In recent supervisory guidance, the Federal Reserve staff expressed concerns that so-called “asset exchange” transactions used by financial institutions to dispose of or reduce nonperforming assets and other real estate owned (OREO) may present significant risks and could compromise safety and soundness. The December 21 guidance, entitled Disposal of Problem Assets through Exchanges (Supervision and Regulation Letter No. 11-15), highlights certain risks specific to asset exchange transactions that are designed to reduce problem assets in the short term. According to the guidance, asset exchanges involve third parties or marketing agents who offer to purchase problem assets from an institution and replace them with performing assets. The guidance warns that a lack of appropriate due diligence may result in heightened risks over the longer term and that incorrect or other inappropriate assumptions used in determining the fair value of purchased assets may result in loss recognition shortly after closing an asset exchange. The supervisory guidance applies to all state member banks, bank holding companies and their nonbank subsidiaries, and savings and loan holding companies that engage in asset exchange transactions. The guidance outlines certain risks specific to asset exchange transactions, relevant risk management considerations for institutions, and the supervisory considerations examiners will use when reviewing such transactions.

      Nutter Notes:  The guidance recommends that management assess relevant risk exposure before entering into asset exchange transactions. Specifically, management should determine an asset exchange’s long-term effect on the institution’s balance sheet and loss exposure, according to the guidance. The guidance also recommends that management determine how these risks align with the institution’s overall risk management strategy. The guidance indicates that examiners typically will not include a specific review of these transactions in routine examination and inspection activities, particularly where there is no evidence that a bank has engaged in such transactions. However, examiners will be looking for indications of possible asset exchange transactions as part of their routine monitoring between examinations. Institutions can expect examiners to discuss asset exchanges with management as part of the supervision process if examiners become aware that the institution is considering these types of transactions. According to the guidance, supervisory monitoring activities will focus on financial statement changes commonly associated with asset exchanges, internal risk management reports, and other documents received on a routine basis. Any review of asset exchanges by examiners will consider whether appropriate risk management measures have been considered and whether management has used appropriate valuations in accordance with GAAP.