Loan payment plans approved by the bankruptcy court frequently do not conform to the original loan payment plan contracted at the beginning of the loan. Many times the court approved payment plan calls for a more lengthy maturity, reduced interest or reduced principal for the loan. Questions have arisen concerning the calculation of past due status for these loans and the correct categorization of these loans for Examination Report and Report of Income and Condition purposes.

Chapter 1 POLICY

Loans which have been accorded new payment plans by a bankruptcy court will be deemed to have received a new contractual payment plan and the past due status will be evaluated based upon the new plan. Loans performing according to the court-approved plan will not be considered past due even though the loans are not performing according to the original payment plan. Loan which become delinquent under the court approved plan will be included in the appropriate past due category according to established guidelines.

However, loans which have a court-approved payment plan may be considered restructured debt. Restructured Loans are loans whose terms have been modified, because of a deterioration in the financial position of the borrower, to provide for a reduction of either interest or principal.

Once an obligation has been restructured because of such credit problems, it continues to be considered restructured until paid in full or until time as the terms are substantially equivalent to terms on which loans with comparable risks are being made.

91-2 – Treatment of Mortgage Loan Pools and Mortgage Servicing Rights Acquired from the RTC

The Resolution Trust Corporation (RTC) packages 1 to 4-family residential mortgage loans into pools for sale to various financial institutions and other entities. Questions have arisen concerning the accounting for the loan pools depends upon whether they are to be held for resale or for long-term investment.

POLICY

before the mortgage loan pool can be classified as a long-term investment, the intent and ability of the bank to hold the loans to maturity or for an extended period must be established. A corporate resolution may be used to document management's intent to hold the pool of loans for an extended period of time or until maturity.

Mortgage loan pools acquired from the RTC for long-term investment are to be booked at cost and carried on the bank's balance sheet in the loan category. The subsidiary loan trial may carry the loans on an individual basis or carry a control amount for the block of loans purchased. A premium or discount may be associated with the purchase of this type of asset and must be amortized or accreted over the life of the loans.

A premium exists when a bank purchases the pool of loans at a price in excess of the principle of the loans within the pool. The difference between the purchase price and balance represents the premium which the bank is required to amortize. Amortization may be calculated on an individual loan basis or may be calculated on the entire pool utilizing a weighted average life method. (The remaining life of each loan is determined and totaled. The total life is then divided by the number of loans within the pool.)

A discount exists when a bank purchases a pool of loans at a price below the principle balance of the loans within the pool The difference between the proposed balance and purchase price presents the discount which the bank is required to accrete. Accretion may be calculated on the individual loans or may be calculated on the entire pool utilizing the weighted average life method previously described.

Mortgage loan pools acquired for sale are booked at the lower of cost or principle balance of the loans within the pool. Discounts resulting from the purchase of a loan pool that are held for sale shall not be realized as income until the loans are actually sold. A gain or loss on he sale is the difference between the sale price and the net carrying amount of the pool. This gain or loss will be reported as noninterest income and will not affect the yield on the pool of loans for the carrying period.

Certain costs incurred in block purchases of mortgage loans can be associated with future servicing income and capitalized and amortized over the estimated average term of the mortgage loans. Appropriately capitalized costs can be added to the book value of the loans, and the lower of cost or principle balance has been determined.

Loans are sometimes warehoused for s short period of time and sold under a repurchase agreement (repo). If the loans are not repurchased in accordance with the repo agreement, the lending institution may exercise ownership of the pool of loans. The seller may pay an agreed-upon rate of interest for the use of funds provided by the lending institution. Repos are accounted for as a borrowing and no sale is recorded.

When the interest paid on the short-term warehouse loans is less than interest received on the asset, a positive spread is created for the repo seller. However sometimes interest rates reverse, and short-term rates exceed long-term rates. This results in a negative spread in interest rates for the repo seller which must be charged to current operations as they are incurred.

Mortgage loans pools held for resale should be segregated on the balance sheet. Disclosure must be made of the method used to determine the lower of cost or market value of the loan pools. Capitalization of servicing rights must be disclosed as follows: (a) amount capitalized; (b) method of amortization used; and (c) amount of amortization.

The bank's loan policy is to address the following information for the purchase of mortgage loan pools from the RTC: inclusion of mortgage loan pools on the list of loans suitable for investment; the maturity desired for these type of loans; documentation requirements; assignment of responsibility for oversight of the pool; and guidelines for accounting, assignment of risk rating, and sale of individual loans from the pool or the entire pool. The reserve for loan losses is to be increased according to the risk assigned to this pool of loans.

ACCOUNTING FOR SERVICING RIGHTS

Part of the mortgage loan pool's purchase price may be the right to receive future servicing income. The amount directly attributable to servicing rights shall be deferred with certain limitations. The first limitation is that the amount deferred shall not be more than the difference between the market value (excluding servicing rights) of the loans at the date of purchase and the total purchase must be in accordance with FASB-65 (lower of cost or market). The following conditions must be met:

a. Prior to date of purchase, commitments from investors to purchase the mortgage loans must be obtained, or the commitments must be obtained no later than 30 days after the date of purchase. The commitment must provide for the seller to continue servicing the mortgage loans.

b. If the sales price to the permanent investor exceeds the market value of the loans at date of purchase, the difference must be applied to reduce any amount deferred for mortgage servicing rights.

c. No other costs relating to the purchase of the loans can be deferred.

NOTE: If the above conditions are not met, the cost of the right to receive future servicing income is usually included as part of the cost of the mortgage loans for the purpose of determining lower of cost or market.

The second limitation is that the amount allocated to the right to receive future servicing income cannot exceed the present value of the estimated future net servicing income. Future net servicing income is the difference between the estimated future servicing revenue and the estimated future servicing costs. probable late charges can be included in future revenues. Servicing costs may be determined on an incremental cost basis.

91-3 – Investment in Student Loan Marketing Association (SALLIEMAE) Preferred Stock

Questions have arisen whether state banks may invest in preferred stock of the Student Loan Marketing Association (SALLIEMAE). State Banks are authorized to purchase common stock in this program pursuant to department regulation.

POLICY

Preferred stock in the Student Marketing Association (SALLIEMAE) will be considered an eligible investment for a state bank for purposes of qualifying to offer guaranteed student loans through its program.

92-3 – Debt Cancellation Contracts

An increasing number of state chartered banks are offering debt cancellation contracts as an alternative to the sale of credit life insurance. Debt Cancellation Contracts provide for losses arising from cancellation of outstanding loans upon the death of borrowers. These contracts contain an element of risk which may impact the safe and sound operation of a bank. Activity in this area should be examined to determine the degree of risk and to insure that proper guidelines have been implemented to provide for safe and sound operations.

The United States Court of Appeals for the Eight Circuit ruled on June 25, 1990, in First National Bank of Eastern Arkansas. A National Banking Association, vs. Ron Taylor, Commissioner of the Insurance Department for the State of Arkansas, that national banks can sell "Debt cancellation contracts". On November 13, 1990, the Supreme Court declined to hear the case, thus affirming the 8th Circuit's decision. State chartered banks are authorized to provide for losses arising from the cancellation of outstanding loans upon the death of borrowers by means of a Resolution of the State Banking Board dated July 17, 1984.

POLICY

State chartered banks engaging in the activity of issuing debt cancellation contracts must consider the following:

- The bank's Board of Directors shall have considered the risks inherent in such activity and determined by resolution that the issuance of debt cancellation contracts is an approved product to be provided to certain loan customers of the bank;

- The Board of Directors shall designate the bank's officers eligible to offer the contracts;

- A loan limit shall be established for which the debt cancellation contracts may be sold (it would appear that debt cancellation contracts should only be offered for personal and consumer type loans);

- The bank shall establish a reasonable reserve based on a five year average of mortality losses experienced with past credit life insurance underwriters or other such method deemed acceptable by the State Bank Commissioner;

- The reserves shall be evaluated at least quarterly for adequacy and records supporting the justification for the reserve balance shall be maintained for examiner inspection; and

- The sale of a debt cancellation contract cannot be a condition to the approval of a loan application and should be offered along with similar products that may be available from other sources.

In the event that the debt cancellation contract is negotiated with the provision that a rebate will be made to the customer if the note is paid in full prior to maturity, the fee income shall be periodically recognized in proportion to the bank's performance under the contract. The bank's performance under the contract is the coverage of the risk associated with each contract. Thus, for those contracts in which the coverage is provided evenly during the term of the contract period, the income should be recognized evenly during the term of the contract. In the event the amount of coverage of the contract declines during the term of the contract, the fee should be recognized in proportion to the coverage during the term of the contract.

In the event that the debt cancellation contract is negotiated without a provision for rebate of a portion of the fee as a result of early payoff of the loan, all fees generated from the sale of the debt cancellation contracts shall be posted to non-interest income. Increases in the required reserve established to absorb losses shall be made by provision expense and posted to non-interest expense. Both the unearned portion of the feel and the reserve set aside for possible losses are to be recognized as liabilities on the bank's books.

Disclosure of the costs of debt cancellation contracts are subject to Section 226.4 of Regulation z - Truth in Lending. This disclosure is required for any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or condition of the extension of credit.

Potential liability also exists for the bank customer due to liability to a third party who may become a beneficiary due to inheritance and the impact of inheritance taxes. The bank is encouraged to disclose this fact to customers who may wish to seek tax advise on this issue.

The unreserved portion of the outstanding balances of loans in excess of the reserve balance are not to be considered contingent liabilities and, as such, debt cancellation contracts will have no effect upon risk based capital calculations.

EXAMINATION POLICY

The evaluation of the practices employed by a bank and bank management in the sale of debt cancellation contracts is to inspect for safety and soundness. The product should be offered so as to minimize risk and limit liability. In the event that minimum safeguards are not employed, management and the board of directors are to be cited for violating prudent banking practices and, in instances where risk is more than ordinary, cease and desist orders will be issued.

Agriculture and/or marketing cooperatives frequently issue certificates of equity and capital based certificates to farmers who market their crops through the cooperative. These certificates represent the farmer's ownership in the cooperative and are a "deferred payment" or a "receivable" to the farmer as a portion of payment which the cooperative withholds from the cash amount it pays the farmer for the value of his crop.

The traditional method of payment for such certificates has been full payment of face value at the end of the ten to twelve years. However, any determination of payment is made by the Board of Directors of the cooperative. These certificates have no maturity, have not established market, and are highly illiquid.

92-4 - Treatment of Certificates of Equity and Capital Based Certificates Issued by Agricultural and/or Marketing Cooperatives

Agriculture and/or marketing cooperatives frequently issue certificates of equity and capital based certificates to farmers who market their crops through the cooperative. These certificates represent the farmer's ownership in the cooperative and are a "deferred payment" or a "receivable" to the farmer as a portion of payments which the cooperative withholds from the cash amount it pays the farmer for the value of his crop.

POLICY

State chartered banks that receive certificates of equity and/or capital based certificates through default of the loan customer will be permitted to retain certificates of equity and/or capital based certificates on their books at a fair market value. Market value must be established by reasonable banking practices acceptable to the Bank Commissioner. This valuation must be fully documented and maintained by the bank.

It is the opinion of the Bank Commissioner that the legislative intent of A.C.A. Sec. 23-32-703(c) addressing the holding period for "goods or chattels" coming into a bank's possession as collateral security for loans or any ordinary collection of debts extends to all assets not specifically excluded by statute. (See A.C.A. 23-32-709 and A.C.A. Sec 23-32-303(2)(b)(iii)) Accordingly, these certificates of equity and/or capital based certificates may not be reckoned as a bank asset for a period longer than twelve months.

Under no circumstances may a bank purchase as an investment a certificate of equity and/or capital based certificate.

93-2 – State and Local Government Leases

Act 508 of 1991, the so-called Local Government Lease Act provided a method for structuring a multi-year lease arrangement that local governments could use to obtain capital improvements, equipment, facilities, goods, etc. Certain provisions of the Act provided for payment of interest by the local government. (See Examination Policy 91-4)

An Arkansas Supreme Court decision, Mason Brown v. City of Stuttgart, Arkansas and First Continental Financial Corporation, Case No. 92-849 (February 22, 1993) may have invalidated Act 508 of 1991. The case held that a multi-year lease arrangement that provided for the payment of "interest" by the municipality was a violation of the Arkansas State Constitution, Article 16, Section 1, which prohibits a city from entering into an obligation with interest bearing indebtedness. The court cited several other provisions for invalidating the lease in this case, such as a great penalty for default, and the fact that there was no way to terminate the lease except if an appropriation was not made for it each year.

While the court did not reach the question of the constitutionality of Act 508 of 1992, it did invalidate the lease in this case.

POLICY

Leases between a lender and state and local governments should be scrutinized for evidence of an interest bearing obligation as well as whether there are major penalties for default from the lease agreement.

Such leases, if discovered, should be accorded a special mention classification and the bank should be requested to confer with bank counsel to determine if a new arrangement should be negotiated due to the above cited Supreme Court decision.

93-4 – Correct Accounting Treatment for State Bank Department Assessments

Assessments for state chartered banks in Arkansas are due semi-annually based upon total assets shown in the bank's Report of Condition for the periods ending June 30 and December 31 of each year. These assessments are based upon the last six months of operation of the institution and, as such, are paid in arrears. The correct accounting treatment for this activity would be to accrue this expense with an offsetting liability entry over the six-month period in which the assessments apply and then pay the assessment when billed. It is incorrect to book payment of Bank Department assessments as a prepaid asset and amortize this expense over the six-month period following payment. Assessments booked in this manner should be accorded a loss classification and promptly charged off.

95-1 – Mortgage Banking Activities

MORTGAGE BANKING OVERVIEW

Mortgage banking activities include loan origination, loan production, mortgage servicing, secondary marketing, and other areas such as mortgage banking management, accounting, and reporting. The areas evaluated during an examination should be determined on a case-by-case basis depending upon the size of a particular company and the business activities in which it engages.

Loan origination is the retail operation in which loans are made directly to the public. The loans are processed, underwritten, and closed. These mortgages become part of the "mortgages held for resale" account where they will remain for the two to three month period necessary to complete the recording of the loan documents and to find a permanent investor to purchase the loans. The mortgage banker obtains purchase commitments from permanent investors and submits completed loan documentation packages to the investors for their approvals in satisfaction of the commitments. The mortgage banker maintains a relationship with a variety of permanent investors to whom the originated mortgages are sold.

Loan production is the function in which the mortgage company acts as a wholesaler and purchases loans in bulk or individually from other mortgage bankers, brokers, and bankers. These loans are purchased with the intent to pool the loans and resell in the secondary market. The mortgage company may then pool loans and sell to private or public investors with servicing rights retained or released. Generally servicing is retained in order to generate an ongoing income stream. During the production process, loans may be warehoused. Loans are retained in an inventory either pending commitment to a pool or to speculate on interest rates.

Mortgage servicing is performing the required duties of a mortgage seller such as collecting and remitting payments, managing the tax and insurance escrow accounts, inspecting the properties when required, pursuing delinquent borrowers, foreclosing on the mortgages when necessary, and providing accounting support. Servicing may be done by the lender or by a company acting for the lender. Due to economies of scale, the servicing portfolio must be sizable for the company to be profitable.

MORTGAGE COMPANY MANAGEMENT

Evaluation of management will entail a review of the organizational structure, board supervision, management oversight, management and board reporting, and the adequacy of management control systems. The organizational structure should be reviewed to determine, on a legal entity basis, the relationship between the mortgage banking company, the bank holding company, and any other bank or nonbank subsidiaries. Supervisory oversight is generally provided through the mortgage banking company's board, which may consist of mortgage banking company executives, bank holding company executives, and outside representatives. The examiner should determine whether a separate board exists, its membership and qualifications. Minutes should be reviewed to determine whether directors are fulfilling their fiduciary responsibilities. Directors' duties include: 1) selecting and retaining a competent executive management team; 2) establishing, with management, the company's short and long-term objectives, and adopting operating policies to achieve those objectives in a safe and sound manner; 3) monitoring operations to ensure they are controlled adequately and are in compliance with laws and policies; 4) overseeing the mortgage banking company's business performance; and 5) ensuring that the company meets the community's residential mortgage credit needs. Board reports should include default rates, new loans, liquidity levels, capital needs, policy exceptions, past dues, geographic concentrations, departmental profit and loss statements, and foreclosure rates.

Management should be evaluated in terms of technical competence, leadership skills, administrative capabilities, and knowledge of relevant State and Federal laws and regulations. Without adequate management oversight, excessive errors can occur, fraud or violations of law may go undetected, and financial information may be reported incorrectly. Management should also be evaluated on its ability to plan effectively. Effective planning entails the annual approval of an operating budget and the development of a long-term business plan which helps management anticipate changes in the internal and external environment and respond to changing circumstances. Without appropriate planning, the company can only react to external events and market forces. Compensation of management should also be examined. Compensation based on volume of production may increase risk, conflicts of interest, and an absence of independence.

Management controls consist of internal audit, external audit, quality control, insurance coverage, fraud detection procedures and related employee training programs. The internal audit function is responsible for detecting irregularities, determining compliance with applicable laws and regulations, and appraising the soundness and adequacy of accounting, operating and administrative control systems. The auditor must be independent and should report directly to the board or a designated committee. Small financial institutions may rely solely on their external auditor to perform these functions. Examiners should review the most recent external audit report and note any significant concerns or weaknesses in the company's internal control structure. Management's response to the audit should also be reviewed.

Quality Control services can be provided internally by an independent party or externally. In a small organization there may be little separation between the person underwriting the loan and the individual reviewing it. Quality Control reviews are necessary to test the quality of loans produced and serviced for investors. Investors such as GNMA, FHLMC, and FNMA issue very specific guidelines that must be met with respect to the scope and frequency of such reviews. At a minimum, these investors require that the servicer/seller sample at least ten percent of all closed loans each month for accuracy, completeness, and adherence to agency underwriting standards. The Quality Control person basically re-underwrites the loan, verifies deposits and employment, recomputes the APR, interest rate, loan to value, debt to equity and so forth. The Quality Control function should serve as an early warning system which alerts management to situations which may jeopardize the financial strength, image, or origination and sale capacity of the company. Quality Control should not substitute work performed by the internal audit and loan review functions. Insurance programs should be reviewed to determine whether coverage adequately protects the company and its affiliate against exposure to undue financial risk. The board should review and approve insurance policies at least annually. A letter should also be obtained from the mortgage company's attorney to determine if any pending litigation could cause losses to the bank and or the mortgage company.

MORTGAGE RELATED AGENCIES

Loans are categorized as either government or conventional loans. Government loans generally carry a below-market interest rate and are either insured by the Federal Housing Administration (FHA) or guaranteed by the Veterans Administration (VA). To be insured or guaranteed, a loan must meet agency standards regarding the size, interest rate, and terms. The lender must obtain a certificate of insurance or guarantee in order to qualify a loan for inclusion in a security.

Loans which are not FHA-insured or VA-guaranteed are referred to as conventional loans. Conventional loans are generally originated for larger loan amounts and can be offered with a fixed or variable interest rate. These loans typically require higher down payments and bear market interest rates. Lenders often require borrowers to obtain mortgage insurance coverage in high-ratio loans (generally, any loan with a loan-to-value ratio above 80 percent). In the primary market, private mortgage insurance (PMI) insurers provide coverage for the top 20 to 25 percent of a mortgage loan.

There are three major organizations involved with the facilitation of mortgage loans in both the primary and secondary mortgage markets: Federal National Mortgage Association (FNMA), Government National Mortgage Association (Ginnie Mae or GNMA), and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The extent of credit risk depends upon the secondary market program under which the loan is originated. GNMA pass-through securities, which are issued by the lender, are backed by pools of FHA-insured or VA-guaranteed mortgages and are fully-guaranteed by the U.S. Government. Pass-through securities provide for monthly installments of interest at the stated certificate rate plus scheduled principal amortization on specific dates, despite the delinquency status of the underlying loans, as well as any prepayments and additional principal reduction. The issuer collects the mortgage payments and after retaining servicing fees, remits monthly payments to the certificate holders. This agency is under general policy direction of HUD.

FNMA operates a secondary market facility for FHA, VA, and conventional loan products which provides a degree of liquidity to holders of mortgage investments. FNMA will purchase FHA approved mortgages from qualified sellers through an auction format, using competitive and noncompetitive bidding procedures, and through convertible standby purchase commitments. These FNMA purchases enable originators to adjust their mortgage inventory levels periodically and maintain their origination capabilities. FNMA will also sell mortgages to qualified buyers which allows the purchasers to meet investor commitments by making up mortgage inventory shortages. The FNMA purchases and sales o