Many community banks have been approached during the last several years by groups claiming to have developed novel methods of converting the bank's OREO or other nonperforming assets into performing assets. Bank regulators have been skeptical about these programs and for the most part have not responded to nonobjection requests for them, but regulators have said little about these programs publicly. Recently, however, the OCC issued guidance warning banks about these programs.

These programs typically claim to reduce nonperforming assets by exchanging OREO or other nonperforming assets for an interest in a performing asset. This “performing asset” is often an equity interest in the entity acquiring the OREO or a trade for a large volume of loans such as home equity lines of credit. The OCC notes that these programs can raise significant safety and soundness, legal, and accounting issues and strongly encourages national banks to consult with their supervisory offices before entering into any such agreements.

Some of the common issues with these programs include:

  • The bank’s loss of control over its OREO assets,
  • The exchange of OREO for an asset of questionable liquidity and value,
  • The commingling of the bank’s OREO with other real estate that may be of poorer quality,
  • Significant up-front fees and recurring management fees paid to the organizing company, and
  • Unfavorable priority of payments between the banks and equity investors.

Other programs involve an offer to purchase the bank’s nonperforming real estate loans or OREO at book value in exchange for the bank's purchase of other assets, at inflated values, from the same party. We have seen many of these types of programs marketed to community banks, including one program that would have involved a swap – at book value -- of the bank's nonperforming loans for an interest in life settlements. The OCC states that this type of transaction “is not only unsafe and unsound but may constitute fraud if it results in the misrepresentation of the bank’s financial statements.”

The OCC bulletin describes one type of exchange it has approved -- the establishment of an LLC for the participants in the original loan to hold the real estate collateral acquired through, or in lieu of, foreclosure. However, the OCC emphasized that its published guidance does not provide legal support for national banks to exchange OREO for an equity interest in an entity aggregating various unrelated OREO parcels from multiple banks.

The OCC encourages national banks to use caution when looking at novel methods of trading nonperforming OREO balances for other assets. The OCC bulletin outlines a number of steps a bank should take before entering into one of these transactions, including conducting adequate due diligence and obtaining board approval. The bulletin concludes that "although the transaction may be marketed as a simple way to reduce nonperforming assets, these transactions can be very complicated and must be reviewed thoroughly before entering into them."