Handle ARM Adjustments with Care

By William J. Showalter, CRCM, CRP, Senior Consultant

Adjustable-rate mortgages (ARM) have not been much of an issue for many banks and thrifts in recent years since fixed rates have been so low. But they are still an important tool for serving those customers who cannot meet the secondary market qualifications applied to most fixed-rate loans. And, many institutions have a portfolio of existing ARM loans that they service. One potential complication for some lenders is the impending discontinuance of the LIBOR index, requiring them to find another comparable index for their ARMs.

ARMs were in the spotlight over 10 years ago because of problems in the subprime market. Many subprime products have variable interest rates, which shift the interest rate risk from lender to borrower. Besides the issues raised then over putting borrowers into inappropriate products, there also are concerns over errors in ARM rate changes.

Do an internet search for “ARM errors” or similar terms and you will come up with numerous firms offering loan audit and information services to borrowers. These firms tell borrowers that their companies can correct ARM errors, bring loans into compliance, and get the borrower a mortgage refund.


The initial furor over these mistakes arose over a report on ARM adjustment errors prepared by a former Federal Savings and Loan Insurance Corporation employee in 1989. His assertions sent a tremor through the mortgage industry. The report concluded that miscalculations in periodic adjustments to rates on ARM instruments resulted in significant overcharges. He found ARM adjustment errors in about 50 percent of the loans he sampled. From these results, he estimated the potential overcharges to be up to $15 billion for ARMs nationwide at the time. This figure has been estimated as high as $50-60 billion in recent years.

The controversy was further stoked by a study from the Government Accountability Office (GAO) released in September 1991 which found between 20 and 25 percent of the ARM loans at the time contained interest rate errors. Such errors occurred when the related mortgage servicer selected the incorrect index date, used an incorrect margin, or ignored interest rate change caps.

The damaging studies kept coming. In July 1994, Consumer Loan Advocates, a non-profit mortgage auditing firm announced that as many as 18 percent of ARMs had errors costing the borrower more than $5,000 in interest overcharges. And, another government study in December 1995 concluded that 50 to 60
percent of all ARMs contained an error regarding the variable interest rate charged to the homeowner. The study estimated the total amount of interest overcharged to borrowers was in excess of $8 billion. Inadequate computer programs, incorrect completion of documents, and calculation errors were cited as the major causes of interest rate overcharges.

Even though no other government studies have been conducted into ARM interest overcharges to date, the potential issue continues to simmer below the surface and lenders need to be vigilant so that it does not erupt into a veritable supervolcano of enforcement actions and lawsuits.

Types of Errors

The kinds of errors lenders are said to make in implementing ARM rate and payment adjustments run the gamut from calculation mistakes to carelessness, including:

  • Mistakes in original loan set up/data input
  • Miscalculation of payment amount
  • Improper allocation of payments between interest and principal (amortization)
  • Use of the wrong index
  • Selection of incorrect index value
  • Application of incorrect interest rate caps
  • Failure to adjust in some years
  • Use of incorrect margins
  • Improper rounding methods (e.g., rounding up instead of rounding to the nearest 1/8th of 1 percent)
  • Math mistakes causing an incorrect rate
  • Use of incorrect loan balance

Banking regulators point out that these errors may be considered breaches of contract and could expose the financial institution to legal action.

Extent of Errors

Since ARMs involve changing index values periodically and oftentimes complex computer calculations, they seem to attract human and software errors. Mortgage audit firms point out that leading publications such as The Wall Street Journal, MONEY, Forbes, and Newsweek have warned borrowers about miscalculations occurring in up to 50 percent of ARMs.

  • The firms get borrowers’ attention by pointing to figures of lender overcharges and borrower refunds like these:
  • Average borrower refund of over $1,500
  • 21 percent of refunds ranging from $3,500 to $10,000
  • 13 percent of errors exceeding $10,000

Reasons for Errors

The calculation of ARM rate changes is a complex process and errors can occur in a variety of ways. Add to this the fact that many lenders offer, and servicers support, a variety of ARM products with different rate adjustment intervals, indices, margins, and other terms. Another potential complicating factor is the widespread practice of transferring loan servicing, presenting another opportunity for human mistakes and software mismatches to cause errors.

In addition, some of the mortgage audit firms assert that ARM rate and payment adjustment errors have been linked to:

  • Lack of training, supervision, and experience of loan servicing personnel
  • Simple human error
  • Computer data entry or software errors
  • Clerical or calculation errors
  • Fraud
  • Sale or transfer of the loan to a different company
  • Rider, handwritten changes, or other irregularities in the note
  • Very complex calculations, use of an unusual index, or interest rate
  • Dissolution or merger of the original loan institution

How to Avoid These Problems

The federal banking supervisors began encouraging financial institutions back in 1991 to perform reviews of their adjustable-rate loan systems to ensure that interest rate information is correctly ascertained and administered, and that rates are adjusted properly.

Banks and thrifts should have effective internal controls and procedures in place to ensure that all adjustments are made according to the terms of the underlying contracts and that complete, timely, and accurate adjustment notices are provided to borrowers. Also, a system for the ongoing testing of adjustments should be in place to ensure that adjustments continue to be made correctly.

A critical component of any successful loan servicing program, including correctly implementing rate and payment adjustments, is a thorough training regime for lending personnel involved in the process. Those involved must be given the appropriate tools – including knowledge – to succeed in their jobs.

Any review of ARM adjustments should include documentation indicating the basis for interest rate adjustments made to a lender’s ARM loans, showing whether changes have been made consistent with the underlying contracts.

If a lender finds that it has made errors in the adjustments for interest rates which have resulted in interest overcharges on ARMs, the supervisory agencies expect that you will have in place a system to correct the overcharges and properly credit the borrower’s account for any interest overcharges. In general, undercharges cannot be collected from borrowers.

Young & Associates, Inc. offers a variety of compliance management and review services that are proven effective for institutions of all types and sizes. For more information on this topic or how Young & Associates, Inc. can assist your institution, contact Bill Showalter at wshowalter@younginc.com or 330.422.3473.

Off-Site Reviews, Virtual/Teleconference Training, and Management Consulting Support

Young & Associates, Inc. remains committed to keeping our employees, clients, and partners safe and healthy during the COVID-19 pandemic. During this difficult and unprecedented time, we have continued to successfully leverage technology to fulfill our commitments to our clients and partners through secure remote access for reviews, virtual/teleconference training, and other management consulting support.

Young &Associates’ commitment to virtual/teleconference training and remote access reviews date back well over five years. We see this ability as a win-win for everyone – the review and training get completed in a timely manner and the bank avoids paying any travel expenses. Concerned about security, please be assured that we use the latest secure technology.

We remain committed to helping our clients with all areas of their operations through off-site reviews and providing the most current regulatory updates through our virtual/teleconferencing training.

Contact one of our consultants today for more information about our off-site reviews or virtual/teleconferencing training:

Bill Elliott, Director of Compliance Education:
bille@younginc.com or 330.422.3450

Karen Clower, Director of Compliance:
kclower@younginc.com or 330.422.3444

Martina Dowidchuk, Director of Management Services:
mdowidchuk@younginc.com or 330.422.3449

Bob Viering, Director of Lending:
bviering@younginc.com or 330.422.3476

Kyle Curtis, Director of Lending Services:
kcurtis@younginc.com or 330.422.3445

Aaron Lewis, Director of Lending Education:
alewis@younginc.com or 330.422.3466

Dave Reno, Director – Lending and Business Development:
dreno@younginc.com or 330.422.3455

Ollie Sutherin, Manager of Secondary Market QC Services:
osutherin@younginc.com or 330.422.3453

Jeanette McKeever, Director of Internal Audit:
jmckeever@younginc.com or 330.422.3468

Mike Detrow: Director of Information Technology Audit/Information Technology:
mdetrow@younginc.com or 330.422.3447

Young & Associates, Inc.’s consultants provide a level of expertise gathered over 42 years. In our consulting engagements, we closely monitor the regulatory environment and best practices in the industry, develop customized solutions for our clients’ needs, and prepare detailed and timely audit reports to ease implementation moving forward. With backgrounds and experience in virtually all areas of the financial services industry, our consultants bring a broad knowledge base to each client relationship. Many of our consultants and trainers have come to the company directly from positions in financial institutions or regulatory agencies where they worked to resolve many of the issues that our clients face daily.

We look forward to working with you as you work to obtain your goals in 2021 and beyond.

Loan Modifications: A Proactive Approach for Working with Borrowers Impacted by Coronavirus (COVID-19), Guided by Recently Issued Interagency Statement

By: Bob Viering, Director of Lending, and Aaron Lewis, Director of Lending Education, Young & Associates, Inc., March 25, 2020

On March 22, 2020, the federal banking regulators issued an interagency statement on loan modifications for customers affected by the Coronavirus Disease 2019 (also referred to as COVID-19). In a number of ways, it resembled historical statements issued in the wake of natural disasters. In keeping with previously issued statements following natural disasters the federal regulators recognize that there can be an impact on borrowers and encourages banks “to work prudently” with those borrowers. However, given the sudden and significant impact of the rapidly spreading coronavirus pandemic that has had a nationwide impact, the breadth of the statement was far more reaching than previous statements issued following natural disasters which historically have been isolated to specific geographic regions. In the statement the federal regulators included the following provisions:

    1. The federal regulators confirmed with the Financial Accounting Standards Board (FASB) that “…short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not troubled debt restructurings (TDRs).”
    2. “…short term (e.g., six months)…”modifications can include: payment deferrals, fee waivers, extension of payment terms or other delays in payments that are “insignificant.”
    3.“Current” is defined as less than 30 days past due. If the credit is current at the time of the modification the borrower is deemed to not be experiencing financial difficulties.
    4. Banks can choose to work with individual borrowers or as “part of a program.”
    5. Borrowers granted a modification will not be “automatically adversely risk rated” by agencies’ examiners. In fact, it is stated that agency examiners will use judgment in reviewing credits modified and “regardless of whether modifications result in loans that are considered TDRs or are adversely classified, agency examiners will not criticize prudent efforts to modify the terms on existing loans to affected customers.”
    6. Loans granted modifications will not be classified as past due if modified, unless they become past due per the terms of the modification.
    7.During the temporary short-term arrangements (as provided in the Interagency Statement), loans should not be reported as “non-accrual.”
    8. As information is gathered, if an adverse classification, non-accrual, or charge-off is warranted, bank actions should follow existing guidance on the topics.

The best way to interpret the Interagency Statement is to consider it as providing banks breathing room while more information is developed that allows the bank to accurately assess the borrower’s financial strength. It is clear throughout the statement that any modifications must be temporary and short-term to not be classified as TDR. This guidance is in keeping with previous statements regarding TDR and relative impact to the credit. While there is no specific definition of what constitutes short-term or temporary, the mention of six months in the Interagency Statement should be a reasonable maximum to consider.

The statement mentions that working with either individual borrowers or as part of a program is acceptable. The term “individual borrowers” is fairly self-explanatory. A “program” for working with borrowers will require a bank to determine criteria to allow for a more automatic deferral decision. This would need to include checking that the borrower was not past due for reasons other than the impact of COVID-19, that the deferral meets the criteria as outlined in the Interagency Statement, and that the bank believes the borrower has been impacted by the Coronavirus. In the case of a program, the decision on granting deferrals may be made by a lender or manager close to the front lines.

Once the deferral decision has been made, the real work begins. As mentioned above, this statement really provides banks with a near-term way to deal with an unknown impact while providing time to fully assess the actual impact on the borrower. Here are the steps we would recommend that banks take in response to the impact of COVID-19:

    1. Make a list of borrowers most likely impacted by COVID-19. Hotels, restaurants, non-essential retailers, ‘Main Street business,’ some manufacturers, distributors, and especially non-owner occupied commercial real estate owners with tenants impacted by COVID-19 are examples of customers that are most vulnerable to the current health crisis.
    2. Reach out to those borrowers to see how they are doing, how they have been impacted, and what they see as next steps for their business. Let your borrowers know you are here to work with them as they navigate through the downturn, including taking pro-active steps to ensure the viability of their business. Let them know what you are doing in the community to help. This is the most important time to keep up communications with your customers. They may well be concerned about what might happen to them and a few kind words of support from their bank can go a long way to letting them know they are not alone.
    3. Based on your initial analysis and conversations with potentially impacted borrowers, you should derive a shorter list of borrowers for which deeper analysis is warranted. As you develop a forward-looking analysis the following considerations should be made:
      a. Last year’s tax return or financial statement may well be meaningless as a source of cash flow analysis if they have been significantly impacted by recent events.
      b. This is the time to work with these borrowers to develop honest, meaningful projections to help determine their ability to overcome any short-term cash flow impact.
      c. For CRE borrowers, a current rent roll with any concessions the owner has made to help tenants or identify tenants that may be at highest risk of defaulting on their lease should be included as part of the bank’s analysis.
      d. It’s also important to have a current balance sheet for any C&I borrowers. This can provide you with another method of assessing the borrower’s financial strength and ability to withstand a downturn. Cash flow analysis alone cannot tell the whole story of a borrower’s repayment ability. A strong balance sheet will include substantial liquidity and limited leverage beyond minimum policy requirements.
      e. Your analysis should be in writing and reviewed by the bank’s loan committee and especially its board of directors to keep them informed about the level of risk to the bank.
      f. For those borrowers where your analysis shows limited long-term problems, great news! Keep in touch to assure that things are actually going as expected.
      g. The overall thrust of the analysis should be on a forward-looking basis in terms of the borrower’s repayment ability, including a defined expectation for receiving frequent and timely financial information. Relying on a tax return, with financial information that could be aged up to 10 months following the borrower’s year-end date could result in a false calculation of future repayment ability.
    4. It is imperative that a pro-active approach is taken by the institution in response to the impact of COVID-19. Sufficient human resources should be dedicated to the bank’s response and outreach to impacted customers. If human resources are limited at the institution, the aforementioned list of borrowers should be prioritized based on factors developed by management, i.e., size of credit, borrower sensitivity to the impact of a downturn, and those businesses considered critical to the well-being of the community (large employers).

In addition to the bottom-up (customer level) analysis discussed above, we would recommend that the bank perform a comprehensive stress test of its loan portfolio to determine the level of impact, if any, on capital which should be addressed by the board and senior management. (This is a great time to update your capital plan as well.)
The next few months are likely to be a difficult period for many banks and their borrowers. As of today, we don’t really know the actual impact on the economy from COVID-19. But, we can be sure it won’t just be a quick blip and a return to normal for all borrowers. Take the time allowed by this unprecedented Interagency Statement and be proactive.

IRR and Liquidity Risk Review – Model Back-Testing / Validation of Measurements

Effective risk control requires conducting periodic independent reviews of the risk management process and validation of the risk measurement systems to ensure their integrity, accuracy, and reasonableness. To meet the requirements of the Joint Policy Statement on Interest Rate Risk (IRR), as well as the Interagency Guidance on Funding and Liquidity Risk Management and the subsequent regulatory guidance, Young & Associates, Inc. can assist you in assessing the following:

  • The adequacy of the bank’s internal control system
  • Personnel’s compliance with the bank’s internal control system
  • The appropriateness of the bank’s risk measurement system
  • The accuracy and completeness of the data inputs
  • The reasonableness and validity of scenarios used in the risk measurement system
  • The reasonableness and validity of assumptions
  • The validity of the risk measurement calculations within the risk measurement system, including back-testing of the actual results versus forecasted results and an analysis of various variance sources

Our detailed interest rate risk review reports and liquidity risk review reports assess each of the above, describe the findings, provide suggestions for any corrective actions, and include recommendations for improving the quality of the bank’s risk management systems, and their compliance with the regulatory guidance. We are happy to customize the review scope to your bank’s specific needs.

For more information, contact Martina Dowidchuk at mdowidchuk@younginc.com or 330-422-3449.

CRE Portfolio Stress Testing

CRE Stress Testing is widely viewed by bankers and bank regulators as a valuable risk management tool that will assist management and the board of directors with its efforts to effectively identify, measure, monitor, and control risk. The information provided by this exercise should be considered in the bank’s strategic and capital planning efforts, concentration risk monitoring and limit setting, and in decisions about the bank’s loan product design and underwriting standards.

Young & Associates, Inc. offers CRE Portfolio Stress Testing that provides an insightful and efficient stress testing solution that doesn’t just simply arrive at an estimate of potential credit losses under stressed scenarios, but provides a multiple page report with a discussion and summary of the bank’s level and direction of credit risk, to be used for strategic and capital planning exercises and credit risk management activities.
Our CRE Stress Testing service is performed remotely with your data, allowing for management to remain free to work on the many other initiatives that require attention, while we make use of our existing systems and expertise.

For more information, contact Kyle Curtis, Director of Lending Services, at kcurtis@younginc.com or 330.422.3445.

Ag Lending Considerations in 2020

By: Robert Viering, Director of Lending

On January 28, 2020, the FDIC published Financial Institution Letter (FIL-5-2020) Advisory: Prudent Management of Agricultural Lending During Economic Cycles. It’s a good summary of many items to consider in the management of your ag portfolio and I recommend you taking a few minutes to read it.

In our loan review practice we have many clients that have a reasonable exposure to agriculture, including agribusiness. We’ve seen a decline in the cash flow generated by these borrowers as the ag sector declined from the historic highs of a few years ago. Over the last two years, we have seen this sector stabilize as most producers have been able to make adjustments to their operation and, while not back to the same levels of profitability, reach a level of acceptable cash flow. For many it has been a case of reducing expenses not only for crop inputs, but also cutting family living. For some that were over-leveraged, we have seen the sale of land (or sale-leaseback) that has brought debt service in line with today’s cash flow or a slowing of capital expenditures. We’ve seen many instances where debt was refinanced to a longer term to bring payments in line with cash flow. However, even with the vast majority of borrowers making adjustments, we have seen more classified ag credits and increased non-performing loans. This has typically been due to high leverage or not being able to make the tough decisions needed to operate successfully today. Management skills are near the top of the list for success in agriculture today.
Based on what we have seen in our reviews of our ag clients and our own experience managing ag portfolios, the following is our list of “best practices” for 2020:

  • Have all the information needed to make an informed credit decision at renewal, including:
    • A complete financial statement with detailed schedules. Take the time to review this with your borrower and ask if they have any other bills, such as payables to input providers or loans from family or friends.
      • For more complex borrowers that may have various partnerships or corporate entities that make up the farming operation, make sure you have financial information for each of the entities, not just the one you may be financing. You need a global financial statement, as well as a global cash flow.
      • Ask about actual ownership of assets. Some assets may be owned by a trust; if so, consider making the trust a co-borrower or guarantor.
      • Have your borrower complete the financial statement as of 12/31 each year. You’ll need this to make accurate accrual adjustments when used with the tax return.
    • A credit report on all individuals that sign personally. Use this report to check for levels of personal debt and compare this report to past years to see if personal debt is increasing or decreasing.
    • A new UCC search. Use this to see if there are other secured lenders.
    • Estimated Costs. If you are getting a cash flow from the borrower to support an operating line, compare the estimated costs to historical costs. We see a lot of borrowers that underestimate their actual costs.
      • Government payments have been a big part of some farms’ cash flow. It is important to understand the impact of those payments on an operation. Consider what happens if the Market Facilitation Program is not extended in 2020.
      • Obtain a basic stress test on the borrower’s cash flow. If small changes in revenue or expenses will bring cash flow below break-even, do understand the level of crop insurance, any hedging program, and have a “Plan B” discussed with those in the operation regarding how they will get through if things are tough. It’s a lot easier to have that conversation about selling some land now than when payments are due in the fall if things don’t go as planned.
    • Cash Flow for New Debt Structure. If you’re going to restructure debt, make sure the operation can cash flow the new debt structure. If it can, great; you probably have a pass loan (or will be soon). If not, then you probably have a classified loan.
    • Trends. Trends matter. What direction are leverage, liquidity, and cash flow going?
    • Working Capital. Working capital is your real secondary source of repayment. If working capital is strong, that will cover an off year and not require a restructure or asset sale.
    • Future Plans. Ask about the plans for 2020, including any capital expenditures (for your good borrowers, don’t forget to pre-approve them for these loans); their marketing plans; and any changes in expenses from the prior year.
  • Know your portfolio:
    • Track risk rating changes for the portfolio. What is the direction of your average risk rating?
    • Stress test your portfolio. Develop moderate and high stress scenarios. Stress revenue, expenses, and collateral values. Understand the impact of moderate and high stress on your capital. (Young & Associates, Inc. can work with you to provide a stress test of your ag or CRE portfolio.)
  • Be proactive:
    • Don’t put off those farm visits. You’ll learn far more about your borrowers’ operation, their concerns, and what they most enjoy by spending a few hours with them at the farm than you ever will just talking in your office, making phone calls, and sending emails or text messages. Document those visits and take pictures for the file. Some banks list all farms they need to visit, estimate when the visit will take place, and track their progress each month.
    • Ask your borrower what information they monitor to manage the farm. You’d be surprised how many operators have a lot more information than they share with you. It’s almost never that they are holding information back as much as it is we haven’t asked.
    • Develop an exit plan if needed. If you have a struggling operation and there doesn’t appear to be a good way to turn it around, you need to have that tough conversation with the borrower about how you will get repaid sooner rather than later. Having a well-planned, cooperative exit plan is almost always in everyone’s best interest.
  • Know that best practices are not for every borrower:
    • Having more information than less is always best, but sometimes we have those very strong, long-time borrowers that provide minimal information. If every indication says the operation is strong, then sometimes you can get by with more limited information. But, in those cases, spell out in your loan presentation what you are not getting and why that does not pose a risk to the bank.

Need Assistance?
Please feel free to reach out to us if we can help you with your loan review, stress testing, or other aspects of your lending operation that you’d like to improve. Our lending team is made up of well-experienced bankers that provide you with realistic solutions. For more information, you can contact me at bviering@younginc.com or 330.422.3476.

Agencies Amend Real Estate Appraisal Regulations (September 27, 2019)

By: Kyle Curtis, Director of Lending Services

The OCC, Board, and FDIC adopted a final rule to amend the regulations requiring appraisals of real estate for residential real estate transactions. The rule increases the threshold level at or below which appraisals are not required for residential real estate transactions from $250,000 to $400,000.

The rule defines a residential real estate transaction as a real estate-related financial transaction that is secured by a single 1-to-4 family residential property. For residential real estate transactions exempted from the appraisal requirement as a result of the revised threshold, regulated institutions must obtain an evaluation of the real property collateral that is consistent with safe and sound banking practices.

The requirements for an evaluation are set forth in the 2010 Appraisal Guidelines, and are more extensive than what many smaller institutions do for evaluations. Readers may wish to review the requirements in that document and determine whether changes need to be made regarding your evaluation practices.

The rule also amends the agencies’ appraisal regulations to require regulated institutions to subject appraisals for federally related transactions to appropriate review for compliance with the Uniform Standards of Professional Appraisal Practice.

Effective Dates
The provisions of much of this final rule will be effective by the time you read this; however, the evaluation requirement for transactions exempted by the rural residential appraisal exemption and the requirement to review appraisals for compliance with the Uniform Standards of Professional Appraisal Practice are effective on January 1, 2020.

Incorporation of the Rural Residential Appraisal Exemption
Congress amended Title XI to add a rural residential appraisal exemption. Under this exemption, a financial institution need not obtain a Title XI appraisal if the property is located in a rural area; the transaction value is less than $400,000; the financial institution retains the loan in portfolio, subject to exceptions; and not later than three days after the Closing Disclosure Form is given to the consumer, the financial institution or its agent has contacted not fewer than three state-certified or state-licensed appraisers, as applicable, and has documented that no such appraiser was available within five business days beyond customary and reasonable fee and timeliness standards for comparable appraisal assignments.

Given the general rule increase to $400,000, essentially these requirements become moot.

Addition of the Appraisal Review Requirement
The Dodd-Frank Act amended Title XI to require that the agencies’ appraisal regulations include a requirement that Title XI appraisals be subject to appropriate review for compliance with USPAP.

Appraisal review is consistent with safe and sound banking practices, and should be employed as part of the credit approval process to ensure that appraisals comply with USPAP, the appraisal regulations, and a financial institution’s internal policies. Appraisal reviews help ensure that an appraisal contains sufficient information and analysis to support the decision to engage in the transaction. We recently had a discussion with a banker who did not review an appraisal. When they “got around to it” they discovered that the appraisal was “not even close,” and ordered a new appraisal. Based on the new appraisal, their LTV was over 130%.

Many financial institutions may already have review processes in place for these purposes. Evaluations need not comply with USPAP. While financial institutions should continue to conduct safety and soundness reviews of evaluations to ensure that an evaluation contains sufficient information and analysis to support the decision to engage in the transaction, the USPAP review requirement in Title XI does not apply to such a review.

The agencies decided to implement the requirement that financial institutions review appraisals for federally related transactions for compliance with USPAP. The agencies encourage regulated institutions to review their existing appraisal review policies and incorporate additional procedures for subjecting appraisals for federally related transactions to appropriate review for compliance with USPAP, as needed.

Readers who wish to read the entire 80-page document as prepared by the regulators can find it at:

Young & Associates, Inc. can offer assistance with appraisal review, and any other compliance topics. Please feel free to contact me for information regarding these services at kcurtis@younginc.com or (330) 422.3445.

Interest Rate Risk Reporting

By: Bryan Fetty, Senior Consultant

There are a few common findings that we note when conducting Interest Rate Risk Reviews for clients that are easily remedied and require very little work on the part of the financial institution. One supervisory requirement is to provide a sufficiently detailed reporting process to inform senior management and the board of the level of IRR exposure. Financial institutions are providing the reports to the board, but in the world of regulators, if it isn’t documented in the minutes, you didn’t do it.
Financial institutions should ensure that their committee and board minutes are detailed enough to show the level of discussion about their reports that takes place at the meeting. There doesn’t need to be extensive narrative on the issues, but the minutes should reflect:

      Whether or not the board reviewed the quarterly IRR reports
      Whether or not the monitored risk measures were in compliance with the policy limits
      If any measurements fell outside of the policy limits or the reports show presence of warning indicators, include a short explanation and management’s recommendations/action items (if applicable)
      If there were any material changes in the risk measurement results compared with the previous period, include a short explanation (for example, changes made to the assumptions used in the model, material changes in the mix of assets or liabilities, any unique circumstances)
      On an annual basis, note when the board reviewed the policy, any independent review reports, the key model assumptions, and any stress or assumption tests
      Whether or not any other ALCO-related topics were discussed during the meeting.

For more information on how Young &Associates, Inc. can assist your financial institution with the annual IRR review and model back-testing process, please email Bryan Fetty at bfetty@younginc.com or give him a call at 330.422.3452.

Proposed Rulemaking – Changes to the Appraisal Threshold for Residential Real Estate-Related Transactions

The OCC, Federal Reserve Board, and FDIC (collectively, the agencies) jointly issued a notice of proposed rulemaking titled Real Estate Appraisals, dated December 7, 2018 which was published in the Federal Register for a 60-day comment period. The Appraisal NPR proposes to increase the threshold for residential real estate transactions requiring an appraisal from $250,000 to $400,000. Evaluations would still be required for transactions exempted as a result of the proposed threshold. In addition, the agencies are proposing several conforming and technical amendments to their appraisal regulations.

The agencies are proposing to define a residential real estate transaction as a real estate transaction secured by a single 1-to-4 family residential property, which is consistent with current references to appraisals for residential real estate.

The proposed rule would amend the agencies’ appraisal regulations to reflect the rural residential appraisal exemption in the list of transactions that are exempt from the agencies’ appraisal requirement. The amendment to this provision would be a technical change that would not alter any substantive requirement, but the proposal would require regulated institutions to obtain evaluations for transactions secured by residential property in rural areas that have been exempted from the agencies’ appraisal requirement pursuant to the Economic Growth, Regulatory Relief and Consumer Protection Act, commonly known as the rural residential appraisal exemption, and would fulfill the requirement to add appraisal review to the minimum standards for an appraisal.

With the proposed increase in the threshold, it is expected that many institutions will now utilize internal staff to prepare evaluations for transactions that are less than $400,000, so it might be time to revisit the Interagency Appraisal and Evaluation Guidelines (Federal Register, Vol. 75, No. 237), as well as the Interagency Advisory on Use of Evaluations in Real Estate-Related Financial Transactions (FDIC, FIL 16-016). While the Guidelines state that an evaluation is not required to be completed by a state-licensed or state-certified appraiser or to comply with USPAP, the evaluation preparer should, however, be knowledgeable, competent, and independent of the transaction and the loan production function of the institution. Evaluations may be completed by a bank employee or by a third party. In smaller communities, bankers and third-party real estate professionals have access to local market information and may be qualified to prepare evaluations for an institution.

An evaluation should provide a reliable estimate of the market value of the property and, therefore, the approach or approaches used in an evaluation should be appropriate to the property being valued, and the intended use, so it may be appropriate to omit one or more of the three approaches to value. If the income approach is the primary approach for a tenant-occupied, income-producing
property, it may be appropriate to omit the sales comparison approach and the cost approach.  Similarly, if the sales comparison approach is the primary approach for a single-family residence, it may be appropriate to omit the cost approach and the income approach.

The Guidelines provide information regarding the minimum content that should be contained in an evaluation. Unlike an appraisal report that must be written in conformity with the requirements of USPAP, there is no standard format for documenting the information and analysis performed to reach a market value conclusion; but like an appraisal report, the evaluation should contain sufficient information to allow a reader to understand the analysis that was performed to support the value conclusion and the institution’s decision to engage in the transaction.

Appraisal and Evaluation Reviews
The proposed rule would make a conforming amendment to the minimum requirements in the agencies’ appraisal regulations to add appraisal review. The agencies propose to mirror the statutory language for this standard. As outlined in the 2010 Guidelines, which provide guidance on the review process, the agencies have long recognized that appraisal review is consistent with safe and sound banking practices.

The agencies are proposing to implement the appraisal review provision in Section 1473(e) of the Dodd-Frank Act, which amended Title XI to require that the agencies’ appraisal regulations include a requirement for institutions to subject appraisals for federally related transactions to appropriate review for compliance with the Uniform Standards of Professional Appraisal Practice (USPAP). While most institutions follow the guidance, the proposed rule would implement this statutory requirement.

For more information on this article or on how Young & Associates, Inc. can assist with the appraisal review process, contact Kyle Curtis at 330.422.3445 or kcurtis@younginc.com.

Assessing Management Skills in Agricultural Borrowers

By: Robert Viering, Senior Consultant & Lending Department Manager

In our loan review practice we have seen an overall deterioration in farm financial results. However, we have noted that there are borrowers that are still providing reasonable returns and acceptable debt service coverage ratios. Our anecdotal observations have been confirmed by data from farm financial databases from farms in the Midwest. In his blog post in the December 19, 2017 Corn + Soybean Digest, Dr. David Kohl observed, “Regardless of farm size or enterprise, the gap between the top one-third of economic performers and the bottom one-third is widening. Among the most profitable, common practices include strong production, a drive towards efficiency, and an executed marketing and risk management.” My interpretation of his comment can be simplified to: Management skills count.

In our loan review client banks, management skills may be a part of the bank’s risk rating model, but how management skills are determined varies widely. All too often most borrowers are rated as having good management skills even if their financial results put them in the bottom third of financial performance. Based on my 30+ years as a banker and now as a loan review professional, management skills are what separates the top and bottom producers. The question becomes, how do we assess the management skills of our borrowers? While there are no hard and fast rules, there are several attributes that can often help in making an assessment of management skills.

The following are items to consider when assessing management skills:

  • Production competency. On the production side, you will want to honestly assess how their level of production compares to others with similar operations. As an example, if they are consistently producing more bushels of corn per acre than similar farms in your market, then their skills should be rated higher than an operation with more variable results or certainly better than those that are consistently below their peers. You will want to consider if their equipment line/livestock production facilities are appropriate for the scale and sophistication of their operation.
  • Financial competency. Questions for you to consider to determine financial competency include: Are you provided accurate, thorough, and timely financial information? Are the cash-flow projections reasonable and based on sound assumptions (you will need to back test borrower’s cash flows to actual results to assess this attribute)? Does the producer understand the financial implications of their decisions?
  • Risk management. Risk management is about protecting what you have and limiting your downside. Among the items to assess include whether they are carrying adequate crop insurance. This can include whether they can cover the difference between what insurance pays and what they expected to produce. Other questions that are important to consider include: Does the borrower have a marketing plan? Do they make good use of hedging strategies? A good marketing plan can help pick up some additional income while limiting the downside of market volatility.
  • Intangible skills. There are a few other items that should be considered that are difficult to quantify but are important to consider. Among the items to ask are: Are they willing to make tough decisions? This is often about expenses and includes the ability to reduce family living, reduce labor costs (even if it means a family member may have to leave the operation), or any other decisions that may not be popular or easy but may be required to succeed. Do they have a long-term vision of where they want to go? Even if they are not considering doing anything different, that is still a strategy that has its risks. Are they realistic in their understanding of their operation’s strengths and weaknesses? Are they open to taking advice from outside experts to improve their operation? Do they have any trusted advisors that they use? If applicable, do they have a plan to transition to the next generation? If so, do they have an understanding of the next generation’s strengths/weaknesses and the risks in their transition plan?

Agriculture is like all other types of business: good management is critical to long-term success and especially to getting through more challenging times like today. As a bank, having a good understanding of the borrower’s management skills is an important aspect of knowing the level of risk in a borrower. We encourage banks to make a thorough assessment of a farm operator’s management skills, especially today as management skills can often be the difference between long-term success and just surviving, or even the difference between just surviving and having to quit farming.

For more information on this article, contact Bob Viering at bviering@younginc.com or 1.800.525.9775.