Posted on Monday, April 4, 2011
The Office of the Comptroller of the Currency (OCC) has issued a notice to the chief executives of all the lenders it regulates warning them of the risks involved in real estate-owned exchange programs.
The agency notes that deterioration in asset quality due to the weak economic environment has led to an increase in banks’ nonperforming assets – including what the OCC categorizes as other real estate owned (OREO), also known as real estate owned (REO), the term more readily used within the industry.
Several companies have started marketing OREO exchange programs to national banks as a means to reduce these problem assets on their balance sheets, according to the OCC.
The agency explained that these programs purport to reduce nonperforming assets by exchanging OREO for an interest in another asset, which is represented to be performing. 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, according to the OCC.
But the agency warns that these programs “can raise significant safety and soundness, legal, and accounting concerns.” The OCC stated that it “strongly encourages national banks to consult with their supervisory offices before entering into any such agreements.”
Among the issues with such programs cited by the OCC are the bank’s loss of control over its OREO assets; 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.
In addition, the entity acquiring the OREO is often involved in activities that are not permissible for national banks, making the exchanged asset acquired by the bank an impermissible asset, the OCC said. Oftentimes, rather than improving its position, the bank ends up in an economically inferior situation, with additional legal and accounting issues, according to the agency.
Another example of transactions offered to national banks to reduce their nonperforming asset balances is an “adjusted price trade.” The OCC explained that this type of transaction involves an offer to purchase the bank’s nonperforming real estate loans or OREO at book value, with the stipulation that the bank purchase other assets, at inflated values, from the same party.
“The ‘adjusted price trade’ is not only unsafe and unsound but may constitute fraud if it results in the misrepresentation of the bank’s financial statements,” the OCC warned.
In a limited number of circumstances, a national bank may acquire a non-controlling equity interest in an LLC in exchange for its interest in OREO, the OCC said. The agency has approved only one type of exchange, in which an LLC was established as a means for the participants in the original loan to hold the real estate collateral acquired through or in lieu of foreclosure.
In this case, the participants in the original loan were the members of the LLC, and each participant held an interest in the LLC which corresponded to its interest in the loan and OREO.
The LLC was established specifically to manage and dispose of the OREO, and the member banks retained control over the OREO asset and maintained the same level of risk as before the exchange. The exchange, however, enabled the participants to manage and dispose of the OREO more efficiently than if each bank had to manage its own partial interest in the property, the OCC explained.
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, according to the federal regulator. The OCC says banks need to use caution when looking at novel methods of trading nonperforming OREO balances for other assets.
By: Carrie Bay, DS NEWS