Office of Thrift Supervision Page 1

Office of Thrift Supervision June 28, 1999

Department of the Treasury

Regulatory Bulletin

RB 32-13

Handbook: Thrift Activities

Subject: Various Sections

Thrift Activities Regulatory Handbook Update

Summary: This bulletin provides updates for the following Thrift Activities Regulatory Handbook sections: 045, Regulatory Action Data System; 219, Leasing Activities; and 230, Equity

Investments. Please replace the existing handbook sections with the enclosed revised sections.

We provide a summary of changes for each section below.

For Further Information Contact: Your Office of Thrift Supervision (OTS) Regional Office or

the Supervision Policy Division of the OTS, Washington, DC. You may access this bulletin at our

web site: www.ots.treas.gov. If you wish to purchase a handbook and a subscription to the updates, please contact the OTS Order Department at (301) 645-6264.

Regulatory Bulletin 32-13

SUMMARY OF CHANGES

OTS is issuing updates to the following Thrift Activities Handbook Sections. We provide a summary of all substantive changes to the Handbook Sections in the listing below. These handbook

sections are in plain language to comply with the President’s June 1, 1998, memorandum “Plain

Language in Government Writing.”

045 Regulatory Action Data System (RAD)

This section reflects changes to the RAD system. It specifically addresses problem areas

involving improper coding of actions, lack of coordination between supervision and enforcement, and lack of timely updates of data.

Introduction: Deletes outdated reference to Supervisory Action Control System

(SACS).

Accuracy and Timeliness: Renames section formerly titled Overview to change emphasis. Deletes reference to reports discontinued with implementation of the Thrift Information Management (TIM) system. Inserts reference to the RAD data used to prepare congressionally mandated reports on enforcement activity. Emphasizes the need for timely

data entry to facilitate accurate monthly reporting. Adds procedures to review RAD reports and to update records during examinations and monitoring. Addresses the types of

action closings.
Regulatory Bulletin 32-13

Page 2 Office of Thrift Supervision

NATS Interface: Removes as inappropriate detail.

Closing Codes: New section.

Enforcement Action Codes: Updates list. Adds three action types: F03D Notice of Prohibition, S04 Mortgage Derivative Product/Swap Restriction, and S06 Growth Restriction. Directs staff to include Safety and Soundness Determination, Notification, and Requests with S02 Supervisory Directives.

Reason Codes: Deletes lengthy descriptions of reasons and incorporates cross reference

to the RAD user guide. Updates list of reason codes.

Actions Against Others (Not Thrifts): Renames section formerly titled Actions Against

Individuals to correct a common misunderstanding. Includes discussion of need for regional staff to monitor open actions coded by inactive thrift docket numbers.

Actions Involving Holding Companies: Incorporates new procedures requiring actions

against holding companies to be coded under holding company docket numbers.

Amended or Initial Actions: Renames section formerly titled Active/Inactive Actions

and provides the reason for the change.

Civil Money Penalties and Restitutions: New paragraph clarifies that regional staff

must report payments to the OTS Controller's staff for posting to RAD. Directs regional

staff to close zero balance actions or explain why they are open.

219 Leasing

We reorganized this section to improve the presentation of information.

Introduction: Includes a definition of general leasing.

Finance Leasing: Reorganizes the discussion on the requirements of a finance lease.

Underwriting and Portfolio Maintenance Considerations: New section.

Servicers: New section.

Documentation: New section.

Lending Limitations: New section.

Leveraged Leases: Clarifies the definition of leveraged lease. Provides an example of a

leveraged lease.
Regulatory Bulletin 32-13

Office of Thrift Supervision Page 3

Consumer Leasing: New section relating to new disclosure laws for consumer leases.

Strategies to Mitigate Risks Associated with Leasing: New section.

Accounting Considerations: Includes definitions of capital lease, sales type of lease, and

direct financing lease. Also includes a brief discussion of sale/leaseback transactions.

References: Revises the 12 CFR references.

Program: Adds a new bullet to No. 11 to determine whether the leasing operation rejected any leases.

General Questionnaire: Adds new questions 3, 4, 5, 7, 8, 9, 13, 16, 17, 18, 19, and 22

through 28.

230 Equity Investments

Reorganizes the Section by type of equity investment and adds detail on supervisory considerations and regulatory requirements. Revises text to reflect provisions in the OTS Subsidiary and Equity Investment Rule, effective January 1, 1997, and other regulatory

changes. Supplements guidance on real estate equity investments with information contained in former Handbook Section 253, Real Estate Held for Investment.

Adds discussion of thrifts' pass-through investment authority codified at 12 CFR § 560.32,

permissible community development-related real estate investments authorized in §

5(c)(3)(A) of the HOLA and de minimis investment authority codified at 12 CFR §

560.36. Updates discussion of capital and OTS reporting standards and replaces detail

with cross-references to appropriate Handbook Sections and OTS issuances.

Incorporates references to revised accounting procedures for thrifts' securities that are

subject to standards in SFAS No. 115. Removes references to obsolete grandfathering/divestiture regulatory provisions. Deletes Appendix A, Service Corporation Investment Limitation. See Handbook Section 730, Subordinate Organizations, for this information.

—Scott M. Albinson

Managing Director, Supervision
CHAPTER: Administration

SECTION: Regulatory Action Data System Section 045

INTRODUCTION

Office of Thrift Supervision June 1999 Regulatory Handbook 045.1

This Handbook Section provides guidance to you

as the examiner or other supervision staff assigned

to work with enforcement actions or the Regulatory Action Data (RAD) system. RAD is the

automated record of OTS enforcement activities

initiated against institutions and individuals or

other entities. It is the source of various internal

and external reports on enforcement actions. You

must record certain enforcement related information in the RAD system to allow the following actions to occur:

• Regional staff to actively and effectively manage caseloads and fulfill management reporting

requirements.

• Washington staff to monitor selected cases and

effectively perform oversight functions.

• The Enforcement division of the Office of Chief

Counsel to prepare accurate enforcement activity reports, including monthly reports to the

public.

• The Press Relations division of the Office of

External Affairs to prepare accurate enforcement activity press releases.

• Applications staff to identify actions against

individuals or companies with applications currently under review.

• Other OTS staff members to prepare or review

reports on enforcement actions as needed.

The RAD System User Guidelines provides detailed instructions for use of the RAD system.

Regulatory action data collected in the system includes significant informal enforcement actions

and all formal enforcement actions.

Accuracy and Timeliness

Accurate and timely entry of enforcement action

data in the RAD System is critical to the integrity

of congressionally mandated monthly reporting of

enforcement activity and to OTS monitoring and

administration of such activity. Supervision and

Enforcement staff must cooperate in reviewing

monthly activity reports to ascertain that RAD

data is up to date at each month end. The Thrift

Information Monitoring System (TIM) provides a

variety of reporting options to monitor and test

RAD data.

Opening an Action

When OTS takes an enforcement action, you must

enter the action into the RAD system and include

the following information:

• Thrift or holding company docket number.

• An action code.

• Reason codes.

• Initiated date.

• Enforcement order number.

• Docket number of related entity, such as an

affiliated thrift or holding company, if applicable.

• Designate whether the action is against a thrift

or other entity.

• Comments identifying the target individual or

entity and a description of the action.

• Enter the effective date of the action once the

action takes effect.

Monitoring an Action

Examination and monitoring are a vital source of

RAD data. During full scope examinations, you

should review an Action History report (TIM EE

AH) of all open actions for the docket. During the

examination, you must check for compliance. You

should note in RAD whether the target of the
SECTION: Regulatory Action Data System SECTION 045

045.2 Regulatory Handbook June 1999 Office of Thrift Supervision

action is in compliance with the terms of the action, the date of your review, and any explanatory

comments.

Closing an Action

As the activity associated with the action concludes, enter the close code, the close date, and

concluding comments. You must enter all dates

and supporting information within five working

days of the actual event, and the information

should be up to date by month end to facilitate accurate reporting. Some actions against individuals

such as Part 513, Removal and/or Prohibition,

Cease and Desist Order, Enforcement of Orders in

U.S. District Court, or Injunctive Action, generally

are not successfully closed before the death of the

target of the action.

Close Codes

You may close actions with any of the following

five close codes in the RAD system:

• AS – successful – when we find the deficiency

or problem that it addresses resolved.

• AC – canceled – when we decide not to pursue

it.

• AT – transferred – when a change in charter

transfers responsibility for the action out of

OTS jurisdiction.

• AM – merged – when the thrift disappears due

to a merger.

• AD – opened-in-error.

Enforcement Action Codes

An enforcement action is OTS’s response to violations of law, regulation, agreement, OTS-imposed

conditions, or unsafe and unsound practices. The

RAD System User Guidelines and Thrift Activities

Regulatory Handbook Section 370, Enforcement

Actions, provide more information on enforcement

actions. Here is a list of codes for all enforcement

action types within the RAD system.

F01 Formal Investigation

F02 Capital Directive

F03A Suspension of Individuals Charged

with Felonies

F03B Immediate Suspension

F03C Part 513 Action (suspension of

practice before the OTS)

F03D Notice of Prohibition

F04 Temporary Cease and Desist Order

F05 Removal and/or Prohibition Order

F06 Cease and Desist Order

F07 Civil Money Penalty

F08 Enforcement of Orders in U.S. Court

F09 Injunctive Action

F10 Restitution

F11 PCA Directive

S02 Supervisory Directive (includes

§570.2 Determination, Notification, 

Request)

S03 Director's Resolution

S04 Mortgage Derivative Products and

Mortgage Swaps Restrictions

S06 Growth Restriction

S07 Capital Plan

S08 Capital Plan Termination Notice or

Modification Request

S10 Exempt Capital Directive

S11 Individual Minimum Capital

Requirement Directive

S12A Commitment Letter

S12B Memorandum of Understanding

S15 Capital Maintenance Agreement

S17 Supervisory Agreement

S19 Request For Voluntary Management

Changes

S20 Marketing Agreement

S21 Consent Merger Agreement

S23 Formal Enforcement Action Waiver

S99 Other Supervisory Action

Reason Codes

You must assign reason codes to identify the types

of problems or deficiencies that the action addresses. Reason codes relate actions to examination types. RAD accepts multiple reasons for one

action. The TIM system has a reporting option of

listing actions limited to one select reason code,
SECTION: Regulatory Action Data System SECTION 045

Office of Thrift Supervision June 1999 Regulatory Handbook 045.3

such as actions with a holding company reason

code.

Reason Codes:

• Asset Quality

• Capital Adequacy

• Compliance

• Criminal Action Response Under 12 USC §

1829

• Discretionary

• Dismissal

• Earnings

• EDP (Information Systems)

• Historical

• Holding Company

• Increase Capital Above Minimum Capital Requirement (IMCR)

• Liquidity

• Management

• Other

• Presumed

• Sensitivity to Market Risk

• Trust

• Y2K

You can find a more detailed description of these

codes in the RAD User Guidelines.

Actions Against Others (Not Thrifts )

OTS may initiate enforcement actions against an

institution or an individual or other entity, such as

a holding company or affiliate. You must code all

actions against any entity that is not a thrift as

against an other party and identify the party in the

comments. This includes actions against persons,

affiliates, holding companies, and subsidiaries.

Always code actions against a thrift board of directors as actions against the thrift. Always code

actions against individual directors as against others and enter a separate action for each individual.

RAD automatically labels all Part 513, Removal

or Prohibition, Suspension of Individuals Charged

with Felonies, Immediate Suspensions, and Requests for Voluntary Management Change as actions against others.

For all actions against other parties, you must

name the individual or entity in the comments. This

allows you to use a word search to locate all actions against the specific individual or entity.

Actions against other entities can remain in effect

for years after a thrift has disappeared (for example: investigations, restitutions, and civil money

penalties). These actions remain the responsibility

of supervision and enforcement staff as long as

they are open. You may list inactive docket numbers in a TIM docket file for easy retrieval of RAD

data on open actions filed under inactive docket

numbers.

Actions Involving Holding Companies

Always code actions involving holding companies

under the holding company's docket number, with

the holding company reason code, and as against

an other entity. Before 1998, RAD listed actions

involving holding companies under a subsidiary

thrift's docket number. Because holding companies

change names and their relationships with thrifts,

holding company actions coded under a thrift

docket number (before 1998) identified the holding

company by name and docket number in the comments. Therefore, you can locate all actions against

a holding company by searching for the holding

company docket number in a report of actions with

the holding company reason code.

Amended or Initial Actions

RAD automatically designates new actions as

“Initial.” When you modify an action, you must

manually designate the action as “Amended” to

provide for correct monthly public disclosure of

modifications of orders and agreements.

Civil Money Penalties and Restitution

You must report all payments on civil money penalties and restitutions to the OTS Controller. The

staff of the Controller’s office enters these transactions into RAD to maintain a correct record of

outstanding balances. When the balance reaches

zero, you should close the action with the
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045.4 Regulatory Handbook June 1999 Office of Thrift Supervision

“AS” code for Action Successful. If certain considerations require the action to remain in effect,

you should enter the reason in the comments.

REFERENCES

Office of Thrift Supervision

Regulatory Action Data System User's Guide

Regulatory Bulletin Series

RB 18 series Enforcement Policy

United State Code (12 USC)

Federal Deposit Insurance Act

§ 1818(u)(1)(C) Public Disclosure of Final Orders

and Agreements
CHAPTER: Asset Quality

SECTION: Leasing Activities Section 219

INTRODUCTION

Office of Thrift Supervision June 1999 Regulatory Handbook 219.1

A lease is a contract between the owner of a property, the lessor, and a person or company

authorized by the lease contract, the lessee, to use

the property. The lease contract specifies the lease

term, the amount and frequency of lease payments,

and who is responsible for insurance, property

maintenance and repairs. Leasing allows the lessee

to use the property without making a large cash

outlay or incurring additional debt.

There are two types of leases:

• Operating or general leases – short-term leases;

the lessor is often responsible for the maintenance of the property.

• Financing leases – also called capital leases;

longer-term leases that the lessee uses as a

means of financing his or her acquisition of a

property.

With operating leases, the lessor often leases property to several different lessees over the property’s

economic life. Examples of this type of leasing often include: leasing of computer systems and heavy

equipment.

Financing leases often cover much of the economic

life of the leased property. They are very similar to

purchase financing. Examples of a financing lease

include: an airline using a long-term lease to acquire its fleet of aircraft and ground support

equipment; and companies and consumers using

automobile leases to acquire their vehicles.

Savings associations typically structure lease contracts so that the association realizes return on the

investment from three sources:

• Contractual payments from the lessee.

• Disposition of the asset at the termination of the

lease.

• Income tax deferral benefits from depreciating

the property.

If properly managed, leasing activities may enhance

a thrift’s asset diversification and product mix, improve its ability to compete in its market, and

provide a favorable return on the investment. While

leasing can provide benefits to both the lessor and

lessee, leasing can be quite complicated and risky.

Prior to engaging in any leasing activities, the institution must determine if it has adequate staff and

capital resources to conduct such activities safely

and profitably. It must also identify, measure,

monitor, and control the risks.

In this section we discuss four topics:

• Regulatory considerations, including a discussion of investment authority and restrictions for

both general leasing and finance leasing.

• Underwriting and portfolio management considerations.

• Tax considerations, including the Internal

Revenue Service (IRS) requirements for determining if lease payments are fully deductible as

expenses.

• Accounting considerations, including a brief

discussion of the methods for recording leases.

REGULATORY CONSIDERATIONS

Federally chartered savings associations may engage in both operating leasing (referred to in OTS

regulations as general leasing) and finance leasing.

Each are allowable under different statutory lending and investment authority.

General Leasing

The Home Owners' Loan Act of 1933 (HOLA)

§1464 authorizes federal thrifts to invest up to 10

percent of their assets in tangible personal property
SECTION: Leasing Activities Section 219

219.2 Regulatory Handbook June 1999 Office of Thrift Supervision

acquired for the purpose of rental or sale. Personal

property includes items such as vehicles, manufactured homes, machinery, equipment, and

furniture. Section 560.41(d) of the regulations specifically allows general leasing activities within this

investment authority.

Within the general leasing authority, savings associations can make several different types of leases

with different purposes and duration. Service leases

(or operating leases) are a type of general lease.

These typically provide for financing and maintenance services, include an option to cancel, and

often are relatively short-term. Savings associations

commonly make service leases for computer systems and other equipment.

Businesses often prefer general leasing to financing

leasing because, in terms of structure, it is less restrictive. An institution may enhance its

profitability and product offering by providing

businesses a flexible instrument such as a general

lease. However, the lack of standard requirements

can expose the institution to substantial risk resulting from the following circumstances:

• Lack of demand for the re-inventoried property.

• Inadequate contracts.

• Unexpected depreciation in asset values.

• Asset obsolescence.

• Abuse of property by the lessee.

• A poor resale market.

• Lack of staff expertise in purchasing and disposing of leased property.

Under the general leasing authority, institutions

may grant leases for consumer or business purposes, but do not have to aggregate such leases

with other commercial or consumer loans for the

purpose of determining the institution’s compliance

with investment limits. Instead, general leases are

grouped together and limited to 10 percent of assets.

Successful general leasing requires extensive expertise. The board of directors should adopt

prudent policies and procedures in accordance with

OTS regulations and policy guidance, and management should closely monitor the institution’s

compliance with such policies. Institution personnel

should follow prudent credit underwriting practices

and have extensive knowledge of assets purchased

for leasing.

Leasing staff should also be familiar with the accounting and tax issues and be able to structure

leases to minimize risks and ensure adequate pricing to cover all costs and provide an adequate

profit. Management should also stay current with

changes in tax law, accounting standards, customer

demand, and other economic factors that may significantly affect its leasing program.

Finance Leasing

OTS may consider certain lease arrangements to be

the functional equivalent of loans. Because the

authorization for financing leases comes from

HOLA’s lending authority, federal savings associations that want to make financing leases under

such authority must structure them as the functional equivalent of loans. Institutions must

aggregate finance leases with loans for the purpose

of determining compliance with the HOLA investment limits. Finance leases are not, however,

aggregated with general leases for determining the

10 percent of assets limit.

As with general leases, institutions may make finance leases for tangible personal property such as

vehicles, airplanes, manufactured homes, machinery, equipment, and furniture. Institutions may

make a finance lease for consumer or commercial

purposes. OTS regulation 12 CFR §560.41(c)

specifies several requirements that must be met for

a lease to qualify as a financing lease. To consider

a lease the functional equivalent of a loan, the institution must structure it to meet the following

requirements:

• The lease must be a net, full pay-out lease, that

the lessee cannot cancel, notwithstanding the

possible early termination of the lease.

A “full pay-out lease” is a lease on which the

institution:
SECTION: Leasing Activities Section 219

Office of Thrift Supervision June 1999 Regulatory Handbook 219.3

 receives full payment of amounts it invests

in the leased property, plus a reasonable

return on the investment over the term of

the lease; and

 does not depend on the sale of the property

at the end of the lease term for more than

25 percent of the original cost of the property.

• Realization of the lessor's investment must primarily depend on the creditworthiness of the

lessee, not the estimated sales price (residual

value) of the leased property. “Realization of

the investment” means the institution can reasonably expect to get back its full investment in

the property, plus financing costs during the

lease term from lease payments, tax benefits,

and the sale of the property at lease end. The

estimate of the sales price of the property at

lease end must be reasonable.

• At the termination of the lease, the institution

must liquidate or re-lease the property as soon

as practical. The institution must reevaluate and

record at the lower of fair market value or book

value any property held in anticipation of releasing.

In addition to being the functional equivalent of a

loan, to qualify as a financing lease, the institution

cannot have direct or indirect involvement in the

operation of the property over the lease term and it

cannot provide any of the following services during

the lease term:

• Servicing, repair, or maintenance of the property.

• Purchasing parts or accessories, unless included

in the full pay-out requirement.

• Lending replacement or substitute property

while the leased property is serviced.

• Purchasing insurance for the lessee (except

where the lessee failed to discharge a contractual obligation to do so).

• Renewing any license, registration, or filing fee

for the property unless necessary to protect the

institution's interest as an owner or financier of

the property.

The characteristics of finance leasing eliminate

some of the risk associated with short-term, general

leases. The institution, however, is still subject to

credit risks, risks associated with estimating residual values at lease end, and the risk of

repossession. We discuss in the following section

the steps institutions should take in underwriting

and servicing leases.

Underwriting and Portfolio Maintenance

Considerations

Historically, institutions focused more on finance

leasing than on operating leases. This is due in

large part to the characteristics of finance leasing

which limit an institution's responsibility for the

leased equipment and pass such costs on to the lessee. Lease financing expanded in recent years with

the involvement of brokers/servicers who pool

leases and offer institutions shares in these pools.

Moreover, due to market demands for automobile

financing, institutions are making shorter-term

leases that often do not meet OTS or accounting

requirements for financing leases, yet allow lessees

to acquire and use the leased vehicles. Thus, institutions may need to underwrite and structure such

operating leases similar to financing leases.

Regardless of how the institution structures the

lease, the underwriting considerations the institution should apply in leasing are basic to the

administration of any credit portfolio and are just

as important in lease financing. The institution

must know the borrower (lessee). This includes

evaluating the lessees character and credit history

as evidence of their willingness to repay the lease

obligation as agreed. The institution should evaluate the lessee’s income and financial resources to

demonstrate their ability to meet the lease obligation according to the terms established. The

institution should also carefully review the collateralization and workout covenants (which are often

unique) to ensure contracts are written to reduce its

risks.
SECTION: Leasing Activities Section 219

219.4 Regulatory Handbook June 1999 Office of Thrift Supervision

The leasing staff’s ability to realistically estimate

the value of the leased property at the end of the

lease is second only to credit underwriting in importance with respect to the success of any leasing

program. Staff may obtain estimates from various

industry pricing guides, such as Kelly Blue Book

and the National Automobile Dealer’s Association

(NADA), which look at trends in used car prices

and project future retail and wholesale prices for

various vehicle makes and models. It is important

that the institution use conservative estimates based

on wholesale, rather than retail values. This is because the institution will likely sell the leased

property at wholesale to a wholesaler or retailer at

lease end.

Finally, an institution should obtain a clear title to

the leased equipment to enable its repossession and

liquidation in the event of the lessee's default.

While thrift management and examiners should be

aware of the various lease underwriting and portfolio maintenance issues (see the General

Questionnaire at the end of this Section), a few areas merit particular attention.

Documentation

Institutions must be thoroughly familiar with the

documentation evidencing the lease financing and

its operation. Lease financing documentation is

similar to the documentation for any secured financing and includes the following documents:

• A lease financing agreement evidencing the

lease obligation, including payment amounts

and the lease term.

• A security agreement that establishes the lessor's right to the leased property in event of

default.

• A financing statement filed under the Uniform

Commercial Code (UCC) that perfects the lessor's right in the property.

• An assignment from the original lessor, passing

rights under the financing arrangement to the institution (only if it purchases the lease from a

broker or invests in a pool of leases).

Management must understand the documentation

regardless of the structure of the transaction. Legal

counsel familiar with leasing and answerable to the

institution should thoroughly review the documentation. There should be clear recourse to the

collateral in the event of a default by the lessee.

Regardless of whether it is originating the financing

leases directly, or purchasing them through a third

party or in a pooled arrangement, the institution

should have control of the documentation. Not only

can the institution readily monitor the documents;

but, in certain situations, possessing the actual

lease can provide a distinct advantage in the perfection and recovery of collateral and the ability to

take control of cash flow from leases.

The board and management should have an effective working knowledge of the leasing operation,

backed up by thorough, institution- specific policies

and procedures.

Servicers

Servicers of lease pools have been known to make

arrangements to replace delinquent leases with performing leases, or to advance payments to cover

delinquent leases. Both of these situations have led

to complacency on the part of thrifts investing in

the lease pools and lack of attention to the quality

and performance of leases accepted. Regardless of

any take-out arrangements that may exist, the thrift

must be aware of the composition and performance

of its lease portfolio. This is crucial if the servicer

fails and the thrift assumes control of the pools.

Lending Limitations

Both general and financing leases are considered

loans or extensions of credit for purposes of 12

CFR §§ 560.93, 563.41, 563.42, and 563.43.

Thus, the amount of funds advanced on behalf of

the lessee/borrower, together with any other extensions of credit, must be aggregated and meet OTS’s

loans to one borrower, transactions with affiliates,

and insider lending rules.

With respect to the loans to one borrower rule, if an

institution uses its general leasing authority to lease

property it already owns, such as its previously

leased or repossessed property, the limitations of

12 CFR § 560.93 may not apply. This is because
SECTION: Leasing Activities Section 219

Office of Thrift Supervision June 1999 Regulatory Handbook 219.5

such extensions of credit are excluded from the

definition of a loan. (See the Office of the Comptroller of the Currency’s (OCC’s) definition in 12

CFR § 32.2(j)(iii).)

Loans to a third party to finance their leases, especially pools, can exhibit characteristics that result

in the credits being considered loans to the originating or brokering company, rather than loans to

the individual lessees. This can result in a violation

of the regulatory limitations for loans to one borrower.

Section 32.3(b)(10) of the OCC’s regulations (12

CFR § 560.93 applies to thrifts) sets forth criteria

that the institution must meet for OTS to treat a

loan to a leasing company as separate loans to underlying lessees. These criteria include:

• Institution evaluation of the creditworthiness of

the lessee on a lease-by-lease-basis.

• The loan to the leasing corporation is without

recourse.

• The institution has a valid security interest in

the leased equipment.

Any institution engaging in a leasing program must

be able to document how and why the lease financing conforms to the lending limitation

regulations.

The provision, by a thrift, of a lease financing or

credit line to a leasing company in no way lessens

the need to secure, understand, and retain information and analyses on the underlying lessees, as

noted above.

Leveraged Leases

Leveraged leasing is a three-party arrangement involving:

• The lessee, who leases the property and makes

lease payments, thus providing cash flow.

• The lessor, who purchases the property for the

lessee and provides some equity funding

(commonly called the equity participant).

• The lender (long-term creditor), who provides

funding for the purchase of the property.

In a leveraged lease, the lessor purchases the asset

by providing only a percentage (usually 20 to 40

percent) of the capital needed. The lender provides

the balance of the purchase price to the lessor. The

security provided to the lender includes a first lien

on the equipment and an assignment of the lease

and lease payments.

If the asset purchase price is very large, there may

be several equity owners (lessors) and debt holders.

In this case, an owner trustee may be named to hold

title to the asset and to represent the equity owners.

The lessor, as the owner, can depreciate the property for income tax purposes, based on the total

cost of the asset, not just the invested amount. The

lessor will also receive the portion of the rental

payments attributable to the difference the lessor

charges for the lease and the rate he or she pays the

lender.

For example, an airline leases an aircraft costing

$100 million for 15 years at $12.5 million each

year (representing a 9 percent lease rate). The lessor obtains a 15-year bank loan for $80 million at

an interest rate of 7.5 percent with payments of

$9.06 million. At the end of the lease, the lessor

expects to sell the aircraft for $20 million. The airline is responsible for all operating expenses,

maintenance, and insurance. If everything goes as

planned, the cash flows to the lessor will be as follows:

Year 1

Lessor’s down payment: -$20.00 million

Years 1-15

Lease income: $12.50 million

Loan payment: -$ 9.06 million

Yearly net cash flow: $ 3.44 million

Lessor’s annual depreciation expense:

$80 million / 15 years = $ 5.33 million

(This will cover the lease income and result in excess depreciation of $2.11 million that can offset

the lessor’s other income.)
SECTION: Leasing Activities Section 219

219.6 Regulatory Handbook June 1999 Office of Thrift Supervision

Year 15

Sale price at end of lease: $20 million

(The lessor receives the amount of the initial investment.)

If realized, the above cash flows result in a 35 percent return to the lessor. However, leveraging cuts

both ways. The early termination of the lease and

forced liquidation of the property can result in

equally large losses.

Leveraged lease financing provides lessors with the

ability to leverage their capital into a larger lease(s)

than they could fund with their capital alone —

hence the name “leveraged leasing.” Savings associations can participate in leveraged leases either as

the lessor or as the financing institution. They can

do so either directly or through a subsidiary. However, such activities are highly risky and the

institution must control such risks. Failure to control such risks will subject the institution to

criticism and possible supervisory action.

One of the risks of leveraged lease transactions is

their complexity, stemming from the large dollar

amounts and number of parties involved, and the

unique relationship between the parties. Legal expenses and administrative costs associated with

leveraged leasing generally limit its use to financing

for large capital investments.

Because of the complexity, institutions should have

qualified staff with a current working knowledge of

all aspects of leasing, including the risks involved,

applicable laws and regulations, and tax consequences. Moreover, when structuring leveraged

leases, institutions should consider all relevant aspects of how the leasing activities will affect the

institution, including capital requirements, estimated future cost of funds, and cash flows. The

return on the institution's investment in leveraged

leases depends largely on these factors, and even a

slight change in the variables can affect profitability.

As with financing and operating/general leases, the

residual value of the property at lease-end is a major element of the return on the investment. The

institution should carefully estimate and support

the value. Because leveraged leases generally involve the financing of very costly property,

institutions should periodically inspect properties

for condition and possible misuse to prevent rapid

deterioration of the value of the property before the

lease term expires. Institutions should also monitor

properties for obsolescence or market value decline, to assist in structuring profitable lease

programs in the future.

Institutions should carefully scrutinize the financial

capacity of all parties involved in the lease. Should

the lessee default, the lessor will have to repay the

loan if they want to recapture at least a part of their

investment. Thus, an institution should not enter

into a leveraged lease as the lender unless the lessor

has the capacity to maintain the lease for a time in

the event the lessee defaults.

Consumer Leasing

A large part of the leasing done by thrifts is consumer leasing of vehicles and other personal

property. This type of leasing creates a homogeneous portfolio of leases that, if underwritten

properly, may involve less credit risk than business

use leasing. Underwriting consumer leases is very

similar to underwriting consumer loans, with three

major exceptions:

• The lease terms are often shorter and may not

provide for the full pay-out of the acquisition

cost of the leased property.

• Down payments (capital reduction costs) and

monthly leases payments are typically lower

than loan purchase payments, so there is no equity build-up.

• Profitability is dependent on the lessor receiving

proceeds from the sale of the leased property.

Actual proceeds may be much less than proceeds estimated at the beginning of the lease.

Originating leases to consumers requires adherence

to the Federal Reserve Board's Regulation M (12

CFR Part 213). This regulation requires comprehensive disclosures for leases of personal property

with a contractual obligation of up to $25,000 and

a term of more than four months. These may be

general or financing leases. Regulation M provides

a model disclosure form. Thrifts engaging in con-
SECTION: Leasing Activities Section 219

Office of Thrift Supervision June 1999 Regulatory Handbook 219.7

sumer leasing must thoroughly understand and

comply with Regulation M.

Strategies to Mitigate Risks Associated with

Leasing

As mentioned previously, leasing activities may

involve considerable risks. Such risks may stem

from the failure of the lessee to meet the terms of

the lease contract or the inability of the institution

to accurately estimate cash flows from the lease,

such as tax advantages or the residual value of the

property at lease-end.

With each lease transaction, the institution should

compute the internal rate of return, considering

lease payments, estimated tax benefits, the estimated residual value at expiration of the lease, and

the cost of funds. (The Thrift Activities Regulatory

Handbook Section 440, Present Value Analysis,

discusses lease calculations.) Any change in variables during the lease term will affect the rate of

return.

Each lease agreement should clearly state the type

of lease structure and identify the specific characteristics that qualify the lease for the designated tax

and accounting classifications.

To effectively minimize these risks, the leasing department should exhibit several key characteristics:

• Comprehensive and prudent written policies,

procedures, and internal controls.

• Expert knowledge of the assets acquired for

leasing (specifically in the areas of market demand, purchasing, disposition, market value

depreciation over time, and appraisal techniques).

• Expertise and experience with structuring lease

contracts and perfecting security interests in the

leased property.

• Procedures for the periodic reviews of policies

to determine consistency with changes in the tax

laws, accounting requirements, and market conditions.

TAX CONSIDERATIONS

Tax benefits to the lessee generally stem from the

lessor’s ability to depreciate the property over a

shorter time than the property’s economic life. This

results in a tax deferral, not the elimination of tax

liability. The deferred taxes must be paid when the

property is either sold or taken out of service.

Therefore, such benefits are more pronounced with

long-term leases than with short-term leases.

The lessee also has tax benefits. The full amount of

the annual lease payments as well as the cost of

operating the property is a deductible business expense for income tax purposes if the Internal

Revenue Service (IRS) agrees that a particular

contract is a genuine lease and not simply an installment sale called a lease. This makes it

important that a lease contract be written in a form

acceptable to the IRS. The IRS considers the inclusion of the following components to meet the

requirements of a bona fide lease transaction:

• The term should be less than the useful life of

the property; otherwise, the lease may be regarded as a form of sale.

• The rent should provide a reasonable return to

the lessor.

• The renewal option should be bona fide. This

requirement may be met by giving the lessee the

first option to meet an equal bona fide outside

offer.

• Any purchase option should not be less than fair

market value.

IRS requirements may change periodically; therefore, the institution should continually monitor tax

law changes.

ACCOUNTING CONSIDERATIONS

Generally Accepted Accounting Principles (GAAP)

regarding lease accounting are very extensive. The

institution should refer to GAAP specifically for a

detailed understanding of the accounting and reporting requirements of lease transactions. SFAS
SECTION: Leasing Activities Section 219

219.8 Regulatory Handbook June 1999 Office of Thrift Supervision

No. 13 discusses the accounting for capital1leases

and operating leases from the perspective of the

lessor and the lessee.

You should ascertain that the institution is using

proper accounting treatment and appropriately recording lease transactions. In certain cases,

institutions have accepted leases that purport to be

straight financing leases of new equipment but, in

actuality, are the sale and leaseback by the lessee of

the lessees current machinery and/or equipment.

You should carefully review sale/leaseback transactions. Often, failing businesses use

sale/leasebacks to generate cash flow.

Lease classification is generally dependent upon six

criteria for lessors and four criteria for lessees. If

any one of the following four common criteria for

both lessors and lessees are met, the lease may

qualify as a capital lease:

• The lease transfers ownership of the property to

the lessee by the end of the lease term.

• The lease contains a bargain purchase option.

• The lease is equal to 75 percent or more of the

estimated life of the leased property. This criterion is not used for purposes of classifying the

lease if the beginning of the lease term falls

within the last 25 percent of the total estimated

economic life of the leased property, including

earlier years of use.

• The present value at the beginning of the minimum lease term of the lease payments equals 90

percent or more of the fair value of the leased

property.

Lessors must meet two additional criteria:

• The collectibility of the minimum lease payments is reasonably predictable.

• No important uncertainties surround the amount

of unreimbursable costs yet to be incurred by

the lessor under the lease.

 

1

 The accounting definition of capital leases is very

Lessor

If, at inception, a lease meets any one of the first

four criteria and both of the last two criteria, the

lessor typically classifies the lease as a direct financing lease. Thus, the lessor records as assets the

present value of total lease receivables (aggregate

rentals due under the lease) and the residual value.

The lessor records the excess of these combined

assets over the actual cost of the leased asset as

unearned income. Subsequently the lessor amortizes the unearned income over the life of the lease

on the level yield basis. Lease rental payments received reduce the recorded asset.

If none of the first four criteria are met or at least

one of the last two criteria is not met, the lessor

records the lease as an operating lease. Thus, the

lessor records the cost of the leased asset on the

balance sheet and depreciates the asset using the

lessor's normal depreciation policy. Lease payments received are recorded in income as rent over

the lease term.

Lessee

If, at inception, a lease meets any one of the first

four criteria, the lessee classifies the lease as a

capital lease. The lessee records an asset and a liability equal to the present value of the minimum

lease payments exclusive of any executionary costs

the lessor will pay.

If none of the first four criteria is met, the lessee

records the lease as an operating lease. The lessee

records the lease payment as accrued expense on a

regular basis.

REFERENCES

United States Code (12 USC)

Home Owners' Loan Act of 1933

§1464 (c)(2)(C) Investments in Personal

 Property

§1464 (c)(2)(D) Consumer Loans and

 Certain Securities

 

similar to OTS’s financing leases.
SECTION: Leasing Activities Section 219

Office of Thrift Supervision June 1999 Regulatory Handbook 219.9

Code of Federal Regulations (12 CFR)

§559.4 What activities are pre-approved

for service corporations?

§560.30 General Lending and Investment

 Powers

§560.41 Leasing

§560.93 Lending Limitations

§563.41 Transactions with Affiliates (TWA)

§563.42 Additional TWA Standards

§563.43 Loans to Insiders

Financial Accounting Standards Board, Statement of Financial Accounting

Standards

No. 13 Accounting for Leases

No. 27 Accounting for Sales with Leasebacks

No. 98 Accounting for Leases
Leasing Activities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision June 1999 Regulatory Handbook 219P.1

Examination Objectives

To determine if the policies, procedures, and controls regarding leasing activities adequately ensure safety and

soundness, profitability, and compliance with laws, regulations, and established guidelines.

To determine the quality of the assets through an analysis of underwriting and lease production, including: creditworthiness, collectability, collateral sufficiency, lease terms and other variables.

To determine if the institution employs qualified officers and employees that can adequately perform their duties and responsibilities associated with leasing.

To determine if financial records and management reports provide accurate and necessary performance and

asset quality information to management and the board of directors.

To determine if any contingent liabilities exist with regard to the institution’s leasing activities and whether

they affect its overall soundness.

To initiate corrective action when deficiencies exist that could affect safety and soundness, or when you note

violations of laws or regulations.

Examination Procedures Wkp.Ref.

Level I

1. Review scoping materials related to leasing, including the following reports and schedules:

• Lease trial balance listings.

• Delinquent leases.

• Classified leases.

• An itemization of repossessed and returned leased property.

• A report of the disposition of repossessed and returned property.

• Leases in which payments are not collected in accordance with the terms of the

lease.

• Leases whose terms have been modified by reduction on interest rate or principal,

or by other restructuring of repayment terms.

• Leases sold since preceding examination.
 Leasing Activities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

219P.2 Regulatory Handbook June 1999 Office of Thrift Supervision

 Wkp.Ref.

• Lease commitments and contingent liabilities.

• Extensions of lease credit to affiliated persons.

• Miscellaneous lease debit and credit suspense accounts.

• The current interest rate structure.

• The minutes of appropriate committees.

• Reports on leasing activities furnished to the board of directors.

• The current status of leases classified during the previous examination.

• A listing of rebooked charged-off leases.

• The nature and extent of leases serviced for others.

• Month-end lease account balance and total delinquency since the previous examination.

2. Evaluate the institution's policies and procedures through review of policy statements,

underwriting guidelines and manuals, interviews with management, and review or recaps

of board minutes.

• Determine if accounting and tax issues are adequately addressed in policies and

procedures.

• Determine whether objectives and related policies are reviewed periodically and any

changes communicated to the appropriate personnel.

3. Review management reports, especially exception reports, related to this area. Assess

the adequacy and accuracy of the reported information.
Leasing Activities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision June 1999 Regulatory Handbook 219P.3

 Wkp.Ref.

4. Review the qualifications, capabilities, and expertise of leasing officers in relation to

their responsibilities.

5. Determine whether the institution corrected deficiencies mentioned in prior examination

reports.

6. Complete the General Questionnaire.

7. Review the Level II procedures and perform those necessary to test, support, and present conclusions derived from performance of Level I procedures.

Level II

8. Review the reconcilement of the subsidiary ledgers for leasing to the general ledger. Investigate any large reconciling items.

9. Select leases for review using an appropriate sampling technique. (For details on sampling, refer to Section 209 of the Thrift Activities Regulatory Handbook.) Include all of

the following in your review:

• A sample of leases per Handbook Section 209.

• Lease accounts of employees, officers, directors, major stockholders, and their interests.

• Lease accounts of officers and directors of other institutions.

• Lease accounts related to significant borrowers.
 Leasing Activities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

219P.4 Regulatory Handbook June 1999 Office of Thrift Supervision

 Wkp.Ref.

• Lease accounts in excess of their credit limits.

10. Analyze a sample of credit files for lessees for credit quality (earnings, indebtedness,

credit history, collateral, loan modifications) and compliance with the credit policy.

11. Review lease repossessions and charge-offs.

• Determine if the institution performs charge-offs in accordance with its policies and

regulatory requirements. Review the current past-due account report and test for

accuracy. Review and discuss with management individual accounts not

charged-off in accordance with regulatory requirements.

• Determine if collection practices are proper and conform to policy. Review written

collection procedures and test check customer contact records.

• Review listings of charged-off leases and recoveries and prepare or update the

carry forward work paper showing charge-offs and recoveries as a percentage of

outstanding leases.

• Determine and discuss with management causes of any adverse trends or significant fluctuations. Excessive lease losses are the product of weak lending and

collection policies and provide a good indication of the soundness of the lease department's operations.

• Determine if the leasing operation has rejected leases offered by brokers or third

parties, or if the leasing operation accepts into portfolio all leases offered. An absence of rejected leases can be an indicator of weak credit policies and procedures.

12. Ensure that the examination meets the Objectives of this Handbook Section. State your

findings and conclusions, and appropriate recommendations for any necessary corrective

measures, on the appropriate work papers and report pages.
Leasing Activities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision June 1999 Regulatory Handbook 219P.5

 Wkp.Ref.

Level III

13. Review any leveraged leases the institution has undertaken as lessor lender. Determine if

the institution structured the lease in a safe and sound manner and that it complies with

all OTS’s loans to one borrower, transaction with affiliates, and insider lending rules.

14. Determine if the institution has adequate inventory controls over property held for leasing.

15. Inspect large lease properties for which the leases are past due.
Leasing Activities

Questionnaire

Exam Date: _______________

Prepared By: ______________

Reviewed By: ______________

Docket #: _________________

TA 219 (6/99) 219 Q/Page 1 of 2

Yes No

General Questionnaire

1. Does the institution have objectives, policies,

procedures, and controls specific to the

leasing activity and are they adequate regarding:

• Accounting designation of financial and

operating leases?....................................

• Credit and accounting analysis?..............

• Tax considerations for both lessees and

lessors?...................................................

• Collection and lease service record

keeping? .................................................

2. Does the institution's board of directors review and approve these objectives, policies,

procedures, and controls?............................

3. Has the board set limits for the leasing activity? ...............................................................

4. Does the board receive periodic reports on

the performance and quality of the leasing

portfolio? ......................................................

5. Has counsel for the thrift, with expertise in

leasing, reviewed the leasing activity? (In

particular, counsel should closely scrutinize

security agreements/ assignments, participation agreements and servicing contracts.)

6. Does the institution have adequate expertise

in the individual leasing areas?.....................

7. Does the institution refrain from undue reliance upon broker/seller/servicers to answer

questions on lease pools?............................

8. Are seller/servicers making payments on

lease pools, potentially masking problems?.

9. Does the institution retain written documentation of initial underwriting and ongoing

analysis? ......................................................

Yes No

10. Are lease financing and general leasing

identified separately and distinctly, with accounting and tax criteria clearly identified?...

11. Does the institution have an adequate procedure for financial analysis? (The institution

should obtain financial information on lessees and lease servicers; and require

regular updates as warranted, particularly for

commercial accounts.).................................

12. Does the institution have proper controls for

the maintenance of leasing records? ...........

13. Does the institution retain on thrift premises

or under the thrift’s control lease files, including the original lease and security

agreements?................................................

14. Does the institution issue lease commitments in writing? ..........................................

15. Does management monitor and report to the

board of directors delinquent lease payments? .........................................................

16. Does the institution take appropriate collection action on delinquent lease accounts?....

17. Does the institution place delinquent lease

accounts in non-accrual status as required in

the TFR instructions and GAAP? .................

18. Does the institution appropriately note,

value, book, and control repossessions?......

19. Do qualified thrift personnel complete valuation reports on repossessed property from

an independent party or source?..................

20. Does the institution ensure the control, inspection, maintenance, and insurance of

lease property? ............................................

21. Does the institution use reliable techniques

to estimate the value of the property at the

end of the lease term? Does the institution

adequately support the estimate? ................
Leasing Activities

Questionnaire

Exam Date: _______________

Prepared By: ______________

Reviewed By: ______________

Docket #: _________________

TA 219 (6/99) 219 Q/Page 2 of 2

Yes No

22. Did the thrift determine the true rate of return

on the lease portfolio? Does that return provide adequate risk compensation?

23. Does the institution obtain and review

audited financial statements on seller/ servicers of lease pools? ..................................

24. Does the thrift aggregate leases with the

institution’s other extensions of credit and

limit them in accordance with loans-to-oneborrower rule § 560.93? Do the leases constitute an unacceptable credit

concentration? ............................................

25. Did the institution properly assess the Allowance for Loan and Lease Losses for the

lease portfolio?............................................

Yes No

26. Are lending or other transactions with principals of a lease broker/servicer

appropriate?................................................

27. Are there indications that the lease broker

has cash flow problems such as an altered

business strategy or lease sales to individual investors?..............................................

28. Is there a high number of out-of-area leases

in the portfolio, rendering collections difficult

and expensive?...........................................

Comments
CHAPTER: Asset Quality

SECTION: Equity Investments Section 230

INTRODUCTION

Office of Thrift Supervision June 1999 Regulatory Handbook 230.1

The term equity investment covers a wide range of

investments. Many of these investments are not

permissible for federal savings associations because

of their inherent risk. Equity investments are riskier

than loans and other permissible investments because all creditors are paid in full before investors’

claims are paid. The return on equity often requires

a sale, rather than amortization from known cash

flow streams. Because of the greater risk of loss,

savings associations should be extraordinarily cautious when making equity investments. Sound

internal policies and procedures and effective diversification of equity investments by individual

savings associations is extremely important to limit

overall portfolio risk. Certain equity investments

will not require the same level of review that is necessary for equity investments that possess higher

risk factors. An equity investment of moderate risk

has the following characteristics:

• The savings association is a passive investor in

an entity engaged in permissible savings association activities.

• The savings association’s liability does not exceed its investment.

The Home Owners’ Loan Act (HOLA) and Office

of Thrift Supervision (OTS) regulations substantially limit a federal savings association's direct

equity investment authority. Permissible equity investments nevertheless can present substantial risk

to the savings association. Your review should reflect the level of risk involved. You should consider

the following items when determining the scope of

your review:

• The adequacy of oversight by the board of directors.

• Compliance with sound internal policies and

procedures for the acquisition, management, and

monitoring of equity investments.

• Composition of the equity investment portfolio.

• Regulatory capital levels.

• Equity investment/loan concentrations.

This Section provides an overview of the following

areas:

• Equity investments authorized for federal savings associations.

• Types of equity investments and applicable

limitations.

• Potential safety and soundness concerns associated with these investments.

PERMISSIBLE EQUITY INVESTMENTS

Unless stated otherwise, this Section specifically

refers to a federal savings association's authority to

make equity investments. State-chartered savings

associations must consult applicable state laws and

regulations to determine whether similar authority

exists. The Federal Deposit Insurance Act (FDIA)

at 12 USC §1831e(c) limits state savings associations' equity investment authority to the type and

amount permissible for federal savings associations.

Federal law pre-empts state laws permitting extensive equity investments by state-chartered savings

associations. In the event that states have equity

investment regulations that are more restrictive than

OTS regulations, state savings associations must

adhere to the more stringent standard.

HOLA §5(c)(1) contains a list of investments,

which include securities of certain government

sponsored entities, that are permissible for federal

savings associations.

This list substantially limits a federal savings association's authority to purchase an equity
SECTION: Equity Investments Section 230

230.2 Regulatory Handbook June 1999 Office of Thrift Supervision

interest (for example, common or preferred stock)

in a corporation that is not a subordinate organization. As discussed further below, the association

can make certain de minimis community development-related investments as well as pass-through

investments. The association can also acquire personal property for sale or lease and make certain

real estate investments.

Notwithstanding the limited scope of allowable

equity investments, such investments could present

substantial risk to the investing savings association. In addition to establishing the association’s

authority to make the investment, consider the following:

• Adequacy of internal policies, procedures, and

controls for the acquisition, management, and

monitoring of equity investments.

• Accuracy of the accounting treatment for, and

valuation of, equity investments.

• Compliance with OTS’s capital standards,

savings association financial reporting requirements, and asset classification policy.

• Whether a significant concentration of assets

exists, including equity investments in, and

loans to, related entities. For example, limited

partnerships that share a common third-party

investor or joint ventures that derive cash flow

from a single project.

Congress grandfathered some equity investments

of federal savings associations chartered before

October 15, 1982, or that converted from a mutual

savings bank charter before August 9, 1989. See

12 USC §1464(i)(4). Federal savings associations,

however, must file notice with the Federal Deposit

Insurance Corporation (FDIC) regarding grandfathered equity investments. Notwithstanding

available grandfathered status under §1464(i)(4),

§1828(m)(3) of the FDIA may prohibit or limit the

grandfathered authority.

A federal savings association may have the FDIC’s

approval consistent with 12 CFR §303.13(d) to

retain an impermissible investment that a former

state-chartered savings association held on August

8, 1989. In such cases, the savings association

should provide access to records documenting such

approval or an acceptable divestiture plan.

TYPES OF EQUITY INVESTMENTS

Equity Securities

For OTS regulatory purposes, equity securities can

include corporate stock, investments in joint ventures, profit-sharing arrangements and loans

having profit-sharing features. Federal thrifts may

invest in the following types of equity securities

consistent with applicable statutory and regulatory

standards. (Also, see discussion of subordinate

organizations and pass-through investment authority.)

• Securities of U.S. government-sponsored corporations. (12 USC §1464(c)(1)). Federal

thrifts may invest in the securities of the following government-sponsored corporations

without investment limit:

 Federal National Mortgage Association

(Fannie Mae)

 Government National Mortgage Association (Ginnie Mae)

 Federal Home Loan Mortgage Corporation

(Freddie Mac)

 Student Loan Marketing Association

(Sallie Mae)

 Federal Home Loan Bank

Federal thrifts may also invest in Federal Agricultural Mortgage Corporation (Farmer Mac)

common stock in nominal amounts necessary to

enable them to sell agricultural loans to Farmer

Mac and participants in Farmer Mac’s secondary

market program.

• National Housing Partnership Corporations and

related partnerships and joint ventures. (12

USC §1464(c)(1)(N))

• Business development credit corporations up to

the lesser of 0.5 percent of total outstanding

loans or $250,000. (12 USC § 1464(c)(4)(A))
SECTION: Equity Investments Section 230

Office of Thrift Supervision June 1999 Regulatory Handbook 230.3

• Shares of an open-ended management investment company that is registered with the SEC

under the Investment Company Act of 1940.

(12 USC §1464(c)(4)(D)). Note: The portfolio of the open-ended investment company must

consist only of investments that a federal savings association by law or regulation, without

limitation as to percentage of assets, may invest

in, sell, redeem, hold, or otherwise deal in.

• Shares in minority enterprise small business

investment companies established for the purpose of aiding the members of a Federal Home

Loan Bank. The thrift’s investment must not

exceed one percent of its assets. (12 USC

§1464(c)(4)(D))

• Shares in bankers’ banks or their holding companies that have depository institutions or

depository institution holding companies as investors in an amount up to 10 percent of the

federal thrift’s capital stock and unimpaired

surplus. (12 USC §1464(c)(4)(E))

SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires that

the association report most equity securities at fair

value (available-for-sale), rather than at amortized

cost. Refer to the Thrift Financial Report (TFR)

Instruction manual for guidance on reporting such

investments.

For a detailed discussion of savings association

investment policies and procedures, refer to the

Investment Securities handbook section. Also,

Handbook Section 410, Financial Records and Reports, addresses accounting considerations for

determining the accuracy of savings association

financial reporting.

De Minimis Investments

Section 560.36 authorizes a federal savings association to invest in community development

investments of a type permitted for a national bank

under 12 CFR Part 24. Savings associations may

invest in such community development projects up

to the greater of one-fourth of one percent of total

capital or $100,000. Generally, these would be

investments that primarily benefit the following

groups or areas:

• Low- and moderate-income individuals.

• Low- and moderate-income areas.

• Areas targeted for redevelopment by local,

state, tribal, or federal government. This includes federal enterprise communities and

federal empowerment zones.

These investments provide or support one or more

of the following activities:

• Affordable housing, community services, or

permanent jobs for low- and moderate-income

individuals.

• Equity or debt financing for small businesses.

• Area revitalization or stabilization.

• Other activities, services, or facilities that primarily promote the public welfare.

Under § 560.36, there are no restrictions as to

control, geographic location, ownership, or organizational structure.

Given the limited investment authority, these investments should not have a significant effect on

the parent federal savings association’s financial

condition.

Personal Property Acquired for Sale or Lease

Typically, federal savings associations acquire

personal property for lease at the request of a customer wanting lease financing, usually for very

expensive items such as mainframe computers,

earth-moving equipment, and fleets of vehicles.

Handbook Section 219, Leasing Activities, further

discusses personal property acquired for sale or

lease.

Pass-Through Investments

Federal savings associations, in accordance with

§560.32, may make limited investments, on a passthrough basis, in certain preapproved entities that

hold only assets or engage in activities permissible

for federal savings associations. Pass-through investment authority enables federal savings

associations to join with others to engage in an
SECTION: Equity Investments Section 230

230.4 Regulatory Handbook June 1999 Office of Thrift Supervision

activity. Joint participation has the potential to reduce capital outlays and operating costs and

enhance profitability, or serve other bona fide

business objectives without jeopardizing safety and

soundness. A federal savings association that

meets all of the following conditions may make

pass-through investments without prior notice to

OTS:

• The federal savings association invests no more

than 15 percent of total capital in any one entity.

• The book value of the aggregate pass-through

investments does not exceed 50 percent of total

capital after making the investments.

• The investment would not give the association

direct or indirect control of the company. See

the definition of control in 12 CFR §362.2(e).

• The federal savings association's liability does

not exceed the amount of the investment.

• The company falls into one of the following

categories:

 Limited partnership. A limited partnership

classifies its members as either general or

limited partners. Under this structure, the

general partner is personally liable for the

partnership's obligations, whereas the limited partner enjoys limited liability as long

as it does not materially participate in the

business of the partnership.

 Open-end mutual fund. These are investment vehicles registered with the SEC

under the Investment Company Act of

1940. The investment company must restrict its portfolio by its investment policy.

The company's investment policy may only

change if authorized by shareholder vote.

The investment company's portfolio must

consist solely of investments that a federal

savings association can make directly.

 Closed-end investment trust. A closed-end

trust differs from an open-end fund in that

it typically has a fixed number of shares,

but is like an open-end fund in that it

trades on a stock exchange.

 Limited liability company (LLC). LLCs

are neither corporations nor partnerships

yet they combine the limited liability of a

corporation with the tax benefits of a partnership. A key advantage of the LLC is

that it provides limited liability to all of its

members and managers, regardless of their

level of participation in the entity's business activities. The members are the

owners of the LLC and may be individuals, corporations, general or limited

partnerships, LLCs, trusts estates or other

entities.

 Entity that a federal savings association

would invest in primarily to use the company's services (for example, data

processing). A federal savings association

may invest in a jointly owned corporation

established to provide services for several

users. The objective of such an investment

is the receipt of services rather than engagement in a speculative investment

through stock investment.

When making a pass-through investment, a federal

association must comply with all the statutes and

regulations that would apply if it were engaging in

the activity directly. For regulatory reporting purposes, to calculate a federal association's lending

and investment limits, the association should aggregate a proportionate share of the entity’s assets

with the assets the association holds directly.

Loans that a savings association makes to the entity are subject to the LTOB rule in the same

manner as loans by a savings association to any

third party. 

To make pass-through investments that do not

meet the standards in §560.32, a federal savings

association must provide OTS with 30 days advance notice. During the 30-day review process,

OTS may require the association to file an application to obtain written approval prior to making

the investment.

Subordinate Organizations

Part 559 of OTS regulations deals with savings

associations’ authority to establish and operate

subordinate organizations, for example, operating

subsidiaries, service corporations and their lower-
SECTION: Equity Investments Section 230

Office of Thrift Supervision June 1999 Regulatory Handbook 230.5

tier entities. For various business reasons, for example, tax considerations or efforts to limit

potential liability, a savings association may prefer

to make permissible investments through a subordinate organization in accordance with 12 CFR

Part 559. Operating subsidiaries must limit their

assets and activities to those authorized for federal

savings associations. A service corporation can

engage in additional lines of business specified in

§559.4 not otherwise allowed at the savings association level.

Handbook Section 730 contains detailed examination guidance for reviewing such investments. The

guidance addresses the following primary considerations in the review of a subordinate

organization’s operations:

• The potential effect of the subordinate organization’s operations on the parent savings

association.

• Compliance with OTS notification or, if applicable, application process.

• Compliance with applicable investment restrictions detailed in 12 CFR Part 559.

• Maintenance of separate corporate identities.

• Any indications of insider abuse.

Accounting for a savings association's investment

in a subordinate organization should follow GAAP

as set forth in Statement of Financial Accounting

Standards (SFAS) No. 94 and Accounting Principles Board (APB) Opinion No. 18. Under GAAP,

a savings association may account for investments

in subordinate organizations by one of three methods:

• Consolidation

• Equity method

• Cost method.

Accurate accounting for investments in subordinate organizations is important to ensure that the

books of the parent adequately reflect the carrying

value of the entities. See Handbook Section 430,

Appendix C, to assess whether the savings association has followed OTS savings association

financial reporting standards for investments in

majority-owned or unconsolidated subordinate organizations. OTS’s capital rule generally refers to

a majority-owned subordinate organization as a

subsidiary. (See also the TFR Instructions.)

Equity Interest in Real Estate Investments

(REI)

Real estate investments include ownership interests

in raw land, residential or commercial development

projects, or established rental properties. GAAP

rules also include in REI loans with equity characteristics. Such lending includes certain project

lending that in essence constitutes investments. An

element characteristic of an investment is that the

lender shares in profits. Although certain types of

REI may qualify as loans under §1464(c), they

remain REI for reporting purposes. However, REI

does not include interests in real estate acquired for

the savings association's own use, such as office

facilities, and other reasonable business purposes

as authorized in 12 CFR §560.77. Also, REI does

not generally include real estate owned (REO) obtained in the settlement of debts previously

contracted. The savings association should classify

as REI real estate acquired in settlement of debts,

if they intend to hold the real estate for investment

purposes or if the savings association will not dispose of the real estate within five years (or a longer

period as approved by OTS). A detailed discussion

of real estate development activities is beyond the

scope of this Section. Handbook Section 740, Real

Estate Development, however, contains guidance

on this subject. Also, Section 212, Real Estate

Mortgage Lending, Section 208, Real Estate Appraisal, Section 260, Classification of Assets, and

Section 251, Real Estate Owned and Other Repossessed Assets, provides relevant guidance.

REI Authorized in HOLA §5(c)(3)(A)

HOLA §5(c)(3)(A) limits REI investments of federal savings associations to those that are

community-development related and certain investments preapproved for service corporations.

Federal savings associations may invest up to two

percent of assets in REI to further community development pursuant to HOLA §5(c)(3)(A). Federal

savings associations must aggregate these REI in-
SECTION: Equity Investments Section 230

230.6 Regulatory Handbook June 1999 Office of Thrift Supervision

vestments with loans allowed under HOLA

§5(c)(3)(A) to determine compliance with a statutory five percent of assets limit. To be permissible

for investment, real estate must be located in areas

receiving concentrated development assistance under Title I of The Housing and Community

Development Act of 1974 (HCDA), or subject to

an OTS no-action letter. Savings associations can

make the investments in the following ways:

• Directly.

• As de minimus investments (see §560.36).

• Through investment vehicles authorized for

federal savings associations that include subordinate organizations (as defined in §559.2).

• On a pass-through basis using investments

authorized in §560.32 (for example, limited

partnerships).

Indirect investments in real estate projects are

subject to the same investment limits that apply to

any direct REI. Include indirect investments in real

estate projects in determining compliance with the

overall five percent of assets statutory investment

or loan limit. When making real estate investments

through an entity, the savings association should

obtain a written commitment that the entity will

comply with applicable OTS standards for such

investments, and routinely monitor compliance.

A common investment vehicle for making a community-development related REI is an investment

in a Low Income Housing Tax Credit (LIHTC)

limited partnership. In making such investments,

savings associations generally rely on the authority

in HOLA §5(c)(3)(A) to invest on a pass-through

basis.

Therefore, such investment must meet the standards in §560.32 (Pass-Through Investments)

including the individual and aggregate investment

limits.

The Tax Reform Act of 1986 authorized LIHTC

programs. LIHTCs are a popular mechanism to

provide equity to affordable multi-family housing

projects. Most LIHTC projects use a limited partnership structure. The partnership raises equity in

the project by selling limited partnership interests

and uses the proceeds to support development or

rehabilitation of affordable multifamily housing.

The tax credits, as well as any profits or losses

from the property, flow through to the limited

partners.

To minimize the risk of tax credit recapture or

project failure, a savings association can participate in a LIHTC fund that diversifies investments

among several LIHTC projects. Of course, the underlying REI must be permissible pursuant to

HOLA 5(c)(3)(A). Diversification among several

projects, however, does not eliminate a savings

association's risk. In reviewing such investments,

you should determine whether the savings association has other relationships that are dependent

upon the success of a particular LIHTC-related

project. This may be an indication of a savings

association's asset concentration in a particular

project. Extensions of credit to the project or guarantee of third-party loans to the project by the

savings association are indications of project concentration.

REI Authorized for Service Corporations

Through service corporations, federal savings associations can engage in additional activities not

permissible for federal savings associations to perform directly. Service corporation activities are

either preapproved by regulation or OTS determines the activities to be reasonably related to the

business of financial institutions. Section 12 CFR

§559.4 lists the preapproved service corporation

real estate activities and includes the following:

• Acquiring real estate in accordance with a prudent program of property development for:

 prompt development or subdivision

 construction of improvements

 resale or leasing to others

 construction

 use as manufactured home sites.

• Acquiring improved real estate or manufactured

homes for:

 rental or resale

 remodeling

 renovating or demolishing
SECTION: Equity Investments Section 230

Office of Thrift Supervision June 1999 Regulatory Handbook 230.7

 rebuilding for sale or rental

 offices and related facilities of a stockholder of the service corporation.

Therefore, in addition to certain REI authorized in

HOLA 5(c)(3)(A), a savings association can make

permissible REI in an amount up to its service

corporation investment limit. Generally, the service

corporation investment limit is three percent of

assets provided any amount over two percent relates to community development activities.

As noted above, investments in service corporations must comply with the standards in Part 559,

including applicable investment limits. Service

corporations, for example, are subject to various

ownership and geographic restrictions. Such restrictions, however, do not apply to the

establishment of a savings association’s lower-tier

entities. For monitoring compliance with applicable statutes, regulations, and OTS policy, it is

important that the savings association’s internal

records indicate the authority for any REI. (Refer

to Handbook Section 730, Subordinate Organizations, for a discussion of service corporation and

lower-tier investment authority.) Also, there are

regulatory capital implications for real estate

service corporations. Savings associations must

deduct from capital any direct investments (both

debt and equity) they or subordinate organizations

make in subsidiaries engaged in activities that are

not permissible for national banks. Handbook Section 120, Capital Adequacy, discusses this subject.

Refer also to the OTS Guide to the Federal Laws

Governing Community Development Activities of

Savings Associations. Appendix D of the guide

addresses capital standards for REI and lists community development related investments

permissible for national banks.

Real Estate Loans with Equity Investment Characteristics

REI includes loans with equity investment characteristics because they are, in essence, equity

investments in the projects being financed even

though such loans are permissible under 12 USC

§1464(c). REI, for example, may include the following types of loans:

• Land loans and nonresidential construction

loans with loan-to-value (LTV) ratios greater

than 80 percent.

• Interest capitalized as part of a real estate loan

balance in accordance with GAAP.

• Loans or advances to, and guarantees issued on

behalf of, partnerships or joint ventures in

which a savings association holds an equity interest in real property as determined under

GAAP.

You should carefully scrutinize loans with equity

characteristics because they present risks similar to

other types of equity investment. This supervisory

oversight is necessary because such loans are permissible investments for savings associations.

These loans are not equity investments under the

capital rule to the extent they are permissible investments for national banks. With one exception,

these loans are generally risk weighted at 100 percent instead of being deducted when computing

risk-based capital. The exception pertains to land

loans and nonresidential construction loans with

LTV ratios greater than 80 percent. Savings associations must include in the 100 percent riskweight category the portion of the loan that represents 80 percent of the project's value. In addition,

they must deduct dollar-for-dollar from total capital the portion of the loan in excess of 80 percent

LTV.

A significant type of loan that often falls within the

definition of equity investment is the highly leveraged acquisition, development, and construction

(ADC) loan. OTS may consider an ADC loan an

equity investment if it possesses any of the following characteristics:

• The lender participates in the expected profit

upon completion of the project.

• The lender supplies virtually all funds for the

project, including the funds to cover loan origination fees and interest on the loan. The

borrower, although having title to the project,

has little or no equity investment in it.

• The only security for the loan is the ADC project itself and, therefore, the lender has no

recourse to other assets of the borrower.
SECTION: Equity Investments Section 230

230.8 Regulatory Handbook June 1999 Office of Thrift Supervision

• The structure of the arrangement precludes default or foreclosure during the project's

development because there are no requirements

for interim payments. This means that the loan

can never become delinquent before its maturity

date.

Accounting and Reporting for REI

Beyond verifying that REI comply with rules and

regulations, you should verify that the savings association's financial reports properly reflect these

investments. REI include the purchase price or

original cost less depreciation of all equity interests

in real property as determined in accordance with

GAAP. Savings associations and others must carry

REI at the lower of the carrying amount or fair

value less cost to sell as prescribed by SFAS

No.121. The cost of the real estate should include

the original purchase price plus allowable items,

such as:

• Cost of construction.

• On-site and off-site improvements.

• Costs of architectural and engineering studies.

• Interest during the construction period (as required by SFAS No. 34).

• Certain pre-acquisition costs meeting the criteria specified in paragraph four of SFAS No.

67.

• Property taxes and insurance incurred during

the development period prior to the property

being substantially complete as addressed in

paragraph six of SFAS No. 67.

Depreciation begins when a project is substantially

complete and held available for occupancy. Charge

all carrying costs to expense when incurred. You

should consider a property substantially complete

and available for occupancy no later than one year

from cessation of major construction activity.

Handbook Section 251, Real Estate Owned and

Other Repossessed Assets, contains guidance on

accounting for sales of real estate. When the seller,

for example, receives a note on a sale of real estate, it is necessary to adjust the sales price to the

estimated fair value of the note. Refer to APB No.

21 for a detailed discussion of determining the appropriate sales price that will affect the gain or loss

on the sale.

Internal Controls for REI

In evaluating risk, you should determine whether

the savings association is prudently managing the

REI portfolio. You should have access to information indicating the authority that the savings

association relied on for making REI or loans with

equity investment characteristics. You should assess the adequacy of internal policies and

procedures for REI. There is often a direct relationship between the competence and expertise of

individuals managing a project and its risk and

profitability. Therefore, you should also review the

savings association’s real estate investment strategy and decision-making analyses (for example,

risk versus return assessment, project feasibility,

expertise of individuals managing the project, real

estate appraisals, financing commitments). You

should document all information relating to management's investment analysis consistent with the

savings association's (or if applicable, its subordinate organization’s) internal policies and

procedures. The analysis can provide substantial

insight into the level of risk involved and facilitate

an assessment of performance projections against

actual results.

It is the responsibility of the savings association to

ensure that any investment in real estate is safe and

sound. Additionally, internal procedures should

address the monitoring of REI. For example, subsequent appraisal reports may be necessary as

dictated by prudent management policy. Examples

requiring subsequent appraisal reports include the

following situations:

• The marketplace suffers a decline.

• The property remains on the market for an extended time period.

• A change in the property or circumstances affects its sale or development.

Finally, you should perform, as appropriate, the

examination procedures contained in Handbook

Section 740, Real Estate Development, which also
SECTION: Equity Investments Section 230

Office of Thrift Supervision June 1999 Regulatory Handbook 230.9

provides guidance on assessing risk associated

with REI.

ADDITIONAL SUPERVISORY

CONSIDERATIONS AND REGULATORY

REQUIREMENTS

As discussed above, a savings association’s internal policies and procedures should address prudent

standards for the acquisition and monitoring of

equity investments. Internal controls include the

plan, procedures, and records that management

uses in making decisions, maintaining reliable financial records, and safeguarding assets. Savings

associations and their subordinate organizations

should monitor the adequacy of internal control

systems. (Refer to Handbook Section 340, Internal

Controls.)

For investments in real estate, for example, internal

procedures should address the pre-acquisition

analysis performed to support the investment decision. This includes obtaining valid appraisals and

feasibility studies. It also includes the management

oversight of various phases of real estate development or property management. In addition to

guidance concerning specific equity investment

authority, an assessment of the following considerations may be appropriate for determining the

effect of equity investments on the savings association’s financial condition.

Asset Concentrations

There are substantial limitations on the levels of

permissible equity investments. Nevertheless, a

concentration of such assets may present safety

and soundness concerns. In assessing risk associated with asset concentrations, consider both loans

to and equity investments in related entities.

There is a concentration if the savings association

extends a substantial level of equity investments,

loans, or guarantees of debt to the following:

• An individual

• An entity

• A project

• A group of borrowers or investors.

There is also a concentration if there is a relationship of common dependency or a common risk

characteristic. A savings association may make

equity investments in entities that are related in

some manner. They share a common third-party

investor or otherwise depend on the cash flow generated by a single operation or project. Section

560.32 limits a savings association’s pass-through

investments in the aggregate to 50 percent of

capital. However, the savings association’s overall

exposure may include the amount of any loans,

subject to applicable loans-to-one-borrower restrictions, to these entities or to individuals

investing in such entities (for example, general

partner or developer). Also, while a savings association’s direct REI cannot, in the aggregate,

exceed two percent of assets, a service corporation

may invest up to three percent of assets in the same

real estate projects. This amount is in addition to

any loan authority available to the savings association or subordinate organization.

Savings association management should adequately address such equity investment

concentrations through policies and procedures

that minimize potential risk presented to the savings association. At a minimum, management

should identify, monitor, and regularly report significant concentrations to the board of directors to

provide a basis for board policy. Refer to Handbook Section 211, Loans to One Borrower, for

additional guidance on assessing asset concentrations.

Internal Asset Classification Systems

Savings associations must periodically evaluate

their equity investments and make any appropriate

adjustments to the carrying value. You should consider relevant documentation supporting such

values during the examination. Also, the savings

association’s and its subordinate organization’s

assets should reflect GAAP valuation standards.

Finally, equity investments are subject to classification consistent with standards in 12 CFR

§560.160 and related OTS policy. For guidance in

this area, refer to Handbook Section 260, Classification of Assets.
SECTION: Equity Investments Section 230

230.10 Regulatory Handbook June 1999 Office of Thrift Supervision

Conflicts of Interest

Conflicts of interest occur when the interests of a

savings association clash with the personal interest

of individuals or the business interests of entities

associated with the savings association. Each savings association should develop a policy on

conflicts of interest and a code of conduct for their

officers and other employees. The existence of

such a policy is particularly important if a strong

potential for conflict exists, such as, numerous REI

involving affiliates. A savings association must

prohibit a person involved in a particular conflict

associated with a transaction from participation in

the savings association's approval process. (Refer

to Handbook Section 330, Management Assessment, for guidance on identifying potential

conflicts of interest.)

Transactions with Affiliate (TWA) Rules

The TWA Rules contained in §§563.41 and

563.42 place quantitative and qualitative restrictions on loans and certain other transactions

entered into by the savings association or its subsidiaries with affiliates. TWA regulations may

affect REI or personal property transactions involving an affiliate or insider. (See Handbook

Section 380.)

OTS Capital Treatment

Handbook Section 120, Capital Adequacy, contains guidance that will help you determine the

treatment of various types of equity investments

under OTS’s capital rule contained in Part 567.

The capital treatment for equity investments, for

the most part, depends on the savings association’s

percentage ownership interest and whether the investment is permissible for national banks. Savings

associations must deduct from capital for reporting

purposes equity investments that are not permissible for national banks.

The actual capital calculations for deducting nonincludable investments differ among equity

investments that are subsidiaries (for example,

majority-owned, control exists) and those accounted for under the equity or cost accounting

method. Savings associations must deduct investments in (including loans to) non-includable

subsidiaries from core capital. In addition, savings

associations must deduct other non-subsidiary equity investments not permissible for national banks

from total capital.

OTS Reporting Requirements

The savings association's internal controls should

ensure the proper reporting of equity investments

in financial reports. These reports must also be in

accordance with GAAP. Under OTS TFR instructions, there are three elements that determine the

appropriate reporting for equity investments:

• The investment authority that the savings association relies upon.

• The savings association’s percentage ownership

interest.

• Whether the investment is permissible for national banks.

For example, a savings association would report

investment in a non-consolidated subordinate organization under the equity or cost method of

accounting on line item SC 50 of the Statement of

Condition of the TFR.

The institution should consolidate the operations of

a majority-owned subordinate organization(s) with

the parent savings association on a line-by-line

basis. However, institutions should report other

permissible equity securities, for example, common

and preferred stock including Freddie Mac and

Fannie Mae stock and shares of mutual funds accounted for pursuant to SFAS No. 115, on SC 140

(Equity Securities except FHLB Stock). Savings

associations should report FHLB stock on SC 690

(Other Assets). A savings association should report direct investments in real estate, including

those held by consolidated subsidiaries on SC 45

(Real Estate Held for Investment). The TFR Instructions provide additional guidance.

REFERENCES

United States Code (12 USC)

Home Owners' Loan Act

§1464(c) Investment Authority
SECTION: Equity Investments Section 230

Office of Thrift Supervision June 1999 Regulatory Handbook 230.11

§1468(a),(b) Affiliate Transactions

Federal Deposit Insurance Act

§1828(m) Activities of Savings Associations and Subsidiaries

§1831e(c) Equity investments

Code of Federal Regulations (12 CFR)

FDIC Rules and Regulations

§303.13 Applications and Notices by

Savings Associations

§303.13(d) Equity investments

OTS Rules and Regulations

Part 559 Subordinate Organizations

§560.30 General Lending and Investment

Powers

§560.32 Pass-through Investments

§560.36 De minimis Investments

§560.37 Real Estate for Office and Related Facilities

§560.41 Leasing

§560.93 Lending Limitations

§560.121 Investment in State Housing

Corporations

§560.160 Asset Classification

§560.172 Re-evaluation of Real Estate

Owned

§563.41 Loans and Other Transactions

with Affiliates and Subsidiaries

§563.42 Additional Standards Applicable

to Transactions with Affiliates

Part 567 Capital

Accounting Principles Board (APB) Opinions

No. 18 Equity Method of Accounting for

Investments in Common Stock

No. 21 Interest on Receivables and Payables

Financial Accounting Standards Board, Statement of Financial Accounting Standards (SFAS)

No. 34 Capitalization of Interest Cost

No. 67 Accounting for Sales of Real Estate

No. 94 Consolidation of All MajorityOwned Subsidiaries

No. 115 Accounting for Certain Investments

in Debt and Equity Securities

Other References

AICPA Audit and Accounting Guide, Banks and

Savings Institutions
Equity Investments

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision June 1999 Regulatory Handbook 230P.1

Examination Objectives

To determine whether the savings association is correctly categorizing and valuing equity

investments.

To evaluate the quality of equity investments and their effect on the financial condition and performance of the

savings association.

To determine whether the savings association makes equity investments in accordance with applicable laws

and regulations.

Examination Procedures Wkp.Ref.

Level I

1. Obtain a list of the savings association's equity investments and review related examination scoping materials. Note: Evaluate the savings association’s investments in

subordinate organizations under separate examination procedures contained in Section

730. As necessary, obtain information relevant to this program from persons reviewing

subordinate organizations.

Verify that the savings association properly categorizes equity investments. Ensure that

equity investments comply with applicable statutory, regulatory or policy standards (for

example, investment limits, activities restrictions).

2. Identify an equity investment or any concentration of equity investments that could have

a significant effect on the savings association's overall financial condition taking into

consideration the adequacy of valuations and internal asset classifications.

3. Assess the adequacy of the savings association's equity investment policies with consideration given to the following areas:

• The acquisition and monitoring of equity investments, for example, risk/return

analysis and objectives, appraisal policy, due diligence performed, tracking relevant

economic indicators, projections versus investment performance.

• Establishing carrying values consistent with GAAP, the savings association internal

asset classification policy, and appropriate valuation allowances.
Equity Investments

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

230P.2 Regulatory Handbook June 1999 Office of Thrift Supervision

Wkp.Ref.

• Accounting for equity investments on savings association financial reports; approaches for identifying and controlling risk for various categories of equity

investment.

• Board of director’s oversight. This includes the frequency of the review of policies

and procedures. Does the board of directors require approval for equity investments

that represent a certain percentage of capital, involve an affiliate or insider or present a potential conflict of interest?

• Compliance with applicable statutory, regulatory or policy standards.

4. For any REI, verify that management conducted an independent and complete evaluation

of the project and the reputation of individuals involved, (for example, partners, members, developers), as well as their experience, expertise, and financial capabilities. (Do

partners have the capacity to meet financial and other obligations? Can personal guarantees be enforced?)

5. Assess the adequacy of management's expertise in relation to the savings association's

equity investment portfolio and related goals and objectives.

6. Analyze the savings association's future equity investment plans in relation to its business plan and overall condition.

7. For pass-through investments, confirm that the savings association appropriately limits

the amount of its investment. Review a savings association’s obligations stated in contracts, agreements, and other legally binding arrangements to ensure that the

association’s potential liability is limited to the amount of its investment. Provisions in

such contracts, agreements, or arrangements would include the sharing of profits and

losses among investors and additional funding requirements.
Equity Investments

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision June 1999 Regulatory Handbook 230P.3

Wkp.Ref.

8. Confirm that the savings association properly reports equity investments when calculating regulatory capital. (Refer to Handbook Section 120, Capital Adequacy, and the

Thrift Financial Report Instructions for guidance.)

9. Review Level II procedures and perform those necessary to test, support, or present

conclusions derived from performance of Level I procedures.

Level II

10. Identify any equity investments that involve a potential conflict of interest or circumstances in which any affiliate or insider (savings association officer, director, or major

shareholder) has benefited directly or indirectly from the savings association's equity investment.

11. If weaknesses exist within internal accounting procedures, reconcile the savings association's current reported equity investments to an audited financial statement.

12. If REI are material, perform any appropriate and relevant procedures detailed in Handbook Section 740, Real Estate Development.

13. Ensure that the examination meets the Objectives of this Handbook Section. State your

findings and conclusions, as well as appropriate recommendations for any necessary

corrective measures, on the appropriate work papers and report pages. Update the continuing examination file, if applicable.
Equity Investments

Questionnaire

Exam Date: _______________

Prepared By: ______________

Reviewed By: ______________

Docket #: _________________

TA 230 (6/99) 230 Q/Page 1 of 2

Yes No

General Questionnaire

1. Does the thrift's asset review and

classification program cover equity

investments?................................................

2. If state chartered, is the thrift complying with

statutory and regulatory investment limits

under state law if more restrictive than

federal limits?...............................................

3. Does the thrift's internal audit program

adequately cover equity investments?..........

4. Does the thrift adequately monitor

compliance with its equity investment

policies and procedures? .............................

5. Does the thrift have definitive written

investment plans for each equity

investment?..................................................

6. Is the thrift complying with its investment

plans? ..........................................................

7. Is the association in compliance with the

statutory investment limits prescribed by the

HOLA and FDIA?.........................................

8. Does the thrift apply the consolidation

method to applicable EIs of operating

subsidiaries for the purpose of determining

its aggregate level of investments? ..............

9. Are equity investment management reports

and information systems adequately

providing management and directors with

decision-making information and the ability

to monitor compliance with established

guidelines?...................................................

10. Does the institution maintain records for

each equity interest in a real estate

investment (REI) parcel (e.g., showing

capital items, expenses, rentals)? Are such

files complete?.............................................

Yes No

11. Does the institution reconcile ledgers for the

individual REI properties to the general

ledger at least monthly? ...............................

Frequency? 

12. Does the thrift maintain insurance coverage

on REI including liability coverage where

advisable?....................................................

13. Does the thrift maintain adequate control

over REI rental income?...............................

14. Are agents who collect REI rents and/or

manage properties bonded? ........................

15. Does the thrift properly control REI security

deposits?......................................................

16. Does the thrift maintain adequate control

over all REI disbursements? ........................

17. Does the thrift physically inspect all REIs at

least quarterly?.............................................

18. Has the thrift imposed limitations on the

securities investment authority of officers?...

19. Does the thrift require dual authorization of

investment security transactions?.................

20. Do procedures preclude the custodian of the

thrift's securities from:

• having sole physical access to security

documents? ............................................

• preparing release documents without the

approval of authorized persons?.............

• preparing release documents not

subsequently examined or tested by a

second custodian? ..................................

• performing more than one of the

following transactions:

 execution of trades?.............................
Equity Investments

Questionnaire

Exam Date: _______________

Prepared By: ______________

Reviewed By: ______________

Docket #: _________________

TA 230 (6/99) 230 Q/Page 2 of 2

Yes No

 receipt or delivery of securities?...........

 receipt and disbursement of proceeds?

21. Does the thrift physically safeguard

securities to prevent loss or unauthorized

removal or use? ...........................................

22. Are registered securities held only in the

name (or street name) of the thrift or

subordinate organization?............................

23. Do thrift and subordinate organization

records of investment securities show all

pertinent data describing the security, its

location, pledged or unpledged status,

premium amortization, discount accretion,

and dividends declared or interest earned,

accrued, and collected? ...............................

24. Do periodic statements the thrift receives

from securities brokers reflect:

• trading activity for the period? .................

• open positions at the end of the period? .

• market value of open positions?..............

• unrealized gains and losses? ..................

• cash balances in accounts? ....................

25. Does someone independent of both the

Yes No

trading and recordkeeping functions receive

the periodic statements?.............................

26. Does the thrift reconcile the periodic

statements to all of the thrift's accounting

records?.......................................................

27. Do persons who do not have direct, physical,

or accounting control of accounts balance EI

subledgers at least annually to the

appropriate general ledger accounts?..........

28. Do persons who do not have direct,

physical, or accounting control of the assets

prepare and post EI subledgers? ................

If not, do persons who do not have direct,

physical, or accounting control of the assets

test the preparation and postings? ...............

29. Does the thrift maintain supporting

documents for all entries to EI accounts?.....

30. Does management report acquisitions and

dispositions of EIs to the board of directors?

31. Does the board of directors review EI

policies at least annually to determine if they

are compatible with changing regulatory

restrictions and market conditions?..............

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