Doug Bennett

What is a Loss-sharing Agreement?

A loss-sharing agreement is an agreement in which the FDIC agrees to absorb a portion of the losses resulting from resolution of the loan portfolio. Usually, the FDIC agrees to absorb 80% of the losses to a stated threshold and 95% of losses thereafter. Such an agreement protects the buyer from a substantial portion of the downside risk in buying a troubled loan portfolio, especially since the period for due diligence in these transactions is very short. In today’s depressed markets, the protection offered by a loss-sharing arrangement, combined with a discount from the stated values of the failed bank’s assets and liabilities, often generates a gain for prospective buyers.

Accounting Considerations

Accounting for business combinations is governed by Financial Accounting Standards Board Statement of Financial Accounting Standards No. 141 (SFAS 141R), codified as Accounting Standards Codification (ASC) 805. In general, assets and liabilities acquired in a business combination, including those of a failed bank that meet the ASC 805 definition of a business, are recorded at fair value. This article focuses on two elements of applying ASC 805 to FDIC-assisted transactions:  accounting for the loan portfolio and accounting for the related loss-share agreement.

Accounting for the Loan Portfolio

The loan portfolio is recorded at acquisition date fair value under ASC 805. No allowance for loan losses is recorded as the fair value incorporates assumptions about credit risk. The loss-share agreement is not included in the fair value of the loans, as it is not contractually embedded in the underlying loan agreements.

Subsequent to acquisition, accounting for the loans depends on whether they are performing or impaired (nonperforming). Loans acquired should be individually evaluated to determine whether they are within the scope of ASC 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality. A loan must meet two criteria to be within the scope of ASC 310-30:

• There is evidence of deterioration of credit quality since origination
• It is probable not all of the contractual cash flows will be collected

For loans within the scope of ASC 310-30, income is based on cash flows expected to be collected rather than contract amounts. In other words, the discount recorded related to credit quality is not accreted. Rather, it is only adjusted when there are changes to cash flows expected at the acquisition date. The remainder of the purchase discount is accreted to earnings using the level-yield method per ASC 310-20, Nonrefundable Fees and Costs.

For loans not within the scope of ASC 310-30, the buyer must make an accounting policy decision. The buyer could choose to analogize to ASC 310-30 and treat the discount related to credit quality in the same manner. If the buyer chooses this policy, they must apply all aspects of the standard, including extensive disclosure requirements. Or, the buyer could apply the methodology in ASC 310-20 and accrete the entire discount to earnings. The conflict in the latter case is, as amounts related to credit quality are accreted, provision must be made to the allowance for loan losses for credit losses previously considered in the purchase discount. The U.S. Securities and Exchange Commission (SEC) staff recently indicated they would not object to either method.

Accounting for the Loss-share Agreement

Initially, the buyer must make another accounting policy choice in recording the loss-share agreement. The staff of the SEC and federal bank regulator have indicated they would not object to accounting for amounts receivable under loss-sharing agreements either as derivatives or as indemnification assets per ASC 805. In either case, the initial measurement is fair value.

Subsequent to acquisition date, the accounting methods depart. If accounted for as a derivative, the asset is remeasured each reporting period at fair value. If accounted for as an indemnification asset, it is accounted for on the same basis as the related asset (loans receivable). At the end of each reporting period, this means the indemnification asset is adjusted for changes in expected cash flows based on the performance of related loans. Better-than-expected performance reduces the asset, while worse-than-expected performance increases it.

In our experience, loss-sharing agreements are most commonly accounted for as indemnification assets to avoid volatility in earnings. Once the initial measurement at fair value is made, adjustments move counter to adjustments made to the loans, minimizing earnings impact, while derivatives are remeasured at fair value every period, subjecting those measurements not only to adjustments related to credit risk but also to other market forces.

Fair Value

Determining fair value of the acquired loans and loss-sharing agreement involves valuation techniques beyond the scope of this overview. They are very complex and will, in most cases, necessitate the services of credentialed valuation professionals.

Conclusion

This is a brief overview of two significant accounting issues related to acquiring failed banks in FDIC-assisted transactions. It does not deal with the other myriad accounting issues under ASC 805, nor does it delve into the mechanics of applying the methods described above. Contact your BKD advisor to discuss these complex issues in greater detail.