On May 22, the Office of Thrift Supervision (OTS) released a letter to the chief executive officers of OTS-regulated institutions related to the agency’s findings after a “horizontal review” it performed with respect to allowance for loan and lease losses (ALLL) at some of the larger thrift institutions (savings banks and savings and loan associations) regulated by the OTS.
According to the letter, the purpose of such horizontal review was to “identify industry practices, including sound practices, in the ALLL estimation process.” Sound practices identified by the OTS with respect to estimating an appropriate ALLL included the following: (i) the use of an ALLL methodology at inflection points (periods of increasing or decreasing losses) that utilizes lagging data supplemented and validated with other methods that rely upon leading data (such as a migration analysis); (ii) the segmenting of sophisticated portfolio products, such as option adjustable-rate mortgages, into multiple risk levels when forecasting delinquency and default; (iii) the application of qualitative factors to specific loan portfolio segments; and (iv) the stress-testing of loss rates and delinquency rates.
Noting that “no single successful method has emerged for predicting losses on loans” and that ALLL methodology is not an exact science but instead relies “heavily on management expertise and judgment”, OTS nonetheless identified ALLL practices that are considered weak and do not appear to be in accordance with generally accepted accounting principles and/or supervisory guidance. Such practices included the following: (i) the charge-off of losses only at foreclosure or when deemed uncollectible; (ii) the placement of loans on nonaccrual status when deemed “uncollectible” and the failure to reverse accrued but uncollected interest through current earnings; (iii) the use of varying look-back periods and simple averages to calculate charge-off or delinquency rates; and (iv) the failure to validate ALLL methodology.
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