loan. Although some-times there are mitigating factors beyond thecontrol of the borrower, such as delays inobtaining materials and supplies, adverse weatherconditions, or unanticipated site work, the bor-rower may be unable to overcome these prob-lems. Such delays usually increase project costsand could hamper the loan’s repayment.

The construction lender should be aware offunds being misused—for example, rebuildingto meet specification changes not previouslydisclosed, starting a new project, or possiblypaying subcontractors for work performed else-where. The practice of ‘‘front loading,’’ wherebya builder deliberately overstates the cost of thework to be completed in the early stages ofconstruction, is not uncommon and, if notdetected early on, will almost certainly result ininsufficient loan funds available to completeconstruction in the event of a default.

Loan Workouts

Sound workout programs begin with a fulldisclosure of all relevant information based on a



realistic evaluation of the borrower’s ability tomanage the business entity (business, technical,and financial capabilities), and the branch’sability to assist the borrower in developing andmonitoring a feasible workout/repayment plan.Management should then decide on a course ofaction to resolve the problems, with the terms ofthe workout documented in writing and formallyagreed to by the borrower. If additional collat-eral is accepted or substituted, the branch shouldensure that the necessary legal documents arefiled to protect the branch’s collateral position.

In those cases where the borrower is permit-ted to finish the project, additional extensions ofcredit for completing the project, due to costoverruns or an insufficient interest reserve, mayrepresent the best alternative for a workout plan.At the same time, the branch should evaluate thecause of the problem(s), such as mismanage-ment, and determine whether it is in its bestinterest to allow the borrower to complete theproject.

SUPERVISORY POLICY

As a result of competitive pressures, manybranches in the early 1980s made constructionloans on an open-end basis, wherein the bor-rower did not have a commitment for longer-term or takeout financing before constructionwas started. Although there was sufficientdemand for commercial real estate space whenthis practice commenced, the supply of spacebegan to exceed demand. One symptom of theexcess supply was an increase in vacancy rates,

which led to declining rental income caused bythe ever greater need for rent concessions. Thisdecline in cash flow from income-producingproperties, and the uncertainty regarding futureincome, reduced the market value of manyproperties to levels considered undesirable bypermanent mortgage lenders. As a result of thesubsequent void created by the permanent lend-ers, banks in the mid- and late-1980s began toextend medium-term loans with maturities of upto seven years (also referred to as mini-perms).These mini-perms were granted with the expec-tation by banks that as the excess supply ofspace declined, the return on investment wouldimprove, and permanent lenders would return.

As these loans mature in the 1990s, borrowersmay continue to find it difficult to obtainadequate sources of long-term credit. In somecases, banks may determine that the most desir-able and prudent course is to roll over or renewloans to those borrowers who have demon-strated an ability to pay interest on their debts,but who presently may not be in a position toobtain long-term financing for the loan balance.

The act of refinancing or renewing loans tosound borrowers, including creditworthy com-mercial or residential real estate developers,generally should not be subject to supervisorycriticism in the absence of well-defined weak-nesses that jeopardize repayment of the loans.Refinancings or renewals should be structured insuch a manner that is consistent with soundbanking principles, supervisory guidelines, andaccounting practices, which would protect thebranch and improve its prospects for collectingor recovering on the asset.



Real Estate Construction LoansExamination ObjectivesEffective date July 1997 Section 3110.2

1. To determine if policies, practices, proce-dures, and internal controls regarding realestate construction loans are adequate.

2. To determine if branch officers are operatingin conformance with the branch’s establishedguidelines.

3. To evaluate the portfolio for collateral suffi-ciency, performance, credit quality, andcollectibility.


5. To initiate corrective action when policies,practices, procedures, or internal controls aredeficient or when violations of law or regu-lations have been noted.


Real Estate Construction LoansExamination ProceduresEffective date July 1997 Section 3110.3

Refer to the Real Estate Loan ExaminationProcedures section of this manual for examina-tion procedures related to all types of real estatelending activity, and incorporate into this check-list those procedures applicable to the review ofthe real estate construction loans. The proce-dures in this checklist are unique to the reviewof a branch’s construction lending activity.

1. Determine the scope of the examination basedon the evaluation of internal controls and thework performed by internal/external auditors.

2. Test real estate construction loans for com-pliance with policies, practices, procedures,and internal controls by performing theremaining examination procedures in thissection. Also, obtain a listing of any deficien-cies noted in the latest internal/external auditreviews and determine if appropriate correc-tions have been made. Review manage-ment’s actions taken in response to priorexamination comments.

3. Review management reports on the status ofconstruction lending activity, economicdevelopments in the market, and problemloan reports.

4. Evaluate the branch with respect to:a. the adequacy of written policies and pro-

cedures relating to construction lending.b. operating compliance with established

branch policy.c. favorable or adverse trends in construc-

tion lending activity.d. the accuracy and completeness of the

branch’s records.e. the adequacy of internal controls, includ-

ing control of construction draws.f. the adherence of lending staff to lending

policies, procedures, and authority as wellas the branch’s adherence to the holdingcompany’s loan limits, if applicable.

g. compliance with laws, regulations, andFederal Reserve policy on constructionlending activity, including supervisoryloan-to-value (LTV) limits and restric-tions; loans to officers, directors, and share-holders; appraisal and evaluation of realestate collateral; and prudent lendingpractices.

5. Select loans for examination, using an appro-priate sampling technique. Analyze the per-

formance of the loans selected for examina-tion by transcribing the following kinds ofinformation onto the real estate constructionloan line cards, when applicable:a. Collateral records and credit files, includ-

ing the borrower’s financial statements,review of related projects, credit report ofthe borrower and guarantors, appraisal orevaluation of collateral, feasibility studies,economic impact studies, and loan agree-ment and terms.

b. Loan modification or restructuring agree-ments to identify loans where interest orprincipal is not being collected accordingto the terms of the original loan. Examplesinclude reduction of interest rate or prin-cipal payments, deferral of interest orprincipal payments, or renewal of a loanwith accrued interest rolled into theprincipal.

c. The commitment agreement, buy/sell con-tract, or the tri-party agreement from theextended-term or permanent lender for thetakeout loan.

d. Cash-flow projections and any revisionsto projections based on cost estimatesfrom change orders.

e. Estimates of the time and cost to completeconstruction.

f. Inspection reports and evaluations of thecost to complete, construction deadlines,and quality of construction.

g. Construction draw schedules and auditsfor compliance with the schedules.

h. Documentation on payment of insuranceand property taxes.

i. Terms of a completion or performancebond.

j. Past-due/nonaccrual-related information.k. Loan-specific internal problem credit analy-

ses information.l. Loans to insiders and their interests.m. Loans classified during the preceding

examination.6. In analyzing the selected construction loans,

the examiner should consider the followingprocedures, taking appropriate action ifnecessary:a. Determine the primary source of repay-

ment and evaluate its adequacy, includingwhether:


• the permanent lender has the financialresources to meet its commitment.

• the amount of the construction loan andits estimated completion date corre-spond to the amount and expiration dateof the takeout commitment and/orcompletion bond.

• the permanent lender and/or the bond-ing company have approved any modi-fications to the original agreement.

• properties securing construction loansthat are not supported by a takeoutcommitment will be marketable uponcompletion.

b. Analyze secondary support afforded byguarantors and partners.

c. Relate collateral values to outstandingdebt by:• assessing the adequacy of the appraisal

and evaluation.• ascertaining whether inspection reports

support disbursements to date.• determining whether the amount of

undisbursed loan funds is sufficient tocomplete the project.

• establishing whether title records assurethe primacy of the branch’s liens.

• determining if adequate hazard, build-er’s risks, and worker’s compensationinsurance is maintained.

d. Determine whether the loan-to-value (LTV)ratio is in excess of the supervisory LTVlimits. If so, ascertain whether the loanhas been properly reported as a noncon-forming loan.

e. Ascertain whether the loan complies withestablished branch policy.

f. Identify any deficiencies in the loan’sdocumentation in both the credit files andthe collateral records.

g. Identify whether the loan is to an officer ordirector of the branch or to a correspon-dent bank, and whether an officer, direc-tor, or shareholder of the bank is a guar-antor on the loan.

h. Review the borrower’s compliance withthe provisions of the loan agreement,indicating whether the loan is in default orin past-due status.

i. Determine if there are any problems thatmay jeopardize the repayment of the con-struction loan.

j. Determine whether the loan was classifiedduring the preceding examination, and, ifthe loan has been paid off, whether all orpart of the funds for repayment came fromanother loan at the bank or from therepossession of the property.

7. In connection with the examination of otherlending activity in the branch, the examinershould check the central liability file on theborrower(s) and determine whether the totalconstruction lending activity exceeds the lend-ing limit to a single borrower.

8. Summarize the findings of the constructionloan portfolio review and address:a. the scope of the examination.b. the quality of the policies, procedures, and

controls.c. the general level of adherence to policies

and procedures.d. the competency of management.e. the quality of the loan portfolio.f. loans not supported by current and com-

plete financial information.g. loans with incomplete documentation,

addressing deficiencies related to itemssuch as appraisals or evaluations, feasibil-ity studies, the environmental impact study,takeout commitment, title policy, construc-tion plans, inspection reports, changeorders, proof of payment for insuranceand taxes, deeds of trust, and mortgagenotes.

h. the adequacy of control over constructiondraws and advances.

i. loans to officers, directors, shareholders,or their interests.

j. causes of existing problems.k. delinquent loans and the aggregate amount

of statutory bad debts. Refer to the manualsection on classification of credits for adiscussion on statutory bad debts or ‘‘A’’paper.

l. concentrations of credit.m. classified loans.n. violations of laws or regulations, and non-

compliance with regulatory requirements.o. action taken by management to correct

previously noted deficiencies and correc-tive actions recommended to managementat this examination, with the branch’sresponse to such recommendations.

3110.3 Real Estate Construction Loans: Examination Procedures


Real Estate Construction LoansInternal Control QuestionnaireEffective date July 1997 Section 3110.4

POLICIES AND OBJECTIVES

1. Has the head office and branch managementadopted and written construction lendingpolicies that:a. outline construction lending objectives

regarding:• the aggregate limit for construction

loans?• concentrations of credit in particular

types of construction projects?b. establish minimum standards for

documentation?c. define qualified collateral and minimum

margin requirements?d. define the minimum equity requirement

for a project?e. define loan-to-value (LTV) limits that are

consistent with supervisory LTV limits?f. require an appraisal or evaluation that

complies with the Federal Reserve realestate appraisal regulation and guidelines?

g. delineate standards for takeoutcommitments?

h. indicate completion bonding require-ments?

i. establish procedures for reviewing con-struction loan applications?

j. detail methods for disbursing loanproceeds?

k. detail project inspection requirements andprogress reporting procedures?

l. require agreements by borrowers forcompletion of improvements accordingto approved construction specifications,and cost and time limitations?

2. Are construction lending policies andobjectives appropriate to the size andsophistication of the branch, and are theycompatible with changing market conditions?

DOCUMENTATION

3. Does the branch require and maintain thefollowing documentation:a. the contractor’s payment of:

• employee withholding taxes?• builder’s risk insurance?• worker’s compensation insurance?

• public liability insurance?• completion insurance?

b. the property owner’s payment of realestate taxes?

4. Does the branch require that files include:a. loan applications?b. financial statements for the:

• borrower?• builder?• proposed prime tenant?• takeout lender?• guarantors/partners?

c. credit and trade checks on the:• borrower?• builder?• major subcontractor?• proposed tenants?

d. a copy of plans and specifications?e. a copy of the building permit?f. a survey of the property?g. the construction loan agreement?h. an appraisal or evaluation and feasibility

study?i. an up-to-date title search?j. the mortgage?k. ground leases?l. assigned tenant leases or letters of intent

to lease?m. a copy of the takeout commitment?n. a copy of the borrower’s application to

the takeout lender?o. the tri-party buy-and-sell agreement?p. inspection reports?q. disbursement authorizations?r. undisbursed loan proceeds and contin-

gency or escrow account reconcilements?s. insurance policies?

5. Does the branch employ standardized check-lists to control documentation for individualfiles and perform audit reviews for adequacy?

6. Does the documentation file indicate all ofthe borrower’s other loans and depositaccount relationships with the branch and asummary of other construction projectsbeing financed by other banks? Does thebranch analyze the status of these projectsand the potential effect on the borrower’sfinancial position?

7. Does the branch use tickler files that:a. control scheduling of inspections and

disbursements?


b. assure prompt administrative follow-upon items sent for:• recording?• attorney’s opinion?• expert review?

8. Does the branch maintain tickler files thatprovide advance notice (such as 30 days’prior notice) to staff of the expiration datesfor:a. the takeout commitment?b. hazard insurance?c. worker’s compensation insurance?d. public liability insurance?

REVIEWING LOANAPPLICATIONS

9. Does branch policy require a personal guar-antee from the borrower on constructionloans?

10. Does branch policy require personal comple-tion guarantees by the property owner and/orthe contractor?

11. Does the branch require a construction bor-rower to contribute equity to a proposedproject in the form of money or real estate?If so, indicate the form of equity contributed.

12. Does the project budget include the amountand source of the builder’s and/or owner’sequity contribution?

13. Does the branch require:a. background information on the borrow-

er’s, contractor’s, and major subcontrac-tors’ development and constructionexperience, as well as other projectscurrently under construction?

b. payment history information from sup-pliers and trade creditors on the afore-mentioned’s previous projects?

c. credit reports?d. detailed current and historical financial

statements, including cash flow-relatedinformation?

14. Do the borrower’s project cost estimatesinclude:a. land and construction costs?b. off-site improvement expenses?c. soft costs, such as organizational and

administrative costs, and architectural,engineering, and legal fees?

d. interest, taxes, and insurance expenses?15. Does the branch require an estimated cost

breakdown for each stage of construction?

16. Does the branch require that cost estimatesof more complicated projects be reviewedby qualified personnel: experienced in-housestaff, an architect, construction engineer, orindependent estimator?

17. Are commitment fees required on approvedconstruction loans?

CONSTRUCTION LOANAGREEMENT

18. Is the construction loan agreement signedbefore an actual loan disbursement is made?

19. Is the construction loan agreement reviewedby counsel and other experts to determinethat improvement specifications conformto:a. building codes?b. subdivision regulations?c. zoning and ordinances?d. title and/or ground lease restrictions?e. health and handicap access regulations?f. known or projected environmental pro-

tection considerations?g. specifications required under the National

Flood Insurance Program?h. provisions in tenant leases?i. specifications approved by the perma-

nent lender?j. specifications required by the completion

or performance bonding company and/orguarantors?

20. Does the branch require all change orders tobe approved in writing by the:a. branch?b. branch’s counsel?c. permanent lender?d. architect or supervising engineer?e. prime tenants bound by firm leases or

letters of intent to lease?f. completion bonding company?

21. Does the construction loan agreement set adate for project completion?

22. Does the construction loan agreement requirethat:a. the contractor not start work until autho-

rized to do so by the branch?b. on-site inspections be permitted by the

lending officer or an agent of the branchwithout prior notice?

c. disbursement of funds be made as workprogresses, supported by documentationthat the subcontractors are receiving pay-

3110.4 Real Estate Construction Loans: Internal Control Questionnaire


ment and that the appropriate liens arebeing released?

d. the branch be allowed to withhold dis-bursements if work is not performedaccording to approved specifications?

e. a percentage of the loan proceeds beretained pending satisfactory completionof the construction?

f. the lender be allowed to assume promptand complete control of the project in theevent of default? If a commercial project,are the leases assignable to the branch?

g. the contractor carry builder’s risk andworker’s compensation insurance? If so,has the branch been named as mortgageeor loss payee on the builder’s risk policy?

h. periodic increases in the project’s valuebe reported to the builder’s risk and titleinsurance companies?

23. In addition to the aforementioned points,does the construction loan agreement forresidential tract construction loans require:a. branch authorization for individual tract

housing starts?b. periodic sales reports be submitted to the

branch?c. periodic reports on tract houses occupied

under a rental, lease, or purchase optionagreement be submitted to the branch?

d. limitations on the number of speculativehouses and the completion of one tractprior to beginning another?

COLLATERAL

24. Are liens filed on non-real estate construc-tion improvements, i.e., personal propertythat is movable from the project?

25. When entering into construction loans, doesthe branch, consistent with supervisory loan-to-value limits:a. limit the loan amount to a reasonable

percentage of the appraised value of theproject when there is no prearrangedpermanent financing?

b. limit the loan amount to a percentage ofthe appraised value of the completedproject when subject to the branch’s owntakeout commitment?

c. limit the loan amount to the floor of atakeout commitment that is based uponachieving a certain level of rents or leaseoccupancy?

26. Are unsecured credit lines to contractors ordevelopers, who are also being financed bysecured construction loans, supervised bythe construction loan department or theofficer supervising the construction loan?

27. Does the branch have adequate proceduresto determine whether construction appraisalor evaluation policies and procedures areconsistently being followed in conformancewith regulatory requirements, and that theappraisal or evaluation documentation sup-ports the value indicated in the conclusions?

INSPECTION

28. Are inspection authorities noted in the:a. construction loan commitment?b. construction loan agreement?c. tri-party buy-and-sell agreement?d. takeout commitment?

29. Are inspections conducted on an irregularbasis?

30. Are inspection reports sufficiently detailedto support disbursements?

31. Are inspectors rotated from project toproject?

32. Are spot checks made of the inspectors’work?

33. Do inspectors determine compliance withplans and specifications as well as theprogress of the work? If so, are the inspec-tors competent to make the determination?

DISBURSEMENTS

34. Are disbursements:a. advanced on a prearranged disbursement

plan?b. made only after reviewing written inspec-

tion reports?c. authorized in writing by the contractor,

borrower, inspector, subcontractors,and/or lending officer?

d. reviewed by a branch employee who hadno part in granting the loan?

e. compared to original cost estimates?f. checked against previous disbursements?g. made directly to subcontractors and

suppliers?h. supported by invoices describing the

work performed and the materialsfurnished?

Real Estate Construction Loans: Internal Control Questionnaire 3110.4


35. Does the branch obtain waivers of subcon-tractor’s and mechanic’s liens as work iscompleted and disbursements are made?

36. Does the branch obtain sworn and notarizedreleases of mechanic’s liens from the gen-eral contractor at the time construction iscompleted and before final disbursement ismade?

37. Does the branch periodically review undis-bursed loan proceeds to determine theiradequacy to complete the projects?

38. Are the borrower’s undisbursed loan pro-ceeds and contingency or escrow accountsindependently verified at least monthly bysomeone other than the individuals respon-sible for loan disbursements?

TAKEOUT COMMITMENT

39. Does counsel review takeout agreementsfor acceptability?

40. Does the branch obtain and review thepermanent lender’s financial statements todetermine the adequacy of its financialresources to fulfill the takeout commitment?

41. Is a tri-party buy-and-sell agreement signedbefore the construction loan is closed?

42. Does the branch require takeout agreementsto include aforce majeure(an act of Godclause) that provides for an automaticextension of the completion date in theevent that construction delays occur forreasons beyond the builder’s control?

COMPLETION BONDINGREQUIREMENTS

43. Does the branch require completion insur-ance for all construction loans?

44. Has the branch established minimum finan-cial standards for borrowers who are notrequired to obtain completion bonding? Arethese standards observed in all cases?

45. Does counsel review completion insurancebonds for acceptability?

LOAN RECORDS

46. Are the preparation, addition, and postingof subsidiary real estate construction loan

records performed or adequately reviewedby persons who do not also:a. issue official checks or drafts?b. handle cash?c. reconcile subsidiary records to general

ledger controls?47. Are the subsidiary real estate construction

loan records reconciled at least monthly tothe appropriate general ledger accounts?Are reconciling items adequately investi-gated by persons who do not also handlecash or prepare/post subsidiary controls?

48. Are loan statements, delinquent accountcollection requests, and past-due noticesreconciled to the real estate constructionloan subsidiary records? Are the reconcili-ations handled by a person who does notalso handle cash?

49. Are inquiries about construction loan bal-ances received and investigated by personswho do not also handle cash?

50. Are documents supporting recorded creditadjustments subsequently checked or testedby persons who do not also handle cash?

51. Is a delinquent accounts report generateddaily?

52. Are loans in excess of supervisory LTVlimits identified in the branch’s records andare the aggregate amounts of such loansreported at least quarterly to the board ofdirectors?

53. Does the branch maintain a daily recordsummarizing note transaction details (loansmade, payments received, and interest col-lected) to support applicable general ledgeraccount entries?

54. Are note and liability trial balances fre-quently reconciled to the general ledger byemployees who do not process or recordloan transactions?

LOAN INTEREST ANDCOMMITMENT FEES

55. Are the preparation and posting of loaninterest and fee records performed oradequately reviewed by persons who do notalso:a. issue official checks or drafts?b. handle cash?

56. Are any independent interest and fee com-putations made and compared or adequately

3110.4 Real Estate Construction Loans: Internal Control Questionnaire


tested to loan interest by persons who do notalso:a. issue official checks or drafts?b. handle cash?

CONCLUSION

57. Is the information covered by this ICQadequate for evaluating internal controls in

this area? If not, indicate any additionalexamination procedures deemed necessary.


Real Estate Construction Loans: Internal Control Questionnaire 3110.4


Real Estate Construction LoansAudit GuidelinesEffective date July 1997 Section 3110.5

Refer to the Credit Risk Management, AuditGuidelines, section of this manual for itemsapplicable to Real Estate Construction Loans.

1. Using appropriate sampling techniques, selectloans from the trial balance and:a. Review loan agreement provisions for

hold back or retention, and determine ifundisbursed loan funds and/or contin-gency or escrow accounts are equal toretention or holdback requirements.

b. If separate interest reserves are main-tained, determine if debit entries to those

accounts are authorized in accordance withthe terms of the loan agreement and ifthey are supported by inspection reports,certificates of completion, individual bills,or other evidence.

c. Review disbursement ledgers and autho-rizations and determine if authorizationsare signed according to the terms of theloan agreement.

d. Verify debits in the undisbursed loan pro-ceeds accounts to inspection reports, indi-vidual bills, or other evidence supportingdisbursements.


Securities Broker and Dealer LoansEffective date July 1997 Section 3120.1

Some branches provide lending services to stockbrokerage firms using stock of listed corpora-tions as collateral. To promote efficiency in thepledging of collateral, the Stock Clearing Cor-poration, a wholly-owned subsidiary of the NewYork Stock Exchange, transfers stock ownershipthrough computer book entries and thus elimi-nates the physical movement of the securities.The operating department of the Stock ClearingCorporation, Central Certificate Service (CCS),handles the technical aspects of that operation.

Brokerage firms deposit shares of eligiblesecurities with CCS. The stock certificates rep-resenting those shares are registered in the nameof a common nominee. CCS has physical con-trol of the securities while they are on deposit.Loan arrangements are made between the brokerand the lending branch with the broker instruct-ing CCS, through written authorization, to debitthe firm’s account and credit that of the branch.CCS sends a copy of the authorization to thebranch and will not reverse the entry or makepartial withdrawals without written authoriza-tion from the branch. Participating financialinstitutions receive daily printouts, showing theirposition in the program by broker name and typeof security. Because of adequately protectedcontrols employed by Stock Clearing Corpora-tion, examiners should accept the daily positionprintouts without further verification.

COMMODITY LOANS

Loans to carry investments in commodities entailthe same basic criteria as in all credit relation-

ships. Borrowers are typically nonproducers ornonprocessors of the commodity and includeindividuals, trading companies, manufacturers,or broker/dealers. The loan may represent adirect investment in the commodity or the car-rying of a forward or futures position in thecommodity. The commodity being purchasedgenerally secures the borrowing. Common pur-poses for commodity loans include:

• The temporary holding by a trader of a com-modity under contract for sale or in anticipa-tion of sale in the near term.

• The holding of a commodity by an entity inanticipation of price appreciation for thatcommodity.

• The holding of a commodity by a manufac-turer or fabricator awaiting transformationinto some other product.

The focus of the examination of the branch’scommodity lending area is on the lending policyand the control exercised over the collateral. Thepolicy should address under what circumstancesand conditions commodity loans will be made,particularly whether the branch will grant loansto finance a speculative position in a commod-ity. For secured loans, collateral margin require-ments should be included in the policy.

Control of the collateral is important. Gener-ally, the commodity will be held in a bondedwarehouse, bank, or other depository institution.The branch should control title to the commod-ity. Because commodity markets can becomevolatile, collateral positions should be moni-tored frequently for compliance with the policy.


Securities Broker and Dealer LoansExamination ObjectivesEffective date July 1997 Section 3120.2

1. To determine if policies, practices, proce-dures, objectives, and internal controlsregarding securities broker and dealer loansare adequate.

2. To determine if branch officers are operatingin conformance with established guidelines.

3. To evaluate the adequacy of collateral, creditquality, and collectibility.

4. To determine the scope and adequacy of theaudit function.


6. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.


Securities Broker and Dealer LoansExamination ProceduresEffective date July 1997 Section 3120.3

1. If selected for implementation, complete orupdate the Internal Control Questionnairefor this area.

2. Based on the evaluation of internal controlsand of the work performed by internal/external auditors, ascertain the scope of theexamination.

3. Test for compliance with policies, practices,procedures, and internal controls in conjunc-tion with performing the remaining exami-nation procedures. Additionally, obtain alisting of any deficiencies noted in the latestreview by internal/external auditors anddetermine if corrections have beenaccomplished.

4. Request the branch to supply:a. Schedule of approved lines for each

dealer, including outstanding balances.b. Delinquent interest billings and date

billed amount of past due interest.5. Obtain a trial balance of all dealer accounts

and:a. Verify balances to departmental controls

and the general ledger.b. Review reconciling items for reasonable-

ness.6. Using an appropriate sampling technique,

select borrowers to be reviewed.7. Using the trial balance, transcribe the fol-

lowing information for each borrowerselected onto the credit line cards:a. Total outstanding liability.b. Amount of approved line.

8. Obtain from the appropriate examiner thefollowing schedules, if applicable to thisarea:a. Past due loans.b. Loan commitments and other contingent

liabilities.c. Miscellaneous loan debit and credit sus-

pense accounts.d. Loans considered problem loans by

management.e. Each officer’s current lending authority.f. Current interest rate structure.g. Any useful information obtained from

the review of the minutes of the loancommittee or any similar committee.

h. Reports furnished to the loan and dis-count committee or any similarcommittee.

i. Reports furnished to the head office.j. Loans classified during the preceding

examination.k. A listing of loans charged off since the

preceding examination.9. Review the information received and per-

form the following:a. For miscellaneous loan debit and credit

suspense accounts:• Discuss with management any large or

old items.• Perform additional procedures as

deemed appropriate.b. For loans classified during the previous

examination, determine disposition ofloans so classified by transcribing:• Current balances and payment status,

or• Date loan was repaid and sources of

payment.c. For loan commitments and other contin-

gent liabilities, analyze if:• The borrower has been advised of the

contingent liability.• The combined amounts of the current

loan balance and the commitments orcontingent liabilities exceed the cutoff.

d. Select loans that require in-depth reviewbased on information derived when per-forming the above steps.

10. For those loans selected in step 6 above andfor any other loans selected while perform-ing the above steps, transcribe the followinginformation from the branch’s collateralrecord onto the credit line sheets:a. A list of collateral held, including date of

entry and amount advanced.b. A brief summary of the agreement

between the branch and the dealer.c. Evidence that the proper documentation

is in place.d. Details of any other collateral held.

11. The examiner should be aware that certainstock-secured transactions with and for bro-kers and dealers are exempt from the mar-gin restrictions of Regulation U. Refer tothe regulation, which can be found in theFederal Reserve Regulatory Service, for acomplete description of such transactionsthat include the following:


a. Temporary advances to finance cashtransactions.

b. Securities in transit or transfer.c. Day loans.d. Temporary financing of distributions.e. Arbitrage transactions.f. Credit extended pursuant to hypotheca-

tion.g. Emergency credit.h. Loans to specialists.i. Loans to odd-lot dealers.j. Loans to OTC market makers.k. Loans to third-market makers.l. Loans to block positioners.m. Loans for capital contributions.

12. At this point, the examiner needs to decidewhether further examination and testing isneeded. If further work is warranted, referto the audit guidelines. After reviewing theaudit guidelines, proceed to step 13.

13. Discuss with appropriate officer(s) and pre-pare summaries in appropriate report formof:a. Delinquent loans.

b. Loans on which collateral documenta-tion is deficient.

c. Recommended corrective action whenpolicies, practices, or procedures aredeficient.

d. Other matters regarding the condition ofthe department.

14. Prepare appropriate comments for the work-papers and the examiner-in-charge statingyour findings with regard to:a. The adequacy of written policies relating

to securities broker and dealer loans.b. The manner in which branch officers are

conforming with established policy.c. Schedules applicable to the department

that were discovered to be incorrect orincomplete.

d. The competence of departmentalmanagement.

e. Internal control deficiencies or exceptions.f. Other matters of significance.

15. Update the workpapers with any informa-tion that will facilitate future examinations.

3120.3 Securities Broker and Dealer Loans: Examination Procedures


Securities Broker and Dealer LoansInternal Control QuestionnaireEffective date July 1997 Section 3120.4

Review the branch’s internal control, policies,practices, and procedures for making and ser-vicing loans. The branch’s system should bedocumented in a complete and concise mannerand should include,where appropriate, narra-tive descriptions, flowcharts, copies of formsused, and other pertinent information.

POLICIES

1. Has a policy been adopted specificallyaddressing securities broker and dealer loansthat:a. Establishes standards for determining

broker and dealer credit lines?b. Establishes minimum standards for docu-

mentation?2. Are such loan policies reviewed at least

annually to determine if they are compatiblewith changing market conditions?

3. Is a daily record maintained summarizingloan transaction details, i.e., loans made,payments received, and interest collected tosupport applicable general ledger accountentries?

4. Are frequent note and liability ledger trialbalances prepared and reconciled with con-trolling accounts by employees who do notprocess or record loan transactions?

5. Is an exception report produced and reviewedby operating management that encompassesextensions, renewals, or any factors thatwould result in a change in customer accountstatus?

6. Do customer account records clearly indi-cate accounts that have been renewed orextended?

LOAN INTEREST

7. Is the preparation and posting of interestrecords performed and reviewed by appro-priate personnel?

8. Are any independent interest computationsmade and compared or adequately tested toinitial interest records by appropriatepersonnel?

COLLATERAL

9. Are multi-copy, prenumbered records main-tained that:

a. Detail the complete description of collat-eral pledged?

b. Are computer generated or typed?

10. Are receipts issued to customers coveringeach item of negotiable collateraldeposited?

11. If applicable, are the functions of receivingand releasing collateral to borrowers and ofmaking entries in the collateral registerperformed by different employees?

12. Are appropriate steps with regard to Regu-lation T being considered in granting brokerand dealer loans?

13. Concerning commodity lending:

a. Is control for the collateral satisfactory,i.e., stored in the branch’s vault, anotherbank, or a bonded warehouse?

b. If collateral is not stored within thebranch, are procedures in effect to ascer-tain the authenticity of the collateral?

c. Does the branch have a documented andrecorded security interest in the proceedsof the future sale or disposition of thecommodity and the existing collateralposition?

d. Do credit files document that thefinanced positions are and remain fullyhedged?

14. Concerning loans to commodity brokersand dealers:

a. Does the branch maintain a list of themajor customer accounts of the brokersor dealers to whom it lends? If so, is thelist updated on a periodic basis?

b. Is the branch aware of the broker/dealer’s policy on margin requirementsand the basis for valuing contracts formargin purposes, i.e., pricing spot versusfuture?

c. Does the branch attempt to ascertainwhether the positions of the broker/dealer’s clients that are indirectlyfinanced by branch loans remain fullyhedged?


CONCLUSION



3120.4 Securities Broker and Dealer Loans: Internal Control Questionnaire


Securities Broker and Dealer LoansAudit GuidelinesEffective date July 1997 Section 3120.5

1. Verify the accuracy of the trial balance.2. Test reconciling items to the extent consid-

ered necessary.3. Using an appropriate sampling technique,

select broker and dealer loans and:a. Prepare and mail confirmation forms to

dealers (information confirmed shouldinclude the loan balance and date of entry).

b. After a reasonable time period, mail sec-ond requests.

c. Follow up on any no-replies or excep-tions, and resolve differences.

d. Obtain a list of the most recent broker anddealer interest billings and check calcula-tion of interest report.

e. Determine whether interest payments aredelinquent and trace to inclusion in delin-quency report.

f. Determine that appropriate action has beentaken to bring delinquent accounts to acurrent status.

4. Review collateral records and:a. Determine the reason for differences

between the branch’s collateral recordsand the actual items held by the branch.

b. Investigate other differences to the extentconsidered necessary.


Securities ActivitiesEffective date July 1997 Section 3130.1

This section addresses securities activities in thebroadest meaning of the term. It is divided intothree sections: Investment Securities, TradingSecurities, and Other, which includes resale andrepurchase transactions.

INVESTMENT SECURITIES

Since January 1, 1994, investment securitiesactivities of branches are subject to FASB State-ment No. 115 (Accounting for Certain Invest-ments in Debt and Equity Securities). Under thisstandard, all branches are required to segregatetheir investment securities portfolios into threecategories: (1) held-to-maturity, (2) available-for-sale, and (3) trading securities. The held-to-maturity category replaces the former held-for-investment category. The available-for-sale cate-gory is new, and the trading category is the sameas before.

Held-to-maturity (HTM) securitiesare debtsecurities that the branch has both the intent andability to hold until maturity. The branch willcontinue to report HTM securities at amortizedcost.

Available-for-sale (AFS) securitiesare definedas debt or equity securities for which the branchdoes not have the positive intent and ability tohold to maturity, yet does not intend to tradeactively as a part of its trading account. AFSsecurities transactions must be reported at fairvalue with any unrealized gains and lossesreported directly as a separate component ofequity capital. Thus, unrealized changes in thesesecurities’ value will have no effect on thereported earnings of the branch.

Trading securitiesare those debt and equitysecurities that a branch buys and holds princi-pally for the purpose of selling in the near term.Trading securities will continue to be reported atfair market value with unrealized gains or lossesreported directly in the income statement as apart of the branch’s earnings.

This section will deal only with investmentsecurities, or those categorized as HTM andAFS. A complete discussion of trading securi-ties is contained in the Federal Reserve’sTrad-

ing Activities Manual.Additional reference mate-rial includes:

• FFIEC’s Supervisory Policy Statement onSecurities Activities as of January 10, 1992.

• SR 93-69—‘‘Risk Management and InternalControls for Trading Activities of BankingOrganizations.’’

• SR 95-17—‘‘Evaluating the Risk Manage-ment and Internal Controls of Securities andDerivative Contracts Used in NontradingActivities.’’

The rationale behind FASB creating the AFScategory and allowing institutions to report AFSsecurities at fair value is that it presents a moreaccurate and realistic picture of an institution’sfinancial condition. The inclusion of net unreal-ized gains and losses with Tier 1 capital pro-vides incentives to institutions to hold securitiesthat have depreciated or appreciated in value,thereby reducing market volatility. However,although market volatility is reduced, bank’scapital ratios are subject to increased volatilitysince their assets will be marked-to marketwhile liabilities remain at book value.

In addition to any restrictions imposed bystate law or regulation, under Section 7(c)(2) ofthe International Banking Act of 1978, allbranches may only hold the types of investmentsecurities that may be held by national banksand state member banks. See 12 USC 24(7); 12CFR Part 1. State-licensed branches, addition-ally, may only hold those types of investmentsecurities permitted under state law. It should benoted that branches must obtain Federal Reserveapproval, before commencing commodity orequity-linked transactions. See 12 CFR 208.128(made applicable to branches by 12 USC3105(c)(2)).

For branches, investment securities includeU.S. government obligations and certain domes-tic corporate debt securities; as well as variousfederal agency bonds; state, county, and munici-pal issues; special revenue bonds; and industrialrevenue bonds. Securities included in the invest-ment account should provide a reasonable rateof return as well as provide the necessaryliquidity the branch requires. Accordingly, aninvestment account should contain some securi-ties that may be quickly converted into cash bysale or by maturity. Hence, liquidity and mar-ketability are of the utmost importance. A bond


is a liquid asset if its maturity is short and ifthere is reasonable assurance that it will be paidat maturity. It is marketable if it may be soldquickly at a price commensurate with its yieldand quality. The highest quality bonds haveeither or both of those two desirable qualities.

Occasionally, it may be difficult to distinguishbetween a loan and a security. Loans generallyresult from direct negotiations between a bor-rower and a lender. A branch may refuse to granta loan unless it and the borrower can agree toterms. A security, on the other hand, is usuallyacquired through a third party, a broker or dealerin securities. Most securities have standardizedterms, which can be compared to the terms ofother market offerings. Because the terms ofmost loans do not lend themselves to suchcomparison, the average investor may not acceptthe terms of the lending arrangement. Thus, anindividual loan cannot be regarded as a readilymarketable security.

An interesting hybrid between a security anda loan is a private placement. A private place-ment is a security transaction whereby the issuerdid not involve any "public offering" but ratheroffered the securities privately. The securitiesare not reviewed by the SEC, and are offeredand sold only to those parties who the issuerbelieves are (1) sufficiently experienced to evalu-ate merits and risks of the investment, or (2) ableto bear the risk of the investment. Throughnegotiation, both parties may tailor the offeringto meet their needs. The issuer saves securitiesregistration costs and the investor makes aninvestment for a specified length of time at astated rate of return. Both investor and issuercomplete the transaction privately without beingsubject to regulatory and public scrutiny. Themajor disadvantage of private placements is thelack of a secondary market, and therefore it maybe highly illiquid. Although private placementshave many characteristics of loans, for regula-tory reporting purposes they are consideredsecurities.

INVESTMENT POLICY

The branch should have an investment policy,which was developed in conjunction with andapproved by its head office, to control andmonitor the branch’s investment activities. Thispolicy should include guidelines for personnelinvolved in securities activities.

The basic objectives of a sound investmentpolicy are the same for all financial institutionsbut the emphasis placed on each objective willvary, according to the individual branch’s needs.The basic objectives include:

• Minimizing risks.• Generating a favorable return on investments,

without undue compromise of the otherobjectives.

• Providing for and managing liquidity.• Meeting any applicable pledge requirements.• Temporary use of excess funds.

The investment policy must encompass morethan a philosophical description of objectives. Ifpolicy development is delegated to local branchmanagement, the examiner should verify thathead office management has reviewed or isaware of the policy and the branch’s level ofcompliance.

TYPES OF INVESTMENTSECURITIES

The investment policy should include guidelineson the quality and quantity of each type ofsecurity to be held. Credit quality is of majorimportance.

U. S. government obligationsare the highestquality investments and are the most readilymarketable. They are riskless from a creditstandpoint but are subject to price fluctuationsbecause of changes in money market interestrates. Longer-term issues tend to fluctuate morewidely than shorter-term issues. All things beingequal, maturity, credit, etc., smaller couponsecurities are more volatile than larger couponsecurities.

Federal agency securitiesare also of very highquality. Similar investments that enjoy wideacceptance in the banking community are U.S.government guaranteed public housing author-ity issues. New housing authority and publichousing authority notes or bonds generally pro-vide the investor with tax exempt income and afull faith and credit guaranty of the U.S.government.

Other tax exempt bondshave varying levels ofindirect U.S. government support. Pre-refunded

3130.1 Securities Activities


or escrowed bonds are often fully and directlysecured by obligations issued by or otherwisesupported by the full faith and credit of theUnited States. Certain municipal housing bondsare partially payable from rental subsidies and/ormortgage credit insurance provided by federalagencies. Pools of partially guaranteed studentloans are sometimes pledged for payment ofmunicipal higher education bonds. There arenumerous programs that provide federal backingfor municipal bonds. Care must be taken todistinguish between those issues that are feder-ally guaranteed and those that are not.

High quality municipal bondsfrequently aredesirable because of their tax exempt status.Many municipal bonds, however, possess an

unfavorable market aspect. Except for highquality issues of larger municipalities, munici-pal bonds often are not readily marketable and,as a result, may produce sizeable spreadsbetween bid and ask prices. The spread may beso wide, it may cost the selling bank a sizeableportion of a year’s interest.

BOND RATINGS

Monthly rating service publications are useful indetermining the investment quality of municipaland corporate obligations. The standard bondrating symbols, as shown on the following page,are listed in the order of their credit quality.

Standard & Poor’s Moody’s Description

Bank Quality Investments

AAA Aaa Highest grade obligations.

AA Aa High grade obligations

A A-1, A Upper medium grade

BBB Baa-1, Baa Medium grade, on the borderline between defi-nitely sound obligations and those containingpredominantly speculative elements. Generally,the lowest quality bond that may qualify for bankinvestment.

Speculative and Defaulted Issues (High Yield or Noninvestment Grade)

BB Ba Lower medium grade with only minor investmentcharacteristics.

B B Low grade, default probable.

Ccc, cc, c, D Caa, Ca, C Lowest rated class, may be in default, extremelypoor material prospects.

Provisional or Conditional Rating

Rating-P Con. (Rating) Debt service requirements are largely dependenton reliable estimates as to future events.

Securities Activities 3130.1


Although the analyses of major rating agen-cies are basically sound and updated frequently,it should be kept in mind that ratings are onlyevaluations of probabilities. In order to deter-mine appropriate credit limits to a particularcounterparty, bond ratings should be supple-mented by the branch’s own credit analysis ofthe issuer.

Sub-investment-quality securities are those inwhich the investment characteristics are dis-tinctly or predominantly speculative. This groupincludes securities in grades below the four

highest grades and unrated securities of equiva-lent quality, defaulted securities and sub-investment-quality stocks. As noted in the fol-lowing chart, securities in grades below the fourhighest grades and unrated securities of equiva-lent quality will be valued at market price. Themarket value will be classified substandard, andthe depreciation will be classified doubtful.Depreciation in defaulted securities and sub-investment-quality stocks will generally be clas-sified loss; market value will be classified sub-standard.

SECURITY CLASSIFICATIONS

Type of Security Classification

Substandard Doubtful Loss

Investment-quality XXX XXX XXX

Sub-investment-quality, except— MarketValue

MarketDepreciation

XXX

Sub-investment-quality, municipalgeneral obligations

BookValue

XXX XXX

Defaulted securities andsub-investment-qualitystocks, except—

MarketValue

XXX MarketDepreciation

Defaulted municipal general obligations:

Interim XXX BookValue

XXX

Final, i.e., when market is reestablished MarketValue

XXX MarketDepreciation

As a matter of policy, an institution shouldnot acquire securities until it has assessed thecreditworthiness of the issuer and determinedthat the risk exposure conforms with its policies.At a minimum, the examiner should expect sucha policy to require credit reviews on all transac-tions before purchase, annual internal creditreviews, and more frequent credit updates on allnonrated issues, municipal obligations with acredit rating that has declined, special revenueand other debt obligations with limited or nomarketability, speculative and defaulted issues,

and stocks acquired through DPC transactions.Credit analysis is always necessary to determineif an investment is appropriate for the branch toown. According to Federal regulation (12 CFR,Section 1.8) it is incumbent upon managementto demonstrate that it has exercised prudence inacquiring all investment securities.

The examiner should be mindful, however,that as part of a larger organization, the branchmay operate soundly outside of the parametersnormally considered acceptable due to its uniquerole within the FBO’s network. When tradi-



tional liquidity analysis results in unsatisfactoryfindings, the examiner should discuss with man-agement the influence of the branch’s relation-ships with related offices.

Policy guidelines for risk diversificationshould be formulated in conformity with legaland prudent investment restrictions. Concentra-tions resulting from the obligations of a single orrelated issuer, credit ratings, geographic andtype distribution may all be compatible withsound investment policy. In many cases, con-centrations would not be considered unwar-ranted but, in all cases, it is essential thatinvestment concentrations be monitored at thehead office level.

The investment policy should also take intoconsideration the applicable federal and stateincome tax laws. Finally, the investment port-folio should be reviewed at least annually byhead office management and quarterly by seniorofficers of the branch. Sufficient analytical datamust be provided to allow head office manage-ment to make an informed judgment of theinvestment policy’s effectiveness. Such reviewsshould consider the information discussed inthis section and the current market value of theportfolio.

Management should maintain clear lines ofauthority and responsibility for acquiring secu-rities and managing risk. This includes settingappropriate limits on risk taking, creatingadequate systems for measuring risk, providingeffective internal controls, and implementing acomprehensive risk reporting and risk manage-ment review process.

TRADING SECURITIES

The following section deals with securities port-folio trading but does not include derivative-related activity. For an in-depth discussion ofderivative-related activity, refer to the FederalReserve’sTrading Activities Manual.

Trading in the investment portfolio is charac-terized by a high volume of purchase and saleactivity, which, when considered in light of ashort holding period for securities, clearly dem-onstrates management’s intent to profit fromshort-term price movements. In this situation, afailure to follow accounting and reporting stan-dards applicable to trading accounts may resultin a misstatement of the branch’s income and afiling of false regulatory reports. It is an unsafe

and unsound practice to record and report hold-ings of securities that result from trading trans-actions using accounting standards that areintended for investment portfolio transactions;therefore, the discipline associated with account-ing standards applicable to trading accounts isnecessary. Securities held in trading accountsmust be periodically marked-to-market withunrealized gains or losses recognized in currentincome. Prices used in periodic revaluationsshould be obtained from sources that are inde-pendent of the securities dealer doing businesswith the branch.

Covered Calls

The writing of covered calls is an option strat-egy that, for a fee, grants the buyer of the calloption the right, but not the obligation to pur-chase a security owned by the option writer at apre-determined price before a specified futuredate. The option fee1 received by the writing(selling) depository institution provides incomeand has the effect of increasing the effectiveyield on the portfolio asset ‘‘covering’’ the call.

Covered call programs have been promotedas hedging strategies because the fee receivedby the writer can be used to offset a limitedamount of potential loss in the price of theunderlying security. If interest rates rise, the calloption fee can be used to partially offset thedecline in the market value of a fixed ratesecurity or the increased cost of market rateliabilities used to carry the security. However,there is no assurance that an option fee willcompletely offset the price decline on the secu-rity or the increased cost of liabilities and theresulting reduced spread between the institu-tion’s return on assets and funding costs.

As a practical matter, the gain on a securitycovered by a written call is limited to theamount of the difference between the carryingvalue of the security and the strike price atwhich the security will be called away. Thepotential for losses on the covered security is notsimilarly limited. In an effort to obtain higheryields, some portfolio managers have mistak-enly relied on the theoretical hedging benefits of

1. Recognition of option fee income should be deferreduntil the option is exercised or expires. The covered call writershall value the option at the lower of cost or market value ateach report date.



covered call writing, and have purchased extendedmaturity U.S. government or Federal agencysecurities. This practice can significantly increaserisks taken by the branch by contributing to amaturity mismatch between its assets and itsfunding.

Institutions should only initiate a covered callprogram for securities when head office andbranch management have specifically approveda policy permitting this activity. This policymust set forth specific procedures for controllingcovered call strategies, including recordkeeping,reporting, and review of activity, as well asproviding for appropriate management informa-tion systems to report the results. Since thepurchaser of the call acquires the ability to callthe security away from the institution that writesthe option, the ability of that institution tocontinue to hold the security rests with anoutside party. Securities held to maturity againstwhich call options have been written shouldtherefore be redesignated as available for saleand reported at fair value. However, when theoption contract requires the writer to deliverheld-to-maturity securities, or when manage-ment has a pattern of practice of delivering held-to-maturity securities when called, manage-ment’s intent to hold other securities to maturitymay be called into question.

However, if an option contract requires thewriter to settle in cash, rather than delivering aninvestment portfolio security, the institution writ-ing the option maintains the ability to hold thesecurity and, thus, the security may be reportedas held-to-maturity. In this case, the option muststill be reported at fair value.

Adjusted Trading

Adjusted trading is a practice involving the saleof a security to a broker or dealer at a priceabove the prevailing market value and thesimultaneous purchase and booking of a differ-ent security, frequently a lower grade issue orone with a longer maturity, at a price greaterthan its market value. Thus, the broker or dealeris reimbursed for losses on the purchase fromthe institution and ensured a profit. Such trans-actions inappropriately defer the recognition oflosses on the security sold and establish anexcessive reported value for the newly acquiredsecurity. Consequently, such transactions areprohibited and may be in violation of 18 USC

sections 1001-False Statements or Entries and1005-False Entries.

Coupon Stripping

Coupon stripping involves detaching unmaturedcoupons from securities and selling either thecoupons or the remaining stripped security.Such transactions are often motivated by anxietyfor immediate income recognition or by taxconsiderations. This practice significantly dimin-ishes the worth, marketability, and liquidity ofthe securities.

U.S. government obligations are the mostcommon type of security used for coupon strip-ping. Corporate or municipal issues may be usedbut are not viewed as attractive alternativesbecause of credit risk and early redemptionfeatures.

The Internal Revenue Service has ruled thatthe proceeds from the sale of unmatured cou-pons constitute ordinary income and are includedin the taxable income for the year in which thesale occurred. A branch can increase currentperiod taxable income to utilize a prior year’stax loss carry-forward by selling all or a portionof the unmatured coupons of their securities.Similarly, an ex-coupon security may be sold atits discounted value. The difference between thesale proceeds and the cost basis of the security isrecognized as a current period tax loss.

There are a limited number of dealers thatparticipate in wholesale and retail trading andreoffering of detached coupons and ex-couponsecurities. That activity is generally viewed asinappropriate for branch dealers; the marketabil-ity and liquidity shortcomings attendant witheither the coupons or the securities result inuncertain suitability for customer purchase with-out complete customer disclosure and consent.Ex-coupon securities or stripped coupons aredistinctly different from securities that have allthe unmatured coupons attached. The ex-couponsecurity and resulting coupons generally:

• Have a diminished and uncertain market valueand impaired practical liquidity.

• Are not, absent adequate customer disclosure,suitable for sale to customers or as repurchaseagreement collateral with customers.

• Are not considered good delivery items bysecurities dealers.



If a branch has engaged or elects to engage insuch transactions, they must be reported asfollows:

• The book value must be allocated between theprincipal portion and the coupons at the timethe security is divided. This allocation will bebased upon the present value of each compo-nent (principal and coupons) at the time ofsale using the yield to maturity at the time thesecurity was purchased as the discount rate.

• The profit or loss on the portion sold must berecognized during the period in which the saleoccurred as other income or other expense. Itwill be the difference between that portion ofthe book value, allocated as above to theportion sold, and the actual selling price ofthat portion. The portion retained will becarried on the books of the branch at itsallocated portion of the book value. Detachedcoupons or principal portions held by a branch,either as a result of purchase or of strippingsecurities held for its own account, will bereported as other notes, bonds and debentures,and not as U.S. Treasury securities, obliga-tions of other U.S. government agencies andcorporations, or obligations of states andpolitical subdivisions in the United States.

Special Guidance onMortgage-Backed Products

Some mortgage-backed products exhibit consid-erably more price volatility than mortgages.Some mortgage pass-through securities canexpose investors to significant risk of loss if notmanaged in a safe and sound manner. This pricevolatility is caused in part by the uncertain cashflows that result from changes in the prepaymentrates of the underlying mortgages.

In addition, because these products are com-plex, a high degree of technical expertise isrequired to understand how their prices and cashflows may behave in various interest rate andprepayment environments. Moreover, becausethe secondary market for some of these productscan be relatively thin, they may be difficult toliquidate should the need arise. Finally, there isadditional uncertainty because new variants ofthese instruments continue to be introduced andtheir price performance under varying marketand economic conditions has not been tested.

General Guidance

Under the FFIEC policy statement, the bankingagencies call for special management ofmortgage-backed products. A general principleunderlying this policy is that mortgage-backedproducts possessing average life or price vola-tility in excess of a benchmark fixed rate 30-yearmortgage-backed pass-through security are‘‘high-risk mortgage securities’’ and are notsuitable investments. All high-risk mortgagesecurities, defined later in this section, acquiredby depository institutions after February 10,1992, must be carried in the institution’s tradingaccount or as assets available for sale. Mortgage-backed products that do not meet the definitionof a high-risk mortgage security at the time ofpurchase may be reported as held to maturity,available for sale, or held for trading, as appro-priate. Branches must ascertain no less fre-quently than annually whether such productshave become high-risk mortgage securities.

Branches generally should hold mortgage-backed products that meet the definition of ahigh-risk mortgage security only to reduce inter-est rate risk in accordance with safe and soundpractices.2 Furthermore, depository institutionsthat purchase high-risk mortgage securities mustdemonstrate that they understand and are effec-tively managing the risks associated with theseinstruments. Levels of activity involving high-risk mortgage securities should be reasonablyrelated to a branch’s capacity to absorb losses,and level of in-house management sophistica-tion and expertise. Appropriate managerial andfinancial controls must be in place and thebranch must analyze, monitor, and prudentlyadjust its holdings of high-risk mortgage secu-rities in an environment of changing price andmaturity expectations.

Prior to taking a position in any high-riskmortgage security, branch management shouldconduct an analysis to ensure that the positionwill reduce the overall interest rate risk. Liquid-

2. Notwithstanding the provisions of the Board’s supervi-sory policy generally requiring that high-risk mortgage secu-rities be used only for the purpose of reducing interest raterisk, this supervisory policy is not meant to preclude aninstitution with strong capital and earnings and adequateliquidity that has a closely supervised trading department fromacquiring high-risk mortgage securities for trading purposes.The trading department must operate in conformance withwell-developed policies, procedures, and internal controls,including detailed plans prescribing specific position limitsand control arrangements for enforcing these limits.



ity and price volatility of these products alsoshould be considered prior to purchasing them.Circumstances in which the purchase or reten-tion of high-risk mortgage securities is deemedby the appropriate regulatory authority to becontrary to safe and sound practices for deposi-tory institutions will result in criticism by exam-iners, who may require the orderly divestiture ofhigh-risk mortgage securities. Purchases of high-risk mortgage securities prior to February 10,1992, generally will be reviewed in accordancewith previously-existing supervisory policies.

Securities and other products, whether carriedon or off the balance sheet (such as CMO swaps,but excluding servicing assets), having riskcharacteristics similar to high-risk mortgagesecurities will be subject to the same supervi-sory treatment as high-risk mortgage securities.

Long-term zero coupon bonds also exhibitsignificant price volatility and may expose aninstitution to considerable risk. Disproportion-ately large holdings of these instruments may beconsidered an imprudent investment practice,which will be subject to criticism by examiners.In such instances, examiners may seek theorderly disposal of some or all of these securi-ties. Assets slated for disposal are to be reportedas assets available for sale at their market value.

Definition of ‘‘High-Risk MortgageSecurity’’

In general, any mortgage-backed product thatexhibits greater price volatility than a bench-mark fixed rate thirty-year mortgage-backedpass-through security will be deemed to be highrisk. For purposes of the FFIEC policy state-ment, a ‘‘high-risk mortgage security’’ is definedas any mortgage-backed product that at the timeof purchase, or at a subsequent testing date,meets any of the following tests.3 In general, amortgage derivative product that does not meetany of the three tests below will be considered tobe a ‘‘nonhigh-risk mortgage security.’’

• Average Life Test. The mortgage-backed prod-uct has an expected weighted average lifegreater than 10.0 years.

• Average Life Sensitivity Test. The expectedweighted average life of the mortgage-backedproduct:— Extends by more than 4.0 years, assuming

an immediate and sustained parallel shiftin the yield curve of plus 300 basis points,or

— Shortens by more than 6.0 years, assumingan immediate and sustained parallel shiftin the yield curve of minus 300 basispoints.

• Price Sensitivity Test. The estimated changein the price of the mortgage-backed product ismore than 17 percent, due to an immediateand sustained parallel shift in the yield curveof plus or minus 300 basis points.4

In applying any of the above tests, all of theunderlying assumptions (including prepaymentassumptions) for the underlying collateral mustbe reasonable. All of the assumptions under-lying the analysis must be available for exam-iner review. For example, if an institution’sprepayment assumptions differ significantly fromthe median prepayment assumptions of severalmajor dealers as selected by examiners, theexaminers may use these median prepaymentassumptions in determining if a particular mort-gage backed product is high risk.

The above tests may be adjusted to considersignificant movements in market interest rates,to fairly measure the risk characteristics of newmortgage-backed products, and to take suchaction that is deemed appropriate to preventcircumvention of the definition of a high-riskmortgage security and other such standards.

Generally, a CMO floating-rate debt classwill not be subject to the average life andaverage life sensitivity tests described above if itbears a rate that, at the time of purchase or at a

3. When the characteristics of a mortgage derivative prod-uct are such that the first two tests cannot be applied (such aswith IOs), the mortgage derivative product remains subject tothe third test.

4. When performing the price sensitivity test, the sameprepayment assumptions and same cash flows that were usedto estimate average life sensitivity must be used. The onlyadditional assumption is the discount rate assumption.

First, assume that the discount rate for the security equalsthe yield on a comparable average life U.S. Treasury securityplus a constant spread. Then, calculate the spread overTreasury rates from the bid side of the market for themortgage derivative product. Finally, assume the spreadremains constant when the Treasury curve shifts up or down300 basis points. Discounting the aforementioned cash flowsby their respective discount rates estimates a price in the plusand minus 300 basis point environments.

The initial price will be determined by the offer side of themarket and used as the base price from which the 17 percentprice sensitivity test will be measured.



subsequent testing date, is below the contractualcap on the instrument. (An institution maypurchase interest rate contracts that effectivelyuncap the instrument.) For purposes of thispolicy statement, a CMO floating-rate debt classis a debt class whose rate adjusts at leastannually on a one-for-one basis with the debtclass’s index. The index must be a conventional,widely-used market interest rate index such asthe London Interbank Offered Rate (LIBOR).Inverse floating rate debt classes are not includedin the definition of a floating rate debt class.

Supervisory Policy for Mortgage-BackedProducts

Prior to purchase, a branch must determinewhether a mortgage-backed product is high-risk. A prospectus supplement or other support-ing analysis that fully details the cash flowscovering each of the securities held by theinstitution should be obtained and analyzedprior to purchase and retained for examinerreview. In any event, a prospectus supplementshould be obtained as soon as it becomesavailable.

Nonhigh-Risk Mortgage Securities

Mortgage-backed products that do not meet thedefinition of high-risk mortgage securities, atthe time of purchase, should be reported as heldto maturity, available for sale, or held for trad-ing, as appropriate. Branches must ascertain anddocument prior to purchase and no less fre-quently than annually thereafter that nonhigh-risk mortgage securities that are held to maturityremain outside the high-risk category. If a branchis unable to make these determinations throughinternal analysis, it must use information derivedfrom a source that is independent of the partyfrom whom the product is being purchased.Standard industry calculators used in themortgage-related securities market place areacceptable and are considered independentsources. In order to rely on such independentanalysis, institutions are responsible for ensur-ing that the assumptions underlying the analysisand the resulting calculation are reasonable.Such documentation will be subject to examinerreview.

A mortgage-backed product that was not ahigh-risk mortgage security when it was pur-

chased as an investment may later fall into thehigh-risk category. When this occurs, the branchmay continue to designate the mortgage-backedproduct as held to maturity, providing thatmanagement still maintains the positive intentand ability to hold the security to maturity.Furthermore, examiners should consider anyunrecognized net depreciation in held-to-maturityhigh-risk securities when reviewing earningsand evaluating liquidity risk.

Once a mortgage-backed product has beendesignated as high-risk, it may be redesignatedas nonhigh-risk only if, at the end of twoconsecutive quarters, it does not meet the defi-nition of a high-risk mortgage security. Uponredesignation as a nonhigh-risk security, it doesnot need to be tested for another year.

High-Risk Mortgage Securities

A branch may, generally, only acquire a high-risk mortgage backed product to reduce itsoverall interest rate risk. (Branches meeting thepreviously mentioned guidance regarding theuse of these securities in a trading account mayalso purchase these securities for trading pur-poses.) A branch that has acquired high-riskmortgage securities to reduce interest rate riskneeds to frequently assess its interest rate riskposition and the performance of these securities.Since interest rate positions constantly change, abranch may determine that these high-risk mort-gage securities no longer reduce interest raterisk. Therefore, mortgage backed products thatare high-risk when acquired shall not be reportedas held-to-maturity securities at amortized cost.

In appropriate circumstances, examiners mayseek the orderly divestiture of high-risk mort-gage securities that do not reduce interest raterisk. Appropriate circumstances are those inwhich the examiner determines that continuedownership of high-risk mortgage securities rep-resents an undue safety and soundness risk tothe branch. This risk can arise from the size ofthe branch’s holdings of high-risk mortgagesecurities in relation to its earnings and headoffice capital, management’s inability to demon-strate an understanding of the nature of the risksinherent in the securities, the absence of internalmonitoring systems and other internal controlsto appropriately measure the market and cashflow risks of these securities, management’sinability to prudently manage its overall interestrate risk, or similar factors.



A branch that owns or plans to acquirehigh-risk mortgage securities must have a moni-toring and reporting system in place to evaluatethe expected and actual performance of suchsecurities. The institution must conduct an analy-sis that shows that the proposed acquisition of ahigh-risk mortgage security will reduce theinstitution’s overall interest rate risk. Subse-quent to purchase, the branch must evaluate atleast quarterly whether this high-risk mortgagesecurity has actually reduced interest rate risk.

The branch’s analyses performed prior to thepurchase of high-risk mortgage securities andsubsequently thereafter must be fully docu-mented and will be subject to examiner review.This review will include an analysis of allassumptions used by management regarding theinterest rate risk associated with the branch’sassets, liabilities and off-balance sheet positions.Analyses performed and records constructed tojustify purchases on a post-acquisition basis areunacceptable and will be subject to examinercriticism. Reliance on analyses and documenta-tion obtained from a securities dealer or otheroutside party without internal analyses by theinstitution are unacceptable and reliance on suchthird-party analyses will be subject to examinercriticism.

Management should also maintain documen-tation demonstrating that it took reasonablesteps to assure that the prices paid for high-riskmortgage securities represented fair marketvalue. Generally, price quotes should be obtainedfrom at least two brokers prior to executing atrade. If, because of the unique or proprietarynature of the transaction or product, or for otherlegitimate reasons, price quotes cannot beobtained from more than one broker, manage-ment should document the reasons for notobtaining such quotes.

In addition, a branch that owns high-riskmortgage securities must demonstrate that it hasestablished the following:

• A head office approved portfolio policy whichaddresses the goals and objectives the branchexpects to achieve through its securitiesactivities, including interest rate risk reductionobjectives with respect to high-risk mortgagesecurities;

• Limits on the amounts of funds that may becommitted to high-risk mortgage securities;

• Specific financial officer responsibility for andauthority over securities activities involvinghigh-risk mortgage securities;

• Adequate information systems;• Procedures for periodic evaluation of high-

risk mortgage securities and their actual per-formance in reducing interest rate risk; and

• Appropriate internal controls.

The branch’s senior management should regu-larly (at least quarterly) review all high-riskmortgage securities to determine whether theseinstruments are adequately satisfying the inter-est rate risk reduction objectives set forth in theportfolio policy. The branch’s senior manage-ment should be fully knowledgeable about therisks associated with prepayments and theirsubsequent impact on its high-risk mortgagesecurities. Failure to comply with this policywill be viewed as an unsafe and unsoundpractice.

OTHER MORTGAGE-BACKEDPRODUCTS

There are advantages and disadvantages in own-ing these products. A branch must consider theliquidity, marketability, pledgeability, and pricevolatility of each of these products before invest-ing in them. It may be unsuitable for a branch tocommit significant amounts of funds to long-term stripped mortgage-backed securities, residu-als, and zero coupon bonds, which fluctuategreatly in price.

Stripped Mortgage-Backed Securities

Stripped mortgage backed securities (SMBS)consist of two classes of securities with eachclass receiving a different portion of the monthlyinterest and principal cash flows from the under-lying mortgage-backed securities. In its purestform, an SMBS is converted into an interest-only (IO) strip, where the investor receives100 percent of the interest cash flows, and aprincipal-only (PO) strip, where the investorreceives 100 percent of the principal cash flows.

All IOs and POs have highly volatile pricecharacteristics based, in part, on the prepaymentof the underlying mortgages and consequentlyon the maturity of the stripped security. Gener-ally, POs will increase in value when interestrates decline, while IOs increase in value wheninterest rates rise. Accordingly, the purchase ofan IO strip may serve, theoretically, to offset the



interest rate risk associated with mortgages andsimilar instruments held by a branch. Similarly,a PO may be useful as an offset to the effect ofinterest rate movements on the value of mort-gage servicing. However, when purchasing anIO or PO, the investor is speculating on themovements of future interest rates and howthese movements will affect the prepayment ofthe underlying collateral. Furthermore, thoseSMBS that do not have the guarantee of agovernment agency or a government-sponsoredagency as to the payment of principal andinterest have an added element of credit risk.

As a general rule, SMBS cannot be consid-ered as suitable investments for all branches.SMBS, however, may be appropriate holdingsfor branches that have highly sophisticated andwell-managed securities portfolios, mortgageportfolios, or mortgage banking functions. Insuch branches, however, the acquisition of SMBSshould be undertaken only in conformance withcarefully developed and documented plans pre-scribing specific positioning limits and controlarrangements for enforcing these limits. Theseplans should be approved by head office man-agement and their terms should be vigorouslyenforced.

Some branches may account for their SMBSholdings in accordance with Financial Account-ing Standards Board Statement Number 91(FASB No. 91), which requires that the carryingamount be adjusted when actual prepaymentexperience differs from prepayment estimates.Other branches may account for their SMBSholdings at market value or the lower of cost ormarket value.

Asset-Backed Securities Residuals

Residuals are the excess of cashflows fromasset-backed securities (ABS) transactions afterthe payments due to the bondholders and thetrust administrative expenses have been satis-fied. This cashflow is extremely sensitive toprepayments and thus has a high degree ofinterest rate risk.

Generally, the value of residual interests inABS rises when interest rates rise. Theoretically,a residual can be used as a risk management toolto offset declines in the value of fixed-ratemortgage or ABS portfolios. However, it shouldbe understood by all residual interest purchasersthat the yield on these instruments is inversely

related to their effectiveness as a risk manage-ment vehicle. In other words, the highest yield-ing ABS residuals have limited risk manage-ment value due to a complicated ABS structureand/or unusual collateral characteristics thatmake modeling and understanding the economiccashflows difficult. Alternatively, those residu-als priced for modest yields generally havepositive risk management characteristics.

In conclusion, it is important to understandthat a residual cashflow is highly dependentupon the prepayments received. Caution shouldbe exercised when purchasing a residual inter-est, especially higher yielding interests, becausethe risk associated over the life of the ABS maywarrant an even higher return in order toadequately compensate the investor for the inter-est rate risk assumed. Purchases of these equityinterests should be supported by in-house evalu-ations of possible rate of return ranges in com-bination with varying prepayment assumptions.

Holdings of ABS residuals should be accountedfor in the manner discussed under strippedmortgage-backed securities and should bereported as Other Assets on regulatory reports.

Other Zero Coupon or StrippedProducts

The interest and/or principal portions of U.S.government obligations are sometimes sold inthe form of stripped coupons, stripped bonds(principal), STRIPS, or propriety products, suchas CATS or TIGRs. Original issue discountbonds (OIDs) have also been issued by a num-ber of municipal entities. Longer maturities ofthese instruments can exhibit extreme pricevolatility. Accordingly, disproportionately large,long-maturity holdings (in relation to the totalportfolio) of zero coupon securities may beunsuitable for investment holdings for financialinstitutions.

STRUCTURED NOTES

This sub-section highlights the growing use ofstructured notes by banking organizations andthe need for examiners to ensure that banks thathold these instruments do so according to theirown investment policies and procedures andwith a full understanding of the risks and pricesensitivity of these instruments under a broad



range of market conditions. Some of theseinstruments can expose investors to significantlosses as interest rates, foreign exchange rates,and other market indices change. Accordingly,examiners should be mindful of these securities,whether they are used in a branch’s trading,investment, or trust activities.

Structured notes, many of which are issued byU.S. government agencies, government-sponsored entities, and other organizations withhigh credit ratings, are debt securities whosecashflows are dependent on one or more indicesin ways that create risk characteristics of for-wards or options. They tend to have mediumterm maturities and reflect a wide variety ofcashflow characteristics that can be tailored tothe needs of individual investors.

As previously noted, the federal bank regula-tory agencies have established price and effec-tive maturity standards for mortgage-backedproducts based on specified scenarios. Institu-tions should ensure that they meet these regula-tory requirements and should employ similartechniques in controlling the exposures of struc-tured notes. The scenarios specified for assess-ing the market risk of these products should besufficiently rigorous to capture all meaningfuleffects of any options. For example, in assessinginterest rate risk, scenarios such as 100, 200 and300 basis point parallel shifts in yield curvesshould be considered as well as appropriatenon-parallel shifts in structure to evaluate poten-tial basis, volatility and yield curve risks.

Structured notes may offer certain advantagesover other financial instruments used to managemarket risk. In particular, they may reducecounterparty credit risk, offer operating efficien-cies and lower transaction costs, require fewertransactions, and address more specifically aninstitution’s risk exposures. Risk to principal istypically small. Accordingly, when they areanalyzed and managed properly, structured notescan be acceptable investments and trading prod-ucts for banks.

Structured notes, however, can also havecharacteristics that cause them to be inappropri-ate holdings for many institutions. They canhave substantial price sensitivity; they can becomplex and difficult to evaluate; and they mayalso reflect high amounts of leverage relative tofixed income instruments with comparable facevalues. Their customized features and embed-ded options may also make them difficult toprice and can reduce their liquidity. Conse-quently, branches considering the purchase of

structured notes should determine whether thesefactors are compatible with their investmenthorizons and with their overall portfoliostrategies.

There are a wide variety of structured notes,with names such as single- or multi-index float-ers, inverse floaters, index-amortizing notes,step-up bonds, and range bonds. These simple,though sometimes cryptic, labels can belie thepotential complexity of these notes and theirpossibly volatile and unpredictable cashflows,which can involve both principal and interestpayments. Some notes employ ‘‘trigger levels,’’at which cashflows can change significantly, orcaps or floors, which can also substantiallyaffect their price behavior.

The critical factor for examiners to consider isthe ability of management to understand therisks inherent in these instruments and to man-age the market risks of their institution in asatisfactory manner. Therefore, examiners shouldevaluate the appropriateness of these securitiesbranch-by-branch, with a knowledge of manage-ment’s expertise in evaluating such instruments,the quality of the institution’s relevant informa-tion systems, and the nature of its overallexposure to market risk. This evaluation mayinclude a review of the institution’s ability toconduct stress tests. Failure of management tounderstand adequately the dimensions of therisks in these and similar financial products canconstitute an unsafe and unsound practice forbanks.

When making investment decisions, someinstitutions may focus only on the low creditrisk and favorable yields of these notes andeither overlook or underestimate their marketand liquidity risks. Consequently, where thesenotes are material, examiners should discusstheir role in the institution’s risk managementprocess and assess management’s recognition oftheir potential volatility.

OTHER

Resale and Repurchase AgreementActivities (REPOS)

Repos typically involve short-term U.S. govern-ment securities purchased for the branch’s ownaccount or acquired under an agreement to reselland then sold under the counterparties agree-ment to repurchase. The rate of interest receivedand paid is generally dictated by prevailing



market rates. Profits are based on a small spreadbetween interest earned and interest paid. Sinceboth the profit margin and inherent risk areminimal, repos are generally used to satisfy abranch’s short-term funding needs. A branchmay attempt to improve profits by increasing thevolume of such transactions by using the pro-ceeds of completed transactions to finance aninventory of assets to be used in further repur-chase arrangements. An alternative method ofincreasing profits is to increase the earningsyield of the instruments employed in thesetransactions by lowering the quality or by mis-matching the maturity of the resale and repur-chase agreements.

Risks inherent in repos should be controlledby policy guidelines that:

• Establish account limits.• Require approximately matched asset and lia-

bility maturities with guidelines for acceptablelevels of asset and liability mismatches.

• Provide for reasonable collateral margin andvaluation techniques.

• Subject the underlying securities of a resaleagreement to periodic market valuation inorder to determine market exposure.

• Mandate credit approvals for parties providingsecurities acquired under agreements to resell.

• Insist that characteristics of the money marketinstruments be compatible with the branch’sown investment standards.

Other Issues for ExaminerConsideration

This section contains several important issuesexaminers should consider when examininginvestment portfolios. It covers (1) transfers oflow quality securities, (2) the selection of secu-rities dealers, and (3) unsuitable investmentpractices.

Transfers of Low Quality Securities

Low quality securities, broadly defined, includedepreciated or sub-investment grade securitiesof questionable quality. As with other poorquality assets, the transfer of such securitiesfrom the branch to another branch or financialinstitution may be made to avoid detection andclassification during regulatory examinations.

These transfers may be accomplished throughparticipations, purchases/sales, and asset swapswith other affiliated or nonaffiliated entities.Examiners should be alert to situations where abranch’s intention seems to be the concealmentof low quality securities for the purpose ofavoiding examination scrutiny and possible clas-sification. Refer to the section on Credit RiskManagement for further information. If situa-tions are uncovered where it is determined that atransfer of securities was undertaken for legiti-mate reasons, the examiner should make certainthat the securities have been properly recordedon the books of the acquiring branch at areasonable or fair market value during theexamination of that branch.

Selection of Securities Dealers

Speculative activity often occurs when an invest-ment portfolio manager follows the advice ofsecurities dealers who, in order to generatecommission income, encourage speculative prac-tices that are unsuitable for the investmentportfolio.

It is common for investment portfolio man-agers to rely on the expertise and advice of asecurities sales representative for recommenda-tions of proposed investments, investment strat-egies, and the timing and pricing of securitiestransactions. Accordingly, it is important forbranch management to know the securities firmsand the personnel with whom it deals.An invest-ment manager should not engage in securitiestransactions with any securities dealer that isunwilling to provide complete and timely dis-closure of its financial condition. Branch man-agement must review the dealer’s financial state-ments and make a judgment about the ability ofthe dealer to honor its commitments. An inquiryinto the general reputation of the dealer also isnecessary.

Head office management should review andapprove, or at least closely monitor, the list ofsecurities firms with whom local branch man-agement is authorized to do business.The fol-lowing securities dealer selection standards arerecommended but are not all inclusive. Thedealer selection process should include:

• A consideration of the ability of the securitiesdealer and its subsidiaries or affiliates to fulfillcommitments as evidenced by capital strengthand operating results disclosed in current



financial data, annual reports, credit reports,etc.

• An inquiry into the dealer’s general reputationfor financial stability and fair and honestdealings with customers, including an inquiryof past or current customers of the securitiesdealer.

• An inquiry of appropriate state or federalsecurities regulators and securities industryself-regulatory organizations, such as theNational Association of Securities Dealers,concerning any formal enforcement actionsagainst the dealer or its affiliates or associatedpersonnel.

• An inquiry, as appropriate, into the back-ground of the sales representative to deter-mine his or her experience and expertise.

• A determination of whether the branch hasappropriate procedures to establish possessionor control of securities purchased. Purchasedsecurities and repurchase agreement collateralshould only be kept in safekeeping with sell-ing dealers when (1) local and head officemanagement is completely satisfied as to thecreditworthiness of the securities dealer,(2) the aggregate value of securities held insafekeeping in this manner is within creditlimitations that have been approved by localand head office management for unsecuredtransactions and (3) at least two signatures arerequired for the sale/release of the security.

The process of managing relationships withsecurities dealers may affect the branch’s codeof ethics or conduct as it relates to employeeactivities. Specifically, the branch should con-

sider prohibiting employees who are directlyinvolved in purchasing and selling securities forthe branch from conducting their own personalsecurities transactions with the same securitiesfirm employed by the branch unless approvedand under periodic review by local and headoffice management. Local and head office man-agement may also wish to adopt a policy appli-cable to officers or employees, concerning thereceipt of gratuities or travel expenses fromapproved dealer firms and their personnel.

Objectionable Investment Practices

Local and head office management is respon-sible for the prudent administration of branchinvestments in securities. An investment port-folio traditionally has been maintained to pro-vide earnings, liquidity, and a means of diversi-fying risks. When investment transactions areentered into in anticipation of taking gains onshort-term price movements, the transactionsare no longer characteristic of prudent invest-ment activities and should be conducted in asecurities trading account. Securities trading isviewed as an unsuitable activity when con-ducted in a branch’s investment account. Secu-rities trading should take place only in a closelysupervised trading account. Acquisitions of thevarious forms of zero coupon, stripped obliga-tions, and asset backed securities residuals willreceive increased regulatory attention and,depending upon the circumstances, may be con-sidered unsuitable for a branch.



Securities ActivitiesExamination ObjectivesEffective date July 1997 Section 3130.2

1. To determine if policies, practices, proce-dures, and internal controls regarding securi-ties activities are adequate.

2. To determine if branch employees are oper-ating in conformance with the establishedinternal and supervisory guidelines.

3. To determine the scope and adequacy of theinternal and external audit functions as itrelates to this area.

4. To determine the overall quality of the invest-ment portfolio and how that quality relates tothe soundness of the branch.

5. To determine if the branch is properlyaccounting for its securities.


7. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawsor regulations have been noted.


Securities ActivitiesExamination ProceduresEffective date July 1997 Section 3130.3

1. If selected for implementation, complete orupdate the Internal Control Questionnairefor this section.

2. Obtain a list of deficiencies noted in theprevious examination report or by internaland external auditors, and determine if man-agement has adequately addressed thedeficiencies.

3. Review the branch’s investment policy anddetermine its adequacy. Ascertain whetherthe policy has been revised since the previ-ous examination.

4. Review the reconcilement of the investmentsecurity trial balances to the general ledger.

5. Review management reports for accuracyand completeness.

6. Review policies for classifying transactionsas held to maturity, available for sale, ortrading.

7. Review policies for classifying investmentsecurities for credit or transfer risk.

8. Obtain a list of securities categorized asheld to maturity, available for sale, andtrading including:a. Descriptions of securities held (par, book,

and market values).b. Names of issuers.c. Issuers’ countries of domicile.d. Interest rates.e. Pledged securities.f. Internal credit rating.

9. Reflecting the scope of the examination,select investments for review. If transactionvolume permits, include all securities pur-chased since the prior examination in thepopulation of items to be reviewed. Per-form the following procedures for eachinvestment:a. For rated issues:

• Compare the branch’s internal ratingsto the most recent published ratings.

• Verify CUSIP.• Check prospectus.

b. For unrated issues:• Perform a credit analysis to determine

if the issues can be consideredspeculative.

c. If market prices are provided to thebranch by an independent party (excludesaffiliates and securities dealers sellinginvestments to the branch) or if they are

independently tested as a documentedpart of the branch’s audit program, thoseprices should be accepted. If the inde-pendence of the prices cannot be estab-lished, test market values by reference toone of the following sources:• Published quotations, if available.• Appraisals by outside pricing services,

if performed.• If market prices are provided by the

branch and cannot be verified by ref-erence to published quotations or othersources, test those prices by using thecomparative yield method to calculateapproximate yield to maturity asfollows:– Annual Interest– Par Value and Book Value– Number of Years to Maturity– Branch Provided Market Price + Par

Valued. Compare the branch provided market

price and the examiner calculatedapproximate yield to maturity to anindependent, publicly offered yield ormarket price for a similar type of invest-ment with similar rating, trading volume,and maturity or call characteristics.

e. Investigate significant market valuevariances.

10. To the extent practical under the circum-stances, perform a credit analysis of:a. Selected obligors on securities purchased

under agreements to resell.b. All defaulted issues.

11. Classify speculative and defaulted issuesaccording to the following standards (exceptthose securities with transfer risk where amore severe classification may be warranted):a. The entire book value of speculative

grade municipal general obligation secu-rities, which are not in default, willbe classified substandard. Market depre-ciation on other speculative issuesshould be classified doubtful. The remain-ing book value usually is classifiedsubstandard.

b. The entire book value of all defaultedmunicipal general obligation securitieswill be classified doubtful. Market depre-ciation on other defaulted bonds should


be classified loss. The remaining bookvalue usually is classified substandard.

c. Market depreciation on nonexempt stockshould be classified loss.

d. Report comments should include:• Description of issue.• How and when each issue was acquired.• Default date.• Date interest paid to.• Rating at time of acquisition.• Comments supporting the classification.

12. With regard to potential unsafe and unsoundinvestment practices, review the list ofsecurities purchased and/or sold since theprior examination and:a. Determine if the branch engages one

securities dealer or salesperson for virtu-ally all transactions. If so:• Evaluate the reasonableness of the

relationship on the basis of the dealer’slocation and reputation.

• Compare purchase and sale prices toindependently established market pricesas of trade dates, if appropriate.

b. Determine if investment account securi-ties have been purchased from thebranch’s own trading department. If so:• Independently establish the market

price, as of trade date.• Review trading account purchase and

sale confirmations and determine if thesecurity was transferred to the invest-ment portfolio at market price.

• Review controls designed to preventgains trading.

c. Determine if the volume of tradingactivity in the investment portfolio seemsunwarranted. If so:• Review investment account daily led-

gers and transaction invoices to deter-mine if sales were matched by a likeamount of purchases.

• Determine whether the branch is financ-ing a dealer’s inventory.

• Compare purchase and sale prices withindependently established market pricesas of trade dates, if appropriate. Thecarrying value should be determinedby the market value of the securities asof the trade date.

13. Discuss with appropriate officer(s) and pre-pare report comments on:a. Defaulted issues.b. Speculative issues.c. Incomplete credit information.d. Absence of necessary legal opinions.e. Significant changes in maturity

scheduling.f. Shifts in the rated quality of holdings.g Concentrations.h. Unbalanced earnings and risk

considerations.i. Unsafe and unsound investment practices.j. Apparent violations of laws, rulings, and

regulations (including compliance withFAS 115).

k. Market value depreciation, if significant.l. Weaknesses in supervision.m. Policy deficiencies.

14. Update workpapers with any informationthat will facilitate future examinations.

3130.3 Securities Activities: Examination Procedures


Securities ActivitiesInternal Control QuestionnaireEffective date July 1997 Section 3130.4

Review the branch’s internal controls, policies,practices, and procedures regarding purchases,sales, and servicing of the investment portfolio.The branch’s system should be documented in acomplete, concise manner and should include,where appropriate, narrative descriptions, flow-charts, copies of forms used, and other pertinentinformation. For information on trading securi-ties, refer to theTrading Activities Manual.

POLICIES

1. Has local and head office managementadopted written investment securities poli-cies that outline:a. Objectives?b. Permissible types of investments?c. Diversification guidelines to prevent

undue concentration?d. Maturity schedules?e. Limitations on quality ratings?f. Policies regarding exceptions to standard

policy?g. Valuation procedures and frequency?

2. Are investment policies reviewed at leastannually by local and head office manage-ment to determine if they are compatiblewith changing market conditions?

3. Are securities designated at time of pur-chase as to whether they are held-to-maturity, available-for-sale, or trading? Whois responsible for the designation?

4. Have policies been established governingthe transfer of securities between the held-to-maturity, available-for-sale, and tradingaccounts? Who is authorized to change asecurity’s designation?

5. Do individual officers have set investmentlimits?

6. Do security transactions require dualauthorization?

7. Are investment securities subject to creditreviews prior to purchase, and are annualreviews performed on nonrated issues andissues with significant deterioration?

8. Are securities purchases within prescribedapproval limits?

9. Are below investment grade securities

included on internal watch lists and subjectto the same scrutiny as problem credits?

10. Are stress tests appropriately performed forhigh risk securities?

CUSTODY OF SECURITIES

11. Do procedures preclude the custodian of thebranch securities from:a. Having sole physical access to securities?b. Preparing release documents without the

approval of authorized persons?c. Preparing release documents not subse-

quently examined or tested by a secondcustodian?

d. Performing more than one of the follow-ing transactions:• execution of trades,• receipt or delivery of securities,• receipt and disbursement of proceeds?

12. Are securities physically safeguarded toprevent loss or unauthorized removal oruse?

13. Are securities, other than bearer securities,held only in the name or nominee of thebranch?

14. Are bearer securities safeguardedappropriately?

RECORDS

15. Do subsidiary records of investment secu-rities show all pertinent data describing thesecurity; its location; pledged or unpledgedstatus; premium amortization; discountaccretion; and interest earned, collected,and accrued?

16. Is the preparation and posting of subsidiaryrecords performed or reviewed by personswho do not also have sole custody ofsecurities?

17. Are subsidiary records reconciled, at leastmonthly, to the appropriate general ledgeraccounts and are reconciling items investi-gated by persons who do not also have solecustody of securities?


PURCHASES, SALES ANDREDEMPTIONS

18. Is the preparation and posting of purchase,sale, and redemption records performed orreviewed by persons who do not also havesole custody of securities or authorization toexecute trades?

19. Are supporting documents, such as brokers’confirmations and account statements forrecorded purchases and sales, checked orreviewed subsequently by persons who donot also have sole custody of securities orauthorization to execute trades?

20. Are purchase confirmations compared todelivered securities or safekeeping receipts

to determine if the securities delivered arethe securities purchased?

CONCLUSION



3130.4 Securities Activities: Internal Control Questionnaire


Securities ActivitiesAudit GuidelinesEffective date July 1997 Section 3130.5

1. Verify the accuracy of the investment accounttrial balances.

2. Test the reconciliations of the trial balancesto the general ledger.

3. If investments are held in safekeeping atlocations outside the branch, request thesafekeeping agent to provide lists of securi-ties held including name, description, parvalue, interest rate, due date, pledge status,and payment date of next coupon.

4. Using appropriate sampling techniques, selectcertain investments and:a. For investments held at the branch:

• Examine and count the securities.• Compare details of certificates to trial

balances.• If securities are pledged to secure the

branch’s liabilities, determine that theyare properly segregated from othersecurities.

• Determine if coupons are intact.• Investigate any discrepancies.

b. For investmentsnot held at the branch:• Compare trial balance details to safe-

keeping receipts and the safekeepingagent’s confirmation list.

• Determine that pledge status, if any, isproperly noted on the safekeeping agent’sconfirmation list.

• Investigate any discrepancies.c. For investments purchased since the prior

audit:• Verify cost by examining invoices, bro-

ker’s advices, or other independentsources.

• Determine that the securities were prop-erly recorded in the general ledger.

• Determine that purchases were approvedby local and head office management.

d. For investments purchased at a premiumor discount, test book value by:• Determining the branch’s method of

calculating and recording amortizationof premiums and accretion of discounts.

• Determining the gross amount of pre-mium or discount at purchase date.

• Determining the period to maturity orcall date.

• Calculating the amount of premiumremaining to be amortized or discountremaining to be accreted.

• Determining that book value is reflectedproperly in the general ledger.

• Investigating any discrepancies.• Scanning previously tested amortization

or accretion schedules for investmentsacquired before the prior audit andinvestigating any significant departurefrom these schedules.

5. Test gains and losses on disposal of invest-ment securities since the prior audit by sam-pling investment sales records and:a. Determining sales price by examining

invoices or brokers’ advices.b. Checking computation of book value on

settlement date.c. Calculating gain or loss and tracing the

amount to its proper recording in thegeneral ledger.

d. Determining that the general ledger prop-erly reflects the disposal of the investmentand other related accounts.

e. Determining that sales were approved bylocal and head office management or adesignated committee.

6. Test accrued interest by:a. Determining the branch’s method of cal-

culating and recording interest accruals.b. Determining that interest accruals are not

being made on defaulted issues.c. Randomly selecting certain transactions

and:• Determining the interest rate and last

interest payment date of coupons andmoney market instruments.

• Calculating accrued interest and com-paring it to the trial balance(s).

7. If the branch is engaged in mortgage-backedor high risk securities, evaluate the interestrisk exposure associated with the variousinstruments by performing independent stresstests.


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