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A federal savings association (bank) supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman the supervisory office’s (SO) determination on accounting adjustments for a loss recovery asset and claims pending account.
The bank appealed the SO’s determination to risk rate as loss and write off the entire balance of a loss recovery asset from ABC Insurance Company (company). The bank had booked a loss recovery asset for a pending lawsuit filed against the company for denying claims on mortgage insurance policies protecting the bank against losses arising out of borrower default. The appeal asserted, “…realization of the recoverable asset is probable and estimable and therefore meets the recognition criteria for a loss recovery contingency. The rebuttable presumption that recovery of the claims is not probable as a result of litigation in process has been overcome and it has been demonstrated that the company has the financial capacity to pay the obligation.” The appeal included a legal opinion from the bank’s counsel providing an assessment of the bank’s probability of recovery from the company.
Regarding the estimable requirement, the appeal asserted that the SO’s requirement to use Level 1 measurement alone to determine fair value is not consistent with generally accepted accounting principles (GAAP) or the call report instructions, particularly when price quotations for the specific asset at issue or for identical assets in active markets are not readily available, as is the case here. The appeal argued a valuation performed by an academic using other inputs was an appropriate means of determining the fair value of the asset. In addition, the appeal asserted that the bank engaged an expert in GAAP who determined that the bank’s recognition of the loss recovery asset was consistent with GAAP and that the SO’s mandate is not appropriate under GAAP. Finally, the appeal asserted that the fact that litigation of the claims is taking a long time does not affect the probability of ultimate collection.
The bank appealed the SO’s requirement that the bank reclassify all government-guaranteed foreclosed mortgages (GGFM) aged over 18 months to other real estate owned (OREO) at fair value less estimated cost to sell the collateral, and establish a full valuation allowance for any amount remaining in claims pending in excess of fair value less cost to sell the collateral. The appeal asserted that the Financial Accounting Standards Board (FASB) Task Force determined that GGFMs should be reclassified as a receivable in the amount of the full unpaid principal balance of the loan and not reclassified to OREO at the fair value less cost to sell with a separate valuation allowance. The appeal contended that writing down GGFM claims pending over 18 months is inconsistent with GAAP and the bank’s historical collection, which the appeal asserts is 100 percent of the principal balance of all government-guaranteed conveyance claims. The appeal asserted there is no factual basis for assuming that a delay in receiving payment has any effect on the collectability of claims filed beyond 18 months after foreclosure. The appeal advised that the bank has established adequate procedures for processing claims to completion.
The Ombudsman conducted a comprehensive review using the following supervisory standards:
The Ombudsman concurred with the SO’s conclusion to apply the interagency risk rating definition of loss for the entire amount of the loss recovery asset. The Ombudsman agreed with the SO that the loss recovery asset was not a bankable asset due to the long-term and protracted nature of the litigation coupled with the lack of probable and estimable support for the asset. The underlying insurance claims have been outstanding and subject to litigation for several years, the bank does not project collection for approximately three more years, and the company may appeal the final judgment once reached, further extending collection. The “Rating Credit Risk” booklet states, “…banks should not maintain an asset on the balance sheet if realizing its value would require long-term litigation or other lengthy recovery efforts.” Further, the Ombudsman determined that the SO’s decision to write off the asset is not in contradiction to GAAP. The interagency “loss” classification is widely accepted in the industry as the functional equivalent to “uncollectible,” as defined in ASC 310-10-35-41, and an acceptable threshold for writing off bad or stale assets.
The Ombudsman determined the bank failed to support that the loss recovery asset is both probable and estimable, as required by ASC 450-20-S99 and BAAS Topic 5C, question 7, and concluded that the rebuttable presumption that recovery of claims subject to litigation is not probable has not been overcome. The BAAS Topic 5C, question 8, response states that a bank can overcome a rebuttable presumption by obtaining a written opinion from competent and independent legal counsel that explicitly states the bank will prevail in its litigation against the insurer, and by demonstrating the insurer has the capacity to pay. The Ombudsman determined that the legal opinion the bank obtained from counsel is not independent because the law firm partner providing the opinion served as a director on the bank’s board during a time when the bank incurred loan losses, submitted insurance claims that were denied by the company, and filed a lawsuit against the company. The company’s capacity to pay was not in dispute by either the bank or the SO.
The Ombudsman determined that the bank had not sufficiently supported an estimate of the insurance recovery asset. The bank submitted valuations from the bank’s chief financial officer and an academic. The Ombudsman concluded that both valuations contained assumptions not acceptable under GAAP. The academic’s valuation did not note whether the value meets the requirements of ASC 820. In addition, the GAAP expert engaged to review the bank’s accounting for the loss recovery asset for appropriate application of GAAP failed to opine on whether the academic’s valuation was in line with the requirements of ASC 820. The Ombudsman also observed that both valuations failed to consider the ongoing cost of litigation with the company, a factor a market participant would consider when pricing the asset. In addition, both valuations used discount rates that were not sufficiently supported and did not reflect a yield an investor would demand for an asset with its risk characteristics.
The Ombudsman determined that the SO did not limit the bank to a Level 1 valuation of the loss recovery asset. ASC 820-10-35-40 defines Level 1 inputs as quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date. The SO’s letter stated, “The most objective and compelling support for the value of the insurance recoverable asset would be a quote from an unrelated third party that acquires litigated claims. Alternatively, the bank could review the yields on sales of litigated claims similar to the recoverable asset.”
The Ombudsman did not agree with the bank or the SO regarding the treatment of GGFMs held in the bank’s “other receivables” account. The Ombudsman concurred with the bank that the SO’s directive is not consistent with ASC 310-40-40, in that this guidance does not address aged claims, including citing a specific time frame for reclassifying aged claims. The Ombudsman, however, concurred with the SO that it is unsafe and unsound for a bank to lack comprehensive and accurate policies, procedures, and controls for managing and monitoring the collection of government-guaranteed loans.
The Ombudsman determined that the bank must sufficiently document that each GGFM booked in the “other receivables” account meets the three conditions outlined in ASC 310-40-40-7A to continue recognition as an “other receivable.” Accounting Standards Update (ASU) 2014-14 at BC9 states that if the requirements are not met, the bank should not be subject to the provisions of ASC 310-40-40-7A and 7B. In addition, the Ombudsman determined that, going forward, the bank must conform to ASC 310-40-40-7A and 7B for classifying GGFMs. The Ombudsman also determined that the bank’s policies, procedures, and controls for managing and monitoring the collection of government-guaranteed loans must be improved.
The Ombudsman instructed the bank to conduct the following analysis for claim eligibility and conformance with ASC 310-40-40-7A:
The Ombudsman’s determinations were based on the following: