Newsletter
2012
Disposition of Other Real Estate Owned: Methods, Risks and Rewards
By Michael T. Carson & David C. Schwartz1
The 2007–2009 recession led to a sharp increase in the level of other real estate owned (OREO) across banks nationwide. Consequently, this led to an increase in banks’ disposition of OREO. On average, banks in the Fifth District saw a greater increase in OREO levels than banks nationwide. While the increase in dispositions has not yet materialized in our District at levels seen nationally, banks across the nation are exploring methods of disposing of OREO properties. These methods historically have included:
- Selling OREO property immediately on an “as-is” basis
- Retaining and managing OREO property until the market improves while making minimal capital investments, during which time the bank may choose to rent out the OREO property2
- Capitalizing on Community Reinvestment Act opportunities in the disposition of OREO property
- In the case of commercial real estate, retaining the property until stabilized value is achieved
Each method has its own risks and rewards, which can be efficiently managed through strong accounting, credit and risk management practices, policies and procedures. As the economy stabilizes, banks will likely begin disposing of OREO at an increasingly rapid pace. Spending time now to ensure proper policies and procedures are in place can help eliminate issues that might otherwise arise in the future. To help in the review of your current policies and procedures, below is a brief overview of some credit implications and existing accounting and regulatory guidance related to the disposition of OREO.
Comparison of Average Total OREO Holdings for Fifth District Banks vs. U.S. Banks Nationally
Policies and Procedures
In general, having a sound strategy and process in place for the management and disposal of OREO is critical. While selling OREO in a depressed market is undesirable for any institution, holding OREO for an extended period can be risky and expensive. Bank management must be aware of all the risks (i.e., market risks, credit risks, operational risks and possible reputational risks) related to its OREO portfolio and take care to meet any federal or state statutory holding period limits that apply to the institution.
Banks must have clear policies and procedures regarding the management, including disposition, of OREO properties. “The bank’s systems (internal controls, policies, practices and procedures) should be documented in a complete and concise manner and should include, where appropriate, narrative descriptions, flowcharts, copies of forms used and other pertinent information.”3 Banks should also maintain documentation reflecting their disposition efforts, which should include: a record of inquiries and offers made by potential buyers, methods used in advertising the property for sale whether by the bank or its agent, and other information reflecting sales efforts.4
Credit Implications
OREO properties are non-earning assets. Higher levels of OREO can undermine a bank’s ability to generate earnings, as capital tied up in distressed assets cannot be deployed to generate earnings. Consequently, banks should strive to keep OREO balances in check and dispose of OREO promptly when feasible and in the best interest of the bank, while remaining in compliance with any statutory holding period limits.
When disposing of OREO, most banks prefer to receive cash from a third-party buyer, who may have acquired financing from another source. To facilitate the disposition, banks, at times, may choose to finance the sale themselves. When financing the sale of OREO, the same strong credit underwriting standards employed when underwriting a new loan should be followed. Failing to do so may result in the bank having to expend resources to acquire, maintain and dispose of the property again at a later date. Moreover, banks must take care in how they structure the transaction, as specific details of the transaction can affect if and when a bank is able to recognize profits on the sale and income on the financing, if provided (see Accounting Considerations below).
An important aspect of maintaining an OREO portfolio is regularly updating appraisal values. In a deteriorating market, OREO values can change quickly. Appraisal values may need to be updated more frequently to ensure that a bank has a true sense of its properties’ values so that the bank can make the best possible decision and properly account for changes. Failing to regularly update property values can have many negative consequences, including making a poor decision based on outdated information (such as choosing to reject a fair offer); increased regulatory scrutiny; and potentially large charges to earnings at the time of sale. Due to declines in property values, periodic charges to earnings may be required when property values are updated. If the decrease in value is recoverable (i.e., temporary), “the charge to earnings may be offset by establishing a valuation allowance specifically for that property.”5 When changes in property values are not prudently updated, the bank may eventually discover that the sales value of the OREO is materially less than its current carrying value, thus requiring the bank to take a substantial charge to earnings at the time of disposition.
Accounting Considerations
When a bank sells OREO and receives cash from a third-party buyer, the bank may recognize an immediate gain or loss on the sale. Accounting complexities arise when a bank finances the sale of OREO. The proper accounting method for the sale of bank-financed OREO depends upon the specific facts and circumstances of the individual transaction and will be accounted for using one of five possible methods:
- Full accrual
- Deposit
- Installment
- Cost-recovery
- Reduced profit methods
Since banks can immediately recognize the entire profit on the sale of OREO under the full accrual method, most banks will attempt to structure the transaction to meet the requirements of that method. A bank may immediately recognize the entire profit on a sale of OREO under this method if the profit on the sale can be determined and the seller is not obligated to perform significant activities after the sale to earn the profit. Additionally, five criteria must be satisfied to use this method: 6
- The buyer’s initial and continuing investments must be adequate to demonstrate a commitment to pay for the property.
- The sale must be consummated.
- The bank’s receivable must not be subject to future subordination.
- The bank must transfer to buyer the usual benefits and risks of ownership.
- The bank must not have substantial continuing involvement with the property.
(Please see the table at the end of this article for guidance in determining whether the above criteria have been met and for additional guidance on determining which of the following methods of accounting is appropriate.)
When the bank is unable to structure the transaction to meet the requirements of the full accrual method, the correct alternative accounting method for the transaction will be determined by the facts and circumstances of the transaction, along with the reason why the transaction failed to meet the requirements of the full accrual method. The timing and ability to recognize profit on the sale, and to recognize any associated interest income, will be dictated by the method of accounting for which the transaction qualifies. Based on anecdotal evidence from exams, when banks self-finance the sale of the OREO and are unable to meet the requirements of the full accrual method, we have typically seen the cost-recovery or installment methods utilized.
The installment method is used when recovery of the cost of the property is reasonably assured if the borrower were to default and when the borrower’s down payment is insufficient to allow the full accrual method. The sale of the property and the corresponding loan are both recognized; however, profits from the sale are recognized only as the bank receives payments from the buyer and interest income is recognized on an accrual basis. Each cash receipt and principal payment received by the bank is split between cost recovered and profit. 7
When the disposition does not qualify for the full accrual or installment methods, the cost-recovery method may be an alternative. Under this method, the sale of the property and the corresponding loan are both recognized, and the loan is maintained on nonaccrual status. Recognition of income is deferred, as principal payments reduce the loan balance and interest payments are accounted for by increasing the unrecognized gross profit. Profit is not recognized until cash payments by the buyer — including principal and interest on debt due to the bank and on existing debt assumed by the buyer — exceed the bank's cost of the property sold, or the transaction later qualifies for a different method of accounting for the disposition. Transactions that qualify for the cost-recovery method may also be accounted for under the deposit method. 8
The deposit method is typically used when the transaction does not meet the full accrual requirements for one of the following reasons:
- The sale is not consummated.
- The down payment is insufficient and recovery of the cost of the property is not reasonably assured.
- There is a sale of an option to purchase the property.
- The seller guarantees a certain return for a limited period of time.
Under this method, the bank does not record a receivable, it does not recognize any profit and it accounts for cash deposits as a liability. The property remains in the OREO balance sheet category. This method is typically used until the sale of the OREO has been consummated and the transaction qualifies for one of the other methods of accounting.9
In rare situations, banks will self-finance the sale of OREO property with a loan amortization schedule that does not meet the requirements for use of the full accrual method. Provided that the bank receives an adequate down payment and the sale of the property has been consummated, in such situations the bank may be able to utilize the reduced profit method. Under this method, the bank recognizes the sale of the property and the corresponding loan. Profits from the sale are recognized only as the bank receives payments from the buyer. Again, this is a rarely used method, as loan structures with inadequate loan-amortization schedules are equally rare. 10
Conclusion
As you can see, there are various options for the disposition of OREO; however, each option presents its own risks and rewards. These risks and rewards can be efficiently managed through a combination of strong accounting, credit and risk management practices, polices, and procedures. So while the general policy of the Federal Reserve is that banks should make a good-faith effort to dispose of OREO at the earliest practical date, banks do have options. One option, recently highlighted by the issuance of SR 12-5, includes the rental of residential OREO. The guidance in SR 12-5 is not just geared toward the big banks — it is also relevant and applicable to community banks. If this is an option you are considering or currently taking, you should thoroughly review the guidance and speak with your Federal Reserve Bank of Richmond relationship manager to discuss any questions or concerns. If you would like to hear more about this SR letter in future editions of this newsletter, please be sure to let us know.
Table: Sources of Credit and Accounting Related OREO Guidance and Training
Sources of OREO related guidance and select training opportunities include the following:
Michael T. Carson is a credit risk specialist with the Federal Reserve Bank of Richmond. He can be reached at michael.t.carson@rich.frb.org.
David C. Schwartz is a credit risk and accounting policy specialist with the Federal Reserve Bank of Richmond. He can be reached at david.schwartz@rich.frb.org.
1 Data analysis provided by Anne Davlin, Quantitative Research Analyst.
2 Please see SR 12-5 Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties.
3 Commercial Bank Examination Manual, Section 2200.4, Page 6, Other Real Estate Owned.
4 Commercial Bank Examination Manual, Section 2200.4, Page 4, Other Real Estate Owned.
5 Commercial Bank Examination Manual, Section 2200.4, Page 3, Other Real Estate Owned.
6 Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) ASC 360-20-40, Property, Plant & Equipment — Real Estate Sales — Derecognition.
7 Commercial Bank Examination Manual, Section 2200.4, Page 6, Other Real Estate Owned.
8 Commercial Bank Examination Manual, Section 2200.4, Page 6, Other Real Estate Owned.
9 FASB ASC 360-20-40, Property, Plant & Equipment — Real Estate Sales — Derecognition.
10 Commercial Bank Examination Manual, Section 2200.4, Page 6, Other Real Estate Owned.
The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any laws, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.
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