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29.2 BANKS AND SAVINGS INSTITUTIONS 29 23 • In addition to all of the customary considerations surrounding credit risk, sovereign risk lending involves economic, social, and political considerations that bear on the ability of the borrower to repay foreign currency obligations. Trade Finance • • Letters of Credit. Letters of credit are instruments used to facilitate trade (most commonly international trade) by substituting an institution’s credit for that of a commercial importing company. A letter of credit provides assurance to a seller that he will be paid for goods shipped. At the same time, it provides assurance to the buyer that payment will not be made until conditions specified in the sales contract have been met. Letter of credit transactions can vary in any number of ways. The issuing and advising institutions may deal with each other through their own local correspondent banks. Some of the documents may flow in different patterns. The requirements for payment and security will certainly vary from transaction to transaction. One of the attractive features of letter of credit financing from the customer’s point of view is its flexibility. Facilities can be tailored to individual transactions or groups of transactions. Bankers’ Acceptances. A bankers’ acceptance is like a letter of credit in that it provides a seller of goods with a guarantee of payment, thus facilitating trade. The institution’s customer is the buyer who, having established an acceptance facility with the bank, notifies the seller to draw up a bill of exchange. The bank “accepts” that bill (by physically stamping “accepted” on its face and having an authorized bank officer sign it) and, in so doing, commits itself to disburse funds on the bill’s due date. A banker’s acceptance represents both an asset and a liability to the accepting bank. The asset is a receivable from the bank’s customer, the buyer in the transaction. The liability is a payable to the holder of the acceptance. The bank’s accounting for open acceptances varies from country to country. In some countries, the asset and liability are both reflected on the bank’s balance sheet. In others, they are netted against each other and thus become, in effect, off-balance sheet items. In European Union (EU) countries, they appear as memorandum items on the face of the balance sheet. By substituting its own credit for that of the buying company, the accepting bank creates a financial instrument that is readily marketable. Bankers’ acceptances trade as bearer paper on active secondary markets. (ii) Accounting for Loans Principal. Loans expected to be held until maturity should be reported as outstanding principal, net of charge-offs, specific valuation accounts and any deferred fees or costs, or unamortized premiums or discounts on purchased loans. Total loans should be reduced by the allowance for credit losses. Loans held for sale should be reported at the lower of cost or market value. Mortgage loans held for sale should be reported at the lower of cost or market value in conformity with SFAS No. 65, “Accounting for Certain Mortgage Banking Activities.” Mortgage-backed securities held for sale in conjunction with mortgage banking activities shall be classified as trading securities and reported at fair value in conformity with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Interest. Interest income on all loans should be accrued and credited to interest income as it is earned using the interest method. Interest income on certain impaired loans should be recognized in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” as amended by SFAS No. 118, “Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures.” The accrual of interest is usually suspended on loans that are in excess of 90 days past due, unless the loan is both well secured and in the process of collection. When a loan is placed on such 29 24 • FINANCIAL INSTITUTIONS nonaccrual status, interest that has been accrued but not collected is reversed, and interest subsequently received is recorded on a cash basis or applied to reduce the principal balance depending on the bank’s assessment of ultimate collectibility of the loan. An exception to this rule is that many banks do not place certain types of consumer loans on nonaccrual since they automatically charge off such loans within a relatively short period of becoming delinquent—generally within 120 days. Loan Fees. Various types of fees are collected by banks in connection with lending activities. SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an Amendment of FASB Statements No. 13, 60, and 65 and a Recession of FASB Statement No. 17),” requires that the majority of such fees and associated direct origination costs be offset. The net amount must be deferred as part of the loan (and reported as a component of loans in the balance sheet) and recognized in interest income over the life of the loan and/or loan commitment period as an adjustment of the yield on the loan. The requirements for cost deferral under this standard are quite restrictive and require direct linkage to the loan origination process. Activities for which costs may be deferred include: (1) evaluating the borrower, guarantees, collateral, and other security; (2) preparation and processing of loan documentation for loan origination, and (3) negotiating and closing the loan. Certain costs are specifically precluded from deferral, for example, advertising and solicitation, credit supervision and administration, costs of unsuccessful loan originations, and other activities not directly related to the extension of a loan. Loan fees and costs for loans originated or purchased for resale are deferred and are recognized when the related loan is sold. Commitment fees to purchase or originate loans, net of direct origination costs, are generally deferred and amortized over the life of the loan when it is extended. If the commitment expires, then the fees are recognized in other income on expiration of the commitment. There are two main exceptions to this general treatment: 1. If past experience indicates that the extension of a loan is unlikely, then the fee is recognized over the commitment period. 2. Nominal fees, which are determined retroactively, on a commitment to extend funds at a market rate may be recognized in income at the determination date. Certain fees may be recognized when received, primarily loan syndication fees. Generally, the yield on the portion of the loan retained by the syndicating bank must at least equal the yield received by the other members of the syndicate. If this is not the case, a portion of the fees designated as a syndication fee must be deferred and amortized to income to achieve a yield equal to the average yield of the other banks in the syndicate. EITF Issue No. 97-3, “Accounting for Fees and Costs Associated with Loan Syndication’s and Loan Participation’s after the Issuance of FASB Statement No. 125,” states that loan participation should be accounted for in accordance with the provision of SFAS No. 140, and loan syndication’s should be accounted for in accordance with the provision of SFAS No. 91. Purchased loans are recorded at cost net of fees paid/received. The difference between this recorded amount and the principal amount of the loan is amortized to income over the life of the loan to produce a level yield. Acquisition costs are not deferred, but are expensed as incurred. The AICPA’s Accounting Standards Executive Committee has a project under way that is expected to result in a new SOP entitled “Accounting for Certain Purchased Loans.” Readers should be alert for a final pronouncement. Additional EITFs have been issued to address purchases of credit card portfolios. Acquisition, Development, and Construction Arrangements. Certain transactions that appear to be loans are considered effectively to be investments in the real estate property financed. These transactions are required to be presented separately from loans and accounted 29.2 BANKS AND SAVINGS INSTITUTIONS 29 25 • for as real estate investments using the guidance set forth in the AICPA Notice to Practitioners dated February 1986. Factors indicating such treatment include six arrangements whereby the financial institution: 1. Provides substantially all financing to acquire, develop, and construct the property, that is, borrower has little or no equity in the property 2. Funds the origination or commitment fees through the loan 3. Funds substantially all interest and fees through the loan 4. Has security only in the project with no recourse to other assets or guarantee of the borrower 5. Can recover its investment only through sale to third parties, refinancing, or cash flow of the project 6. Is unlikely to foreclose on the project during development since no payments are due during this period and therefore the loan cannot normally become delinquent Troubled Debt Restructurings and Impaired Loans. Banks may routinely restructure loans to meet a borrower’s changing circumstances. The new loan terms are reflected in the financial statements essentially as if a new loan has been made. However, if “a creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession . . . that it would not otherwise consider,” then SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings,” as amended by FASB Statements No. 114, No. 121, “Accounting for Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of,” and No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” applies. TROUBLED DEBT RESTRUCTURINGS. the following: • • Troubled debt restructurings may include one or more of Transfers of assets of the debtor or an equity interest in the debtor to partially or fully satisfy a debt Modification of debt terms, including reduction of one or more of the following: (1) interest rates with or without extensions of maturity date(s), (2) face or maturity amounts, and (3) accrued interest Prior to the release of SFAS No. 114, under a SFAS No. 15 restructuring involving a modification of terms, the creditor accumulated the undiscounted total future cash receipts and compared them to the recorded investment in the loan. If these cash receipts exceeded the recorded investment in the loan, no loss or impairment was deemed to exist; however, if the total cash receipts did not exceed the recorded investment, the recorded investment was adjusted to reflect the total undiscounted future cash receipts. For restructurings involving a modification of terms that occurred before the effective date of SFAS No. 114, this accounting still applies as long as the loan does not become impaired relative to the restructured terms. Restructurings involving a modification of terms after the effective date of SFAS No. 114 must be accounted for in accordance with SFAS No. 114. IMPAIRED LOANS. In May 1993, SFAS No. 114, “Accounting by Creditors for Impairment of a Loan (an Amendment of FASB Statements No. 5 and 15),” was issued primarily to provide more consistent guidance on the application of SFAS No. 5 loss criteria and to provide additional direction on the recognition and measurement of loan impairment in determining credit reserve levels. The application of this statement was required beginning in 1995. SFAS No. 114 applies to all impaired loans, uncollateralized as well as collateralized, except: large groups of smaller balance homogeneous loans that are collectively evaluated for impairment such as credit card, residential mortgage, and consumer installment loans; loans that are measured at fair value or at the lower of cost or fair value; leases; and debt securities, as defined in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” 29 26 • FINANCIAL INSTITUTIONS A loan is impaired when, based on current information and events, it is probable (consistent with its use in SFAS No. 5—an area within a range of the likelihood that a future event or events will occur confirming the fact of the loss) that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. As used in SFAS No. 114 and in SFAS No. 5, as amended, all amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement. It is important to note that an insignificant delay or insignificant shortfall in the amount of payments does not require application of SFAS No. 114. A loan is not impaired during a period of delay in payment if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay. SFAS No. 114 provides that the measurement of impaired value should be based on one of the following methods: • • • Present value of expected cash flows discounted at the loan’s effective interest rate The observable value of the loan’s market price The fair value of the collateral if the loan is collateral dependent The effective rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan. For variable rate loans, the loan’s effective interest rate may be calculated based on the factor as it changes over the life of the loan, or it may be fixed at the rate in effect at the date the loan meets the SFAS No. 114 impairment criterion. However, that choice should be applied consistently for all variable rate loans. All impaired loans do not have to be measured using the same method; the method selected may vary based on the availability of information and other factors. However, the ultimate valuation should be critically evaluated in determining whether it represents a reasonable estimate of impairment. If the measure of the impaired loan is less than the recorded investment in the loan (including accrued interest, net deferred loan fees or costs, and unamortized premium or discount), a creditor should recognize an impairment by creating a valuation allowance with a corresponding charge to bad-debt expense. Subsequent to the initial measurement of impairment, if there is a significant change (increase or decrease) in the amount or timing of an impaired loan’s expected future cash flows, observable market price, or fair value of the collateral, a creditor should recalculate the impairment by applying the procedures described above and by adjusting the valuation allowance. However, the net carrying amount of the loan should at no time exceed the recorded investment in the loan. Any restructurings performed under the provisions of SFAS No. 15 need not be reevaluated unless the borrower is not performing in accordance with the contractual terms of the restructuring. EITF Issue No. 96-22, “Applicability of the Disclosures Required by FASB Statement No. 114 When a Loan Is Restructured in a Troubled Debt Restructuring into Two (or More) Loans,” states that when a loan is restructured in a troubled debt restructuring into two (or more) loan agreements, the restructured loans should be considered separately when assessing the applicability of the disclosures in years after the restructuring because they are legally distinct from the original loan. However, the creditor would continue to base its measure of loan impairment on the contractual terms specified by the original loan agreements. In-Substance Foreclosures. SFAS No. 114 clarified the definition of in-substance foreclosures as used in SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings,” by stating that the phrase “foreclosure by the creditor” in paragraph 34 should be read to mean “physical possession of debtor’s assets regardless of whether formal foreclosure proceedings take place.” Further, until foreclosure occurs, these assets should remain as loans in the financial statements. 29.2 BANKS AND SAVINGS INSTITUTIONS 29 27 • (p) CREDIT LOSSES. Credit loss estimates are subjective and, accordingly, require careful judgments in assessing loan collectibility and in estimating losses. (i) Accounting Guidance. SFAS No. 114, “Accounting by Creditors for Impairment of a Loan (an Amendment of FASB Statements No. 5 and 15)” and SFAS No. 5, “Accounting for Contingencies (as amended by SFAS No. 118, ‘Accounting by Creditors for Impairment of Loan-Income Recognition and Disclosures’)” are the primary sources of guidance on accounting for the allowance for loan losses. SFAS No. 5 requires that an estimated loss from a contingency should be accrued by a charge to income if both of the following conditions are met: • • Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss. The amount of loss can be reasonably estimated. SFAS No. 5 states that when a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset (whether related to contractual principal or interest) can range from remote to probable. Probable means the future event or events are likely to occur; however, the conditions for accrual are not intended to be so rigid that they require virtual certainty before a loss is accrued. The allowance for loan losses should be adequate to cover probable credit losses related to specifically identified loans, as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date. Credit losses related to off-balance sheet instruments should also be accrued if the conditions of SFAS No. 5 are met. Actual credit losses should be deducted from the allowance, and the related balance should be charged off in the period in which they are deemed uncollectible. Recoveries of loans previously charged off should be added to the allowance when received. SFAS No. 114 addresses the accounting by creditors for impairment of certain loans, as discussed in Subsection 29.2(o)(ii). (ii) Regulatory Guidance. The regulatory agencies issued the “Interagency Policy on the Allowance for Loan and Lease Losses” in December 1993. The policy statement provides guidance with respect to the nature and purpose of the allowance; the related responsibilities of the board of directors, management, and the bank examiners; adequacy of loan review systems; and issues related to international transfer risk. The policy statement also includes an analytical tool to be used by bank examiners for assessing the reasonableness of the allowance; however, the policy statement cautions the bank examiners against placing too much emphasis on the analytical tool, rather than performing a full and thorough analysis. The OCC also provides guidance in its “Comptrollers’ Handbook, Allowance for Loan and Lease Losses,” issued in June 1996. In separate releases on July 6, 2001, the SEC and the FFIEC issued guidance on methodologies and documentation related to the allowance for loan losses. In SAB No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” the SEC staff expressed certain of their views on the development, documentation, and application of a systematic methodology as required by Financial Reporting Release No. 28 for determining allowances for loan and lease losses in accordance with generally accepted accounting principles. In particular, the guidance focuses on the documentation the staff normally would expect registrants to prepare and maintain in support of their allowances for loan losses. Concurrent with the release of SAB No. 102, the federal banking agencies issued related guidance through the FFIEC entitled “Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions.” The Policy Statement, developed in 29 28 • FINANCIAL INSTITUTIONS consultation with the SEC staff, provides guidance on the design and implementation of allowance for loan and lease losses methodologies and supporting documentation practices. Both SAB No. 102 and the Policy Statement reaffirm the applicability of existing accounting guidance; neither attempts to overtly change GAAP as they relate to the ALLL. (iii) Allowance Methodologies. An institution’s method of estimating credit losses is influenced by many factors, including the institution’s size, organization structure, business environment and strategy, management style, loan portfolio characteristics, loan administration procedures, and management information systems. Common Factors to Consider. Although allowance methodologies may vary between institutions, the factors to consider in estimating credit losses are often similar. Both SAB No. 102 and the Policy Statement require that when developing loss measurements, banks consider the effect of current environmental factors and then document which factors were used in the analysis and how those factors affected the loss measurements. The following are examples of factors that should be considered: • • • • • • • • Levels of and trends in delinquencies and impaired loans Levels of and trends in charge-offs and recoveries Trends in volume and terms of loans Effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practices Experience, ability, and depth of lending management and other relevant staff National and local economic trends and conditions Industry conditions Effects of changes in credit concentrations Supplemental data, such as historical loss rates or peer group analyses, can be helpful; however, they are not, by themselves, sufficient basis for an allowance methodology. Portfolio Segments. Another common practice is dividing the loan portfolio into different segments. Each segment typically includes similar characteristics, such as risk classification and type of loan. Segments typically include large problem loans by industry or collateral type and homogeneous pools of smaller loans, such as credit cards, automobile loans, and residential mortgages. Credit Classification Process. A credit classification process involves categorizing loans into risk categories and is often applied to large loans that are evaluated individually. The categorization is based on conditions that may affect the ability of borrowers to service their debt, such as current financial information, historical payment experience, credit documentation, public information, and current trends. Many institutions classify loans using a rating system that incorporates the regulatory classification system. These definitions are as follows: SPECIAL MENTION. Some loans are considered criticized but not classified. Such loans have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets or of the institution’s credit position at some future date. Special mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification. SUBSTANDARD. Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are 29.2 BANKS AND SAVINGS INSTITUTIONS 29 29 • characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected. DOUBTFUL. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. LOSS. Loans classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. Pools of Smaller-Balance Homogeneous Loans. Loans not evaluated individually are included in pools and loss rates are derived for each pool. The loss rates to be applied to the pools of loans are typically derived from the combination of a variety of factors. Examples of the factors include: historical experience, expected future performance, trends in bankruptcies and troubled collection accounts, and changes in the customer’s performance patterns. Foreign Loans. The Interagency Country Exposure Risk Committee (ICERC) requires certain loans to have allocated transfer risk reserves (ATRRs). ATRRs are minimum specific reserves related to loans in particular countries and, therefore, must be reviewed by each institution. The ICERC’s supervisory role is pursuant to the International Supervision Act of 1983. The collectibility of foreign loans that do not have ATRRs should be assessed in the same way as domestic loans. Documentation, Completeness, and Frequency. The institution’s allowance methodology should be based on a comprehensive, adequately documented, and consistently applied analysis. The analysis should consider all significant factors that affect collectibility of the portfolio and should be based on an effective loan review and credit grading (classification) system. Additionally, the evaluation of the adequacy of the allowance should be performed as of the end of each quarter, and appropriate provisions should be made to maintain the allowance at an adequate level. SAB No. 102 and the 2001 Policy Statement specifically require, for any adjustments of loss measurements for environmental factors, that banks maintain sufficient objective evidence (1) to support the amount of the adjustment and (2) to explain why the adjustment is necessary to reflect current information, events, circumstances, and conditions in the loss measurements. (q) LOAN SALES AND MORTGAGE BANKING ACTIVITIES. Banks may originate and sell loans for a variety of reasons, such as generating income streams from servicing and other fees, increasing liquidity, minimizing interest rate exposure, enhancing asset/liability management, and maximizing their use of capital. (i) Underwriting Standards. When loans are originated for resale, the origination process includes not only finding an investor, but also preparing the loan documents to fit the investor’s requirements. Loans originated for resale must normally comply with specific underwriting standards regarding items such as borrower qualifications, loan documentation, appraisals, mortgage insurance, and loan terms. Individual loans that do not meet the underwriting standards are typically eliminated from the pool of loans eligible for sale. Generally, the originating institutions may be subject to recourse by the investor for underwriting exceptions identified subsequent to the sale of the loans and any related defaults by borrowers. 29 30 • FINANCIAL INSTITUTIONS (ii) Securitizations. A common method of transforming real estate assets into liquid marketable securities is through securitization. Securitization is where loans are sold to a separate entity which finances the purchase through the issuance of debt securities or undivided interest in the loans. The real estate securities are backed by the cash flows of the loans. Securitization of residential mortgages has expanded to include commercial and multifamily mortgages, auto and home equity loans, credit cards, and leases. The accounting guidance for sales of loans through securitizations is discussed in Section 29.3, “Mortgage Banking Activities.” (iii) Loan Servicing. When loans are sold, the selling institution sometimes retains the right to service the loans for a servicing fee, which is collected over the life of the loans as payments are received. The servicing fee is often based on a percentage of the principal balance of the outstanding loans. A typical servicing agreement requires the servicer to perform the billing, collection, and remittance functions, as well as maintain custodial bank accounts. The servicer may also be responsible for certain credit losses. (iv) Regulatory Guidance. Regulatory guidance with respect to loan sales and mortgage banking activities continues to evolve with the increased activity by institutions. In December 1997, the OCC issued regulatory guidance for national banks in its Comptrollers’ Handbook: Asset Securitization. The FRB issued a Supervision and Regulation Letter, “Risk Management and Capital Adequacy of Exposures Arising from Secondary Market Credit Activities.” (v) Accounting Guidance. The accounting guidance for purchasing, acquiring, and selling mortgage servicing rights is discussed in Section 29.3. (vi) Valuation. The accounting guidance addressing the valuation of loans held for sale is discussed in Section 29.3. (r) REAL ESTATE INVESTMENTS, REAL ESTATE OWNED, AND OTHER FORECLOSED ASSETS. The type and nature of assets included in real estate investments, former bank premises, and other foreclosed assets can vary significantly. Such assets are described next. (i) Real Estate Investments. Certain institutions make direct equity investments in real estate projects, and other institutions may grant real estate loans that have virtually the same risks and rewards as those of joint venture participants. Both types of transactions are considered to be real estate investments, and such arrangements are treated as if the institution has an ownership interest in the property. Specifically, GAAP for real estate investments is established in the following authoritative literature: • • • • • • AICPA Statement of Position 78-9, “Accounting for Investments in Real Estate Ventures” SFAS No. 34, “Capitalization of Interest Cost” SFAS No. 58, “Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method” SFAS No. 66, “Accounting for Sales of Real Estate” SFAS No. 67, “Accounting for Costs and Initial Rental Operations of Real Estate Projects” SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (ii) Former Bank Premises. Many institutions have former premises that are no longer used in operations. Such former bank premises may be included in real estate owned. 29.2 BANKS AND SAVINGS INSTITUTIONS 29 31 • (iii) Foreclosed Assets. Foreclosed assets include all assets received in full or partial satisfaction of a receivable and include real and personal property; equity interests in corporations, partnerships, and joint ventures; and beneficial interests in trusts. However, the largest component of real estate owned by banks and savings institutions is comprised of foreclosed real estate assets. Guidance on accounting for and reporting of foreclosed assets is established in the following authoritative literature: • • • SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings” SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” SOP 92-3, “Accounting for Foreclosed Assets” In October 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Asset,” (FAS No. 144, or the Statement). The Statement supersedes FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”; however, it retains the fundamental provisions of that Statement related to the recognition and measurement of the impairment of long-lived assets to be “held and used.” In addition, the Statement provides more guidance on estimating cash flows when performing a recoverability test, requires that a long-lived asset (group) to be disposed of other than by sale (e.g., abandoned) be classified as “held and used” until it is disposed of, and establishes more restrictive criteria to classify as asset (group) as “held for sale.” The Statement is effective for year ends beginning after December 15, 2001 (e.g., January 1, 2002, for a calendar year entity) and interim periods within those fiscal years. Earlier application is encouraged. Transition is prospective for committed disposal activities that are initiated after the effective date of the Statement or an entity’s initial application of the Statement. The Statement also provides transition provisions for assets “held for sale” that were initially recorded under previous models (APB No. 30 or FAS No. 121) and do not meet the new “held for sale” criteria within one year of the initial application of the Statement (e.g., December 31, 2002, for a calendar year-end entity that adopts the Statement effective January 1, 2002). (s) INVESTMENTS IN DEBT AND EQUITY SECURITIES. Banks use a variety of financial instruments for various purposes, primarily to provide a source of income through investment or resale and to manage interest-rate and liquidity risk as part of an overall asset/liability management strategy. Institutions purchase U.S. government obligations, such as U.S. Treasury bills, notes, and bonds, in addition to the debt of U.S. government agencies and government-sponsored enterprises, such as the U.S. Government National Mortgage Association (Ginnie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Institutions also purchase municipal obligations, such as municipal bonds and tax anticipation notes. Another common form of investments, which can be tailored to a wide variety of needs, are called asset-backed securities (ABSs). Banks can hold ABSs as securities, or they can be the issuer of ABSs along with both governmental and private issuers. The ABSs are repaid from the underlying cash flow generated from other financial instruments, such as mortgage loans, credit card receivables, and mobile home loans. ABSs secured by real estate mortgages are often called mortgagebacked securities (MBSs). The level of risk related to ABSs is often related to the level of risk in the collateral. For example, securitized subprime auto loans, experiencing a decline in credit quality, may also cause a reduction in the value of the ABS, if receipt of the underlying cash flow becomes questionable. ABSs often include a credit enhancement designed to reduce the degree of credit risk to the holder of the ABS security. Examples of credit enhancement include guarantees, letters of credit, overcollateralization, private insurance, and senior/subordinate structures. The degree of 29 32 • FINANCIAL INSTITUTIONS protection provided by the credit enhancement depends on the nature of the collateral and the type and extent of the credit enhancement. ABSs are structured into a variety of products, many of which are complex. Risk variables, such as prepayment risk, changes in prevailing interest rates, and delayed changes in indexed interest rates, make the forecasting of future cash flows more difficult. ABSs with several investment classes may have varying terms such as maturity dates, interest rates, payment schedules, and residual rights, which further complicates an analysis of the investment. Collateralized mortgage obligations (CMOs) and real estate mortgage investment conduits (REMICs) are two examples of multiclass mortgage securities. The underlying objective of all types of ABSs and mortgage securities is to redistribute the cash flows generated from the collateral to all security holders, consistent with their contractual rights, without a shortfall or an overage. Banks are generally restricted in the types of financial instruments they may deal in, underwrite, purchase, or sell. Essentially banks may only deal in U.S. government and U.S. government agency securities, municipal bonds, and certain other bonds, notes, and debentures. These restrictions are also limited based on capitalization. The Federal Financial Institutions Examination Council (FFIEC) policy statement issued in February 1992 addresses the selection of securities dealers, policies and strategies for securities portfolios, unsuitable investment practices, and mortgage derivations. (i) Accounting for Investments in Debt and Equity Securities. Investment securities are classified in three categories: held-to-maturity, trading, and available-for-sale. SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. Such securities are classified in three categories and accounted for as follows: Held-to-Maturity. Securities for which an institution has both the ability and positive intent to hold to maturity are classified as held-to-maturity and are carried at amortized cost. (Any difference between cost and fair value is recorded as a premium or discount, which is amortized to income using the level yield method over the life of the security.) Trading. Securities that are purchased and held principally for the purpose of selling them in the near term are carried at fair value with unrealized gains and losses included in earnings. Available-for-Sale. All other securities are classified as available-for-sale and carried at fair value with unrealized gains and losses included as a separate component of equity. SFAS No. 115 addresses changes in circumstances that may cause an enterprise to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future. For individual securities classified as either available-for-sale or held-to-maturity, entities are required to determine whether a decline in fair value below the amortized cost basis is other than temporary. If such a decline is judged to be other than temporary, the cost basis of the individual security should be written down to fair value as the new cost basis. The amount of the write-down should be treated as a realized loss and recorded in earnings. The new cost basis shall not be changed for subsequent recoveries. Investment securities are required to be recorded on a trade date basis. Interest income on investment securities is recorded separately as a component of interest income. Realized gains and losses on available-for-sale securities and realized and unrealized gains and losses on trading securities are recorded as a separate component of noninterest income or loss. Upon the sale of an available-for-sale security, any unrealized gain or loss previously recorded in the separate component of equity is reversed and recorded as a separate component of noninterest income or loss.