Although many independent banks across the United States have had little to do with the current economic abyss into which the country has fallen, the impact of the financial industry crisis and related mortgage fallout has begun to creep into the lobbies and onto the financial statements of banks. This impact is felt not just by struggling banks but also by well-rated and well-run independent financial institutions, and its negative effects often approach like a thief in the night. This “stealth bandit” is beginning to arrive in the form of nongovernment- backed private label paper, more commonly referred to as mortgage-backed securities, or “MBOs.” The effects of holding MBOs, particularly those that have been downgraded, can reach far and wide into an otherwise sound and well-capitalized bank.  

The purpose of this article is to alert you to the regulatory impact of holding MBOs, particularly those that are rated less than investment grade, and how these MBOs and the concept of “other than temporarily impaired,” or “OTTI,” can thrust an otherwise healthy institution into a stress condition typically experienced by troubled institutions, and can lead to classification, liquidity and capital problems. Furthermore, these problems are not mutually exclusive, and just because a bank is not required to recognize OTTI in its portfolio does not necessarily mean that the bank is out of the woods. Any bank holding MBOs may still experience the regulatory pitfalls that accompany classification and risk-weighting issues associated with these securities. This is why it is important to understand your portfolio hold and analyze the holdings in light of the current economic environment. An ounce of prevention today may be worth more than a pound of cure tomorrow.  

Which Institutions Should Be Concerned?  

All institutions, but certainly those with a significant portfolio of MBOs, should be aware of the OTTI concept and the impact it can have on a bank’s balance sheet and capital position. Credit crises, recessions and overall economic stresses can significantly affect the value of MBOs. During market downturns, accounting guidelines require a determination of value, impairment to value and, if there is an impairment to value, a determination whether that impairment is considered “other-than-temporary.” If there is OTTI, the bank must take a write-down on the security with a related charge to current-period earnings and capital.

Accounting guidance under United States generally accepted accounting principles (“GAAP”) requires financial institutions to categorize an investment security, such as an MBO, into one of three categories upon its acquisition (i) “held to maturity” (“HTM”), (ii) “available for sale” (“AFS”) or (iii) “trading.” In addition to defining the appropriate categories, GAAP also requires the bank, for each reporting period, to assess both the classification of HTM and AFS securities and, more importantly for OTTI purposes, to determine whether any decline in value of the security should be considered OTTI. The relevant accounting guidance is either FASB Statement 115 (“FAS 115”) or EITF 99-20 (as amended by EITF 99-20-1), depending on the type of asset in question. EITF 99-20-1 is specifically applicable to mortgage- and asset-backed securities, while FAS 115 is the standard applicable to other assets.  

How is OTTI Determined?  

There are no “bright-line” or “rule of thumb” tests for OTTI, so a bank should use all available objective and identifiable information, including data prepared by outside consultants and advisers, to aid in its OTTI determination. The specific accounting principles underlying OTTI are far beyond the scope of this article, but a summary of the process may be helpful.  

There is a basic three-step process to determine whether the MBOs have impairment and, if so, whether it constitutes OTTI. First, the bank must analyze its MBOs (and other securities, other than those that are “trading”) to determine each security’s value and whether the security has experienced impairment. For MBOs, the basic accounting rule is that the MBO will be considered “impaired” if it is probable that there has been an adverse change in estimated cash flows of the asset. In other words, the bank must assess whether it is probable that a change, whether favorable or unfavorable, could occur in the estimated cash flows of the MBO from amounts previously projected to be received by the bank on that MBO. If it is determined that the asset is impaired, the bank must recalculate the acceptable yield to determine the amount of the impairment, and then proceed to the next step to determine whether the impairment is OTTI.  

The second step, determining whether the impairment is OTTI, is a very subjective test that inevitably will require assistance from outside consultants such as the bank’s accountants and its investment adviser. All available data should be considered when ascertaining OTTI. The subjective exercise includes factors such as the nature and extent of the decrease in fair value of the security; the nature of the investment and the recent investment grades for the asset; the ability and intent of the bank to hold the security for a reasonable period of time (which may be in excess of one year) sufficient to achieve forecasted recovery in value; the cause of the impairment, including the financial condition and prospects of the issuer; adverse economic conditions specifically related to the issuer; the issuer’s cash position or the issuer’s geographic market; the severity and duration of the impairment, factoring in the length of time and extent of any market correction; forecasts of economic, market or industry trends; and any other evidence deemed to be relevant in reaching a conclusion.  

If it is determined that the impairment to the MBO is OTTI, the final step in the process is for the bank to recognize an impairment loss equal to the difference between the asset’s amortized investment cost and its current fair value. The bank should work closely with its third-party advisers, including its accountants, to properly calculate and report the OTTI. The impact of OTTI, which can be significant, will be seen in the bank’s income statement and its balance sheet, and may require restatements of earnings, amended call or thrift financial reports and other regulatory and accounting adjustments.

Additional Concerns

Although the major concern with holding MBOs (and other securities) in this economic environment is the issue of OTTI, holding MBOs in particular can affect the bank in two other ways — asset classification and risk weighting. Each of these, in turn, can affect the bank’s capital ratios and its overall regulatory health.  

For asset classification, the question is how should MBOs be classified when the MBO has been downgraded to below investment grade? Under the Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks and Thrifts (“Uniform Agreement”), as interpreted by the bank regulatory agencies, examiners are required to use published ratings as a proxy for the classification definitions employed, including the classification of an asset as “substandard.”  

Under the Uniform Agreement, an asset is considered “substandard” when it is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. These assets are characterized by the possibility that the institution (note, not the MBO itself) will sustain loss if the deficiencies are not corrected. A security rated below the four highest investment grades is normally considered “substandard.” Accordingly, a single-obligor corporate bond or a multiple-obligor MBO that has been downgraded to below investment grade would be classified as “substandard” under the Uniform Agreement.  

One problem here is that the Uniform Agreement is based on the premise that deficiencies relate to the characteristics of a single-obligor security, such as a corporate bond. This approach is not uniformly applicable to MBOs, which are by nature multiple-obligor securities. With MBOs, there may be some obligors with deficiencies, but many others that are well-performing, thus resulting in no overall loss to the MBOs, with a lessened probability of loss ever occurring, and certainly little, if any, possibility that the institution will sustain a loss. In other words, a broad-brush ratings approach to classification of MBOs overstates the risk.  

Having said all that, and while the Uniform Agreement provides that an examiner may, in limited cases, “pass” on a security that is rated below investment grade, our experience with the regulators is that they will take a hard-line, literal approach in applying the Uniform Agreement. As a result, any MBOs held by the bank that are rated at below investment grade will likely be classified as “substandard.” Obviously, the more classified assets the bank has as compared to its total assets and to its capital, the more the regulators will take notice, which will affect the bank’s CAMELS ratings. This in turn can affect the bank’s operations and ability to borrow funds, pay dividends and raise capital. Nevertheless, the bank should not simply nod and apologize, but should instead attempt to argue for a more favorable view of MBO classification that does not rely solely on investment ratings.  

Similarly, concerning risk weighting and capital ratios, the issue is whether the bank is required to assign a risk weight to its MBOs according to the ratingsbased tables under the risk-based capital guidelines (Guidelines) (which for below-investment-grade ratings would result in a 200 percent risk weighting in most cases), or whether the bank may, in the alternative, use the 100 percent (or less) risk weighting of the standard risk weightings under the Guidelines. The likely answer is that there is some flexibility, but the regulators often interpret the Guidelines differently. If the bank holds MBOs, the bank should carefully review the Guidelines applicable to it (whether OCC, Federal Reserve or FDIC guidelines — there are differences) to determine how to risk-weight the MBOs. Special attention should be paid to MBOs that are rated less than investment grade, as these MBOs may have to be weighted at 200%. If so, the bank’s capital ratios can be immediately and adversely affected, which likely will bring the regulators to the bank’s front door. Careful application of the Guidelines may enable the bank to “look through” the MBOs to the underlying mortgages and risk-weight them based upon the underlying mortgages (as low as 50% risk weighting) in a “bifurcated” approach to risk weighting. To do this, however, the bank must meet certain requirements, such as credit analysis and due diligence standards.  

To summarize, if the bank holds MBOs, the bank should consider implementing an OTTI Policy, and in fact may be required to do so by its regulators. We are beginning to encounter this on a much more frequent basis. Furthermore, if any of the MBOs held by the bank are downgraded, the bank should promptly consider the impact of the downgrade on the bank’s asset classification and capital position. Being proactive in this area is much better than getting a surprise phone call from the bank’s regulators. In addition, these problems can materialize sometimes overnight, so continual attention is required if the bank holds MBOs.