Significant Implications to Accounting for Loan Participation Sales
Significant Accounting and Regulatory Implications to Accounting for Loan Participation Sales, Including SBA Loans
FASB Accounting Standards Codification (ASC) Topic 860 (formerly FAS 140 and FAS 166) has modified the accounting for transfers and servicing of financial assets
While this amended guidance has a meaningful impact on companies that have “qualifying special-purpose entities,” it also created the concept of a “participating interest” which has a significant impact on how community banks account for loan participations and sales of the guaranteed portion of SBA loans. This amended guidance becomes effective for transfers of participating interests on or after Jan. 1, 2010 for calendar year companies.
Definition of a participating interest
A participating interest requires 1) proportionate ownership interest in an entire financial asset; 2) all cash flows (excluding fees for servicing or other services that are arms length) to be divided among participants in proportion to share of ownership; 3) that rights of each participating interest holder have the same priority (i.e. there can be no recourse and no participating interest holder is subordinated to another); and 4) that no party has the right to pledge or exchange the entire financial asset unless all participating interest holders agree to do so.
Loan participation issue
If a transfer of a portion of a financial asset does not meet the definition of a participating interest, the transaction must be accounted for as a secured borrowing. As such, “last-in, first-out” (LIFO) and “first-in, first-out” (FIFO) structured participations do not meet the definition of a participating interest and must be accounted and reported for as secured borrowings. For example, a FIFO participation generally pays principal cash flows to the lead lender first. All banks are encouraged to review their participation agreements to determine if they conform to the new definition of a participating interest.
It should be noted that loan participations transferred prior to the effective date of this guidance (Jan. 1, 2010) are not affected. However, 2010 advances under line of credit agreements (even if entered into prior to Jan. 1, 2010) will be impacted if they do not meet the definition of participating interest.
SBA loan sale accounting issue
The participating interest definition also applies to transfers of government-guaranteed portions of loans, for example, those guaranteed by the Small Business Administration (SBA).
A financial institution may originate a loan on which it obtains a SBA guarantee. The SBA will guarantee up to 90 percent of the loan. After origination, the institution may sell (transfer) the guaranteed portion of the SBA loan on the secondary market. At the date the guaranteed portion of the SBA loan is sold, the institution certifies that: (a) the institution has no knowledge of default by the borrower or likelihood of default; (b) the institution has paid the SBA the guaranty fee; (c) the loan is properly closed and fully disbursed; and (d) the institution acknowledges that it has no authority to unilaterally repurchase the guaranteed interest. The guaranteed portion of the loan is generally sold for a premium or at par.
Under the standard SBA loan sale agreement (SBA Form 1086), there is a 90-day warranty period during which the institution would be required to refund any premium received. For example, if the borrower prepays the loan for any reason within 90 days, the institution must refund any premium received. Also, if the borrower fails to make the first three monthly payments due after the sale (transfer) date and the borrower enters uncured default within 275 calendar days, the institution must refund any premium received.
Among the many changes made by this amendment & guidance, one change in particular impacts the ability of the institution to recognize the transfer of a receivable until after the 90-day warranty period has expired. That change specifically requires that the portion transferred qualify as a participating interest. The related guidance states, “In certain transfers, recourse is provided to the transferee that requires the transferor to reimburse any premium paid by the transferee if the underlying financial asset is prepaid within a defined time frame of the transfer date. Such recourse would preclude the transferred portion from meeting the definition of a participating interest. However, once the recourse provision expires, the transferred portion shall be reevaluated to determine if it meets the participating interest definition.”
As such, financial institutions will not be able to recognize gain on sales of the guaranteed portion of SBA loans when those loans are sold at a premium since the recourse precludes the transferred portion from meeting the definition of a participating interest. The transaction should be accounted for as a secured borrowing. After the expiration of the warranty period, the transfer should be re-evaluated to determine whether the conditions in ASC 860 have been met in order to achieve sale accounting treatment. The guaranteed portion of the loan (i.e. the portion sold) could be derecognized and the gain on sale could be recognized at that point.
In addition, there are transactions whereby the SBA loan is transferred at par and the seller agrees to pass interest to the purchaser at less than the contractual interest rate. The resulting spread is generally viewed as an interest-only strip. An interest-only strip results in a disproportionate sharing of cash flows on the entire SBA loan meaning the transaction must be accounted for as a secured borrowing.
The SBA recently solicited views from the public on the impact this amended accounting guidance is having on the SBA 7(a) program in an effort to consider potential revisions to the program that may minimize any adverse impact on the program. The deadline for providing comments to the SBA was April 19, 2010.
For more information regarding the above, including certain call reporting considerations, banks should review Financial Institution Letter (FIL-11-2010).
Tim Tiefenthaler is a managing director with McGladrey McGladrey. For more information, contact him at tim.tiefenthaler@McGladreyus.com.