A bank appealed to the ombudsman a violation of
12 U.S.C. 161 cited in a letter from the bank's supervisory office.
This letter was written following a meeting that the bank had
initiated to disclose the reasoning behind the bank's refiling of
its December 31, 1993 call report. The cited violation was based
upon a materially inaccurate call report for the quarter ended
December 31, 1993, resulting from an inadequate ALLL balance. The
letter also stated that the violation was of concern because the
bank had received previous OCC reprimands and penalties for similar
violations. These reprimands and penalties were associated with a
similar violation in 1992 resulting from an inadequate method of
determining ALLL adequacy and noncompliance with Banking
Circular-201. The bank's correction of those deficiencies was
confirmed by OCC examiners during 1993.
Background
The bank felt this appeal
was necessary for the following three reasons.
- Management believes the ALLL was adequate as
originally reported as of December 31, 1993. The bank refiled its
call reports to comply with its internal ALLL policies and because
of the previous violation of 12 U.S.C. 161 with associated civil
money penalties and reprimands. The bank did not re-file because
it had determined the ALLL was inadequate.
This dispute over ALLL
adequacy centers around a certain large loan relationship and a
proviso in the bank's ALLL policy requiring a minimum ALLL balance
equal to 50 percent of nonaccrual loans. The bank claimed in its
appeal letter that, through an oversight, the senior loan officer
had inadvertently failed to include the large relationship in the
calculation of the required minimum ALLL balance. When the bank's
external accountant discovered the omission, the bank immediately
corrected the problem by first visiting the OCC supervisory office
to explain the matter and then refiling the December 31, 1993 call
report. Documentation obtained through our review of this appeal
demonstrates that the minimum coverage calculation for nonaccrual
loans was included in the December 31, 1993 ALLL analysis and the
board made a conscious decision not to make the associated ALLL
adjustment. Not withstanding this discrepancy, the question remains
whether a violation actually occurred.
- The bank is concerned about the threat of
future civil money penalties.
The bank claims that the
examiner-in-charge of its next examination told bank officials he
did not believe the cited violation would be significant and was not
going to refer it for civil money penalties. The error should have
been caught, but the bank immediately corrected the situation upon
discovery. Despite this assurance, the bank felt that the
circumstances warranted an appeal to a neutral third party to assess
the seriousness of the alleged violation.
- The bank perceives OCC hostility stemming
from an alleged ethical conflict concerning a former OCC
employee.
The bank is convinced that
this situation created an unfavorable relationship with the
supervisory office. The board of directors is concerned that every
violation of any kind will be vigorously pursued because of the
bank's less than friendly relationship with the supervisory office.
The bank believes that all possible violations of law, no matter how
minor, have now become major issues, causing great anxiety among the
management and directors of the bank.
Discussion
12 U.S.C. 161(a) requires
national banks to file accurate reports of condition and income to
the Comptroller of the Currency in accordance with the Federal
Deposit Insurance Act. Each report of condition shall contain a
declaration by the president, a vice president, the cashier, or by
any other officer designated by the board of directors of the bank
to make such declaration, that the report is true and correct.
The ALLL must be maintained
at a level that is adequate to absorb all estimated inherent losses
in the bank's loan and lease portfolio. The Instructions for
Preparation of the Consolidated Reports of Condition and Income
state the following: "At the end of each quarter, or more frequently
if warranted, the management of each bank must evaluate, subject to
examiner review, the collectability of the loan and lease financing
receivable portfolios, including any accrued and unpaid interest,
and make appropriate entries to bring the balance of the allowance
for loan and lease losses (allowance) on the balance sheet to a
level adequate to absorb anticipated losses. Management must
maintain reasonable records in support of their evaluations and
entries."
SFAS No. 5 is the primary,
authoritative accounting document concerning the accrual of the
ALLL. It defines an inherent loss (loss contingencies) as an
existing condition, situation, or set of circumstances involving
uncertainty as to possible loss that will ultimately be resolved
when one or more future events occur or fail to occur. The
conditions associated with most loans involve some degree of
uncertainty about collectability. However, a provision to the ALLL
for an inherent loss (loss contingency) associated with loans should
be made only if both of the following conditions of SFAS No. 5 are
met:
- Information available as of the
evaluation date indicated that it is probable that the value of
the loan had been impaired. (One or more future events must be
likely to occur and confirm the fact of the loss.)
- The amount of loss can be reasonably
estimated. (Under Financial Accounting Standards Board
Interpretation No. 14, the ability to estimate a range of loss is
sufficient to satisfy this condition.)
The timing of certain events
in the sequence of this case is central to the question as to
whether a violation of law occurred. The bank placed a portion of
the large relationship on nonaccrual in November 1993, with the
balance placed on nonaccrual in December. At year end 1993, the
entire relationship was internally classified
substandard/nonaccrual. The bank was involved in active negotiations
with the managing partners of the project. Based on the strong
financial capacity of the guarantors, the bank did not expect any
loss on this relationship. The bank filed its December 31, 1993 call
report on January 25, 1994. The bank's external CPA confirmed that
the ALLL balance was adequate based on the information available to
the bank at the time.
However, the large
relationship deteriorated during the month of February, in the midst
of the external CPA's annual audit of the bank. The bank's president
decided to initiate litigation against the guarantors and charged
off the loan on February 28, 1994. At that point, the CPA became
uncomfortable with the ALLL balance. Since his FYE audit was still
in progress, he recommended an additional provision adjustment to
the December 31, 1993 ALLL balance based upon his own analysis. To
make the bank's RAP book consistent with its GAAP book, the CPA's
additional provision adjustment was made retroactive and the bank
refiled its initial call reports. The charge-off and the
accompanying provision of equal amount were both treated as first
quarter events.
Conclusion
The Ombudsman's office
decided that there is not conclusive evidence that a violation of 12
U.S.C. 161 occurred. The fact that the bank did not comply with its
policy for calculating the allowance does not, in and of itself,
constitute a violation of law. It is extremely difficult to pinpoint
the exact date a loss should have been recognized in prior periods.
We found no justification that the large relationship was improperly
graded at December 31, 1993, nor were we able to corroborate that
the ALLL balance was inadequate as originally filed in the bank's
initial December 31, 1993 call report.
Further, the tone of the
supervisory officer's letter to the bank was inappropriate. The bank
immediately brought the alleged violation to OCC's attention, made
appropriate adjusting entries, and refiled the affected call report.
The supervisory office agreed to take the following actions:
- Reiterate to the bank that OCC
acknowledges the bank' forthrightness in bringing this matter to
OCC's attention upon discovery by the bank. No violation of law
will be cited and no civil money penalties or other administrative
action contemplated.
- Send a revised version of the supervisory
office's letter to the bank eliminating any
inappropriate language. References to past reprimands
and penalties will be deleted.
The alleged ethical conflict
involving the former OCC employee was referred to the OCC'S ethics
counsel. Subsequently, this matter was referred to the
Department of the Treasury Office of the Inspector General for
appropriate investigation.
APPEAL OF REQUIREMENT
ON PHYSICAL SEPARATION OF LOAN UNDERWRITING AND CREDIT ORIGINATION
(FIRST QUARTER 1995)
Background
A bank requested that the
Ombudsman's Office reconsider OCC's requirement that the mortgage
loan underwriters of the bank's mortgage company subsidiary be
located in separate buildings from the credit origination function.
At the time of the bank's acquisition of the mortgage company, the
bank agreed to separate the functions, pursuant to OCC
interpretations of the branching rules, in order to receive a speedy
approval of the application for the acquisition. The bank's appeal
is motivated by the competitive disadvantage these restrictions
create. Physical separation of underwriters causes the mortgage
company to incur additional expense, creates employee morale
issues, and is contrary to industry practice.
Discussion
Under the McFadden Act, any
bank office that performs certain "core" banking activities,
including accepting deposits, paying checks, and lending money, is a
branch and thus subject to location restrictions (12 U.S.C. 36(f),
12 U.S.C. 81). Interpretative Ruling 7.7380 permits national banks
to originate loans at locations other than the main office or a
branch office of the bank provided that the loans are approved and
made at the main office or a branch office of the bank or at an
office of the subsidiary located on the premises of or
contiguous to, the main office or branch office of the bank.
A letter signed by Eric
Thompson, director of OCC's Bank Activities and Structure Division,
dated October 13, 1994, states that it is permissible to maintain
loan approval offices in the same buildings as loan production
offices (LPO) of a mortgage company subsidiary of a national bank.
The locations in question are not branches of the bank. The loan
approval office would be located on a different floor than the LPO;
be in an area not identified by any mortgage company signs; have a
different entrance to the building than the LPO; be in an area that
is not accessible to the public, including customers of the mortgage
company; and have a staff that is separate and independent from the
loan origination personnel. In no case will loan proceeds be
disbursed at either an LPO or a loan approval office.
Similar conclusions are
communicated in a letter signed by Frank Maguire, Senior Deputy
Comptroller for Corporate Activities and, Policy Analysis, dated
October 12, 1994. This letter approves the acquisition of a
mortgage company by a national bank subject to certain conditions.
In this case, credit underwriting offices are located in the same
buildings as LPO's, but are either located on different floors of a
multi-story
building, or in separate
areas on the same floor. There is no public access to the
underwriting offices and no customers visit these offices. Each
underwriting office will be staffed separately from the LPO, and
underwriting personnel will operate independently of the LPO.
Both letters conclude that,
under the given circumstances, locations where LPO's and credit
underwriting offices are maintained in separate areas of the same
building should not be considered branches for purposes of 12
U.S.C. 36. A nonpublic office that only performs credit underwriting
functions is not a branch and situating it in the same building as
an LPO does not change the non-branch character of either
office.
Conclusion
The Ombudsman's Office
decided that the interpretive letters provide the mortgage company
an avenue to locate underwriting and origination functions in the
same building. Consistent with the facts and circumstances
contained in these letters, the mortgage company subsidiary no
longer needs to maintain the mortgage loan underwriters in separate
buildings from the credit origination function.
APPEAL OF CONDITIONS
FOR APPROVAL OF LICENSING APPLICATION (FIRST QUARTER
1995)
Background
A bank appealed two
conditions imposed in OCC's approval of a corporate licensing
application. The bank sought approval for a proposed reorganization
by the bank's parent company (BHC) of its credit card business
among two of its subsidiary banks ("Bank A" and "Bank B"). The
reorganization would be effected, in part, through a sale of Bank
A's credit card portfolio to Bank B, which is engaged exclusively in
credit card and related activities.
The transaction would be
structured as follows. Bank A would sell to Bank B its credit card
business, including the existing receivables and billed accounts as
well as certain limited unsecured lines of credit and related
fixtures, equipment, and personal property. The transaction would
exclude any receivables that are low-quality assets. Simultaneous
with the transfer to Bank B of its credit card business, Bank A
would make a combined dividend to and stock repurchase from and
distribution to the BHC. The dividend component would be sized to
equal income realized by Bank A through
reversal of card related loan loss reserves less write down
of low-quality assets to current market value. The dividend would be
paid by Bank A in cash and the stock repurchase and distribution
paid first in-kind with low-quality assets and the remainder in
cash. The BHC estimates that the current market value of the
low-quality assets equals approximately 50 percent of the
outstanding balances. The BHC would contribute as common equity
capital to Bank B all dividend and stock purchase proceeds received
from Bank A. The BHC would also purchase a certain amount of tier 2
capital qualifying subordinated debt from Bank B.
OCC placed the following
conditions on the proposed transaction:
- The portion of the transfer to be
structured as direct sale from Bank A to Bank B must be accounted
for at fair value.
- The accounting for the Bank A common
stock repurchase must include a proportional deduction from
undivided profits of any amount paid in excess of the issue price
of the shares retired.
Discussion
The Instructions for the
Preparation of the Consolidated Reports of Condition and Income specifically prohibit accounting
for such transactions at cost. Under the glossary entry for property
dividends, the instructions state that "the transfer of securities
of other companies, real property, or any other asset owned by the
reporting bank to a stockholder or related party is to be recorded
at the fair value of the asset on the declaration date of the
dividend." Also, Topic 11-A of the Bank Accounting Advisory Series
states that "the transfer of assets between a bank
and a related party should be accounted for on the basis of the
asset's fair value." The agencies base this long-standing position
on the necessity of maintaining consistency of accounting policy
regarding transactions involving affiliated and nonaffiliated
institutions. They believe that otherwise the reliability of call
reports would be diminished when comparing an independent bank to
one owned by a holding company.
The accounting for
retirement of treasury stock has varied treatment under GAAP. OCC
has generally required use of the pro rata approach (via
undivided profits) rather than deducting the entire amount from
capital surplus. The intent of this approach is that capital surplus
should not be reduced by more than the amount applicable to shares
retired. Accounting Principles Board Opinion No. 6 which
governs the accounting for such transaction designated the
method required by OCC as an acceptable method. However, GAAP would
allow other methods. Accounting Research Bulletin No. 43,
Restatement and Revision of Accounting Research Bulletins, states in Paragraphs 7 and 8 Chapter 1B that there is "general
agreement that the difference between the purchase price and the
stated value of a corporation's common stock purchased and
retired should be reflected in capital surplus.while the net
asset value of the shares of common stock outstanding in the hands
of the public may be increased or decreased by such purchase and
retirement, such transactions relate to the capital of the
corporation and do not give rise to corporate profits or losses.
"The Current Text of Accounting Standards
published by the Financial Accounting Standards Board states the
following in Section C23, Paragraph 102: "If an enterprise's
[capital] stock is retired, or purchased for constructive retirement
(with or without an intention to retire the stock formally in
accordance with applicable laws):.b. An excess of par or stated
value over purchase price shall be credited to additional
paid-in capital. [APB6, Pl2a]."
Conclusion
The bank's appeal was
granted. The ombudsman decided that the most practical
approach, looking at the substance and intent of the bank's
proposal, was to grant an exception to OCC's long-standing
regulatory
accounting requirement that asset transfers among affiliated
institutions be accounted for at fair value. The bank may
disregard the conditions imposed by the supervisory office. The
direct sale of credit card assets from Bank A to Bank B may be
accounted for at the GAAP alternative of lower of market value or
book value. Further, the Bank A common stock repurchase need not
include a proportional deduction from undivided profits.
This exception is
exclusively applicable to the unique facts and circumstances associated with
this transaction. Nothing in this decision undermines or
compromises OCC's consistent preference for fair value
accounting in the transfer of assets between legal entities. The
Ombudsman' Office fundamentally agrees that it is inappropriate to
allow appreciated assets to be transferred out of a bank at less
than fair value. Such transactions may obscure the true value of
transferred assets and allow banks to shift assets in order to
distort the earnings of affiliates. Also, they could be used to
circumvent regulatory dividend rules when an institution is
otherwise unable to pay dividends.
Central to this decision is
the fact that, in substance, it is a one-time reorganization of the
BHC's credit card business to achieve operational efficiencies. The
bank would not initiate this transaction with an unrelated party
because it is not "selling assets," per se. The ombudsman also
recognizes that the affiliate banks in transaction could have
reached similar regulatory capital results had the transaction been
accounted for at fair value. The transaction is consistent with
generally accepted accounting principles. There is no concern that
this transaction involves a dissipation of assets or capital.
Neither is it viewed as an attempt to circumvent any legal
requirements such as dividend limitations.
There are no other safety
and soundness concerns associated with the transaction.
Likewise, because the
accounting for common stock repurchases is not clear under GAAP, the
ombudsman has no supervisory concerns regarding the accounting
methodology proposed by the
bank.
APPEAL OF REQUIRED
ACCOUNTING TREATMENT FOR SALE OF RESIDENTIAL MORTGAGE AND
SERVICING (FIRST QUARTER 1995)
Background
A bank appealed to the
Ombudsman's Office for reconsideration of the accounting
treatment required by OCC regarding the sale of residential
mortgages and servicing. The bank originates first mortgage loans,
most of which are FHA-insured or VA-guaranteed, and sells them
without recourse along with the servicing rights to large
institutional buyers who package and sell them in the secondary
market. The buyers of the servicing rights require the bank to bear
the servicing costs of defaulted mortgages which become delinquent
by more than 60 days during the first six months after origination.
The bank must either reimburse the servicing entity for its
foreclosure costs, or repurchase the loan from the servicing entity
and initiate foreclosure procedures itself.
First, the bank claims OCC
is requiring of it a more stringent application than that afforded
other national banks on this issue. Second, the bank believes it is
illogical for OCC to allow sales treatment for mortgages sold when
the servicing rights are retained but require financing treatment
for mortgages sold when the servicing rights are sold. The bank
maintains that it has no more recourse exposure by selling the
servicing rights than it would if it retained them. Finally, the
bank believes OCC policy favors the larger institutions that
can afford to retain large servicing portfolios.
The bank would like OCC to
allow sales rather than financing treatment for these loans. The
bank would establish a reserve account, calculated in a manner
satisfactory to OCC, that would account for and offset all expected
future costs and losses relating to any recourse risks retained in
the sale of these loans.
Discussion
Regulatory policy generally requires that the
sale of assets with recourse be accounted for as borrowings during
the period of time the recourse provisions apply. Capital is held
against the entire amount of loans involved in the
arrangement.
The glossary entry for sales of assets in the
Instructions for the Preparation of the Consolidated Report of
Condition and Income states the general rule that transfers of
assets are reported as sales by the selling institution only if the
transferring institution retains no risk of loss from the assets
transferred resulting from any cause and has no obligation to any
party for the payment of principal or interest on the asset
transferred for any cause. For any given transfer, the determination
of whether risk is retained by the transferring institution is to be
based upon the substance of the transfer agreement.
Footnote 14 in Appendix A of 12 CFR 3 states
that, for risk-based capital purposes, the definition of the, sale
of assets with recourse, including one- to four-family residential
mortgages, is generally the same as the definition contained in the
call report instructions. Capital is held against the entire
amount of assets sold in transactions in which the bank retains risk
in a manner constituting recourse under the call report
instructions, but which are not reported on the bank's statement of
condition.
Banks may service loans for investors with or
without recourse. Government National Mortgage Association (GNMA)
servicing is generally without contractual recourse.
Under the Veterans Administration (VA) "no bid" program,
however, the service has exposure for principal loss in the event of
mortgagor default, and exposure for interest loss on FHA loans. This
exposure does not preclude sales treatment under regulatory
accounting principles. GNMA, Federal National Mortgage
Association (FNMA), and Federal Home Loan Mortgage Corporation
(FHLMC) services all incur non-reimbursable expenses as part of the
collection process for defaulted mortgages. These costs are
considered normal requirements incidental to servicing mortgages and
are not considered recourse.
The FNMA program provides two options for
services: "regular," or "special." For regular servicing, the bank
retains all default risk of loss. There is no recourse associated
with special servicing other than the normal representations and
warranties. FHLMC servicing options are similar to those under
FNMA. The exposure associated with GNMA servicing is not subjected
to a capital charge. Therefore, when a bank sells FHA or VA
mortgages into GNMA pools and retains the servicing rights, the
transaction is granted sales treatment and no capital is required
against the mortgages sold. Mortgages sold under FNMA and FHLMC non
recourse programs are also granted sales treatment and no capital is
required against the mortgages sold.
Conclusion
The ombudsman concurs with the bank's concern
that regulatory accounting policy is inconsistent for mortgage
sales where servicing rights are retained versus sold. Accordingly,
the Ombudsman's Office granted sales treatment for the portion of
the sales related to mortgage loans on which the bank's exposure is
limited to reimbursement of the services foreclosure costs. Further,
consistent with the treatment afforded banks that package and sell
loans into GNMA pools, under FNMA's "special" programs, and FHLMC
non recourse programs and retain the servicing, the bank need not
hold capital against mortgages which qualify for sales treatment. In
order to qualify for sales treatment, the bank must not take back or
substitute any loans. Financing treatment is required for all
loans sold under recourse arrangements with the exception of FNMA
and FHLMC programs. FNMA and FHLMC loans sold under recourse
programs must be included as assets when determining risk-based
capital.
The mortgage loans and the servicing will be
accounted for as separate components. The bank must continue to
defer recognition of the sale of the servicing until the recourse
period expires. Accordingly, the sales proceeds must be allocated
between the sale of the mortgages and the sale of the servicing. All
income related to the sale of the servicing, including the
servicing release fees, must be deferred until the recourse
period expires. Should the expected loss exposure exceed the amount
of the deferred income, a reserve must be established through a
charge to operations.
An interagency working group, operating under the
auspices of the Federal Financial Institutions Examination
Council, is currently studying the entire recourse issue in great
detail. OCC policies in this area may be revised as a result of this
interagency effort.
APPEAL OF REPORT OF EXAMINATION (FIRST
QUARTER 1995)
A formal appeal was received concerning two
aspects of a Report of Examination (ROE). The bank had
previously appealed several violations of Regulation Z that
resulted from the implementation of a secured credit card program.
This subsequent appeal dealt with two specific issues of the secured
credit card program. The first involved a citing of a Regulation Z
violation, and the other dealt with the method in which the
examiners determined the classified portion of the pool of secured
credit card loans.
Background
Nine months before a routine examination, the
bank entered into a business relationship with a loan broker. The
agreement was that the loan broker would solicit credit card
applications from individuals and would require these applicants to
pledge collateral (either cash or the cash value of a life insurance
policy) in favor of the loan broker. In exchange, the loan broker
would present the applications to the bank and offer the bank
partial guarantee of the loan broker on the underlying obligation of
the customers. The loan broker charged the applicants fees for its
services. At the time the bank entered into the relationship with
the loan broker, the programs were limited to "cash cards" and
"insurance cards" Four months later the insurance card program was
no longer offered. At that time, a derivation of the cash cards
called "installment loan cards" became available. In addition to
offering the above, the bank purchased existing credit card accounts
receivables from another bank. The other bank previously had a
relationship with this loan broker. The highlights of the agreement
are detailed below.
Establishment and Maintenance
of Pool. The loan broker agreed to deposit to the
pool an amount equal to approximately 50 percent of the approved
line for each credit application accepted by the bank. In addition
to the above, funds in a similar pool were transferred from the bank
in which the receivables were purchased. If a customer of the loan
broker defaulted on his or her obligation to the bank and the
default remained uncured for three billing cycles from the date
of default, the default in the credit was cured by payment in full
from the funds in the pool. The loan broker agreed that at all times
at least 30 percent of the dollar amount of the aggregate approved
credit card lines would be maintained in the
pool.
Loan Broker's
Guarantee. The partial guarantee covered all amounts
due to the bank in connection with the cards of the loan broker
customers to the extent such amounts were incurred or charged within
four years after the issuance date of the credit card. The
guarantee was limited to $1MM after the bank's receipt and
application of the pool and the bank's receipt and application of
all collateral under a pledge and security agreement of the same
date.
Cash Cards. An
applicant would offer cash collateral in the amount of the credit
line desired. In addition, the applicant would pay the loan broker a
participation fee.
In exchange, the loan broker would agree to
submit the credit card application to the bank and to support the
application with its own partial guarantee, which it collateralized
with the pool account. The loan broker agreed to return the
collateral to the individual upon cancellation of the card and
repayment of all indebtedness there under.
Insurance
Cards. Each customer had the following three options that
could be used to secure a credit card:
(a) Provide cash collateral to the loan
broker;
(b) Provide an existing life insurance policy
with a sufficient cash surrender value to the loan broker;
(c) Purchase life insurance with sufficient cash
value through the loan broker and then pledge that insurance to the
loan broker.
Once sufficient collateral was pledged to the
loan broker, the loan broker would present the application to the
bank. If the application was approved, the loan broker would extend
a partial guarantee on the customer's indebtedness for four years.
The loan broker supported the guarantee with the deposit account
described above. The pledge of the insurance to the loan broker
remained in effect only as long as the credit card remained
outstanding. Once the credit card was cancelled the customer
would own the insurance policy free of any assignment. The insurance
was universal life insurance or whole life insurance, not credit
insurance. Neither the bank, loan broker, nor any loan account
was ever listed as a beneficiary on any of these policies. Each
insured was at liberty to list his or her own designated
beneficiary. The bank had no knowledge of how much insurance
each customer purchased. These cards were only offered for four
months.
Installment Loan Card. When
the bank and the loan broker stopped offering insurance cards, the
bank began to offer the installment loan card. This program was a
derivation of the cash card program, designed for persons who did
not have sufficient cash to meet the loan broker collateral
requirements. Under this program the loan broker would arrange
a 24-month installment loan from the bank for the borrower. The
borrower would instruct the bank in writing to disburse all of the
proceeds to the loan broker. The loan broker would keep one portion
of the loan proceeds as its fee. The loan broker would place the
remainder of the proceeds in the pool account. In some instances,
the loan broker promised to return the portion of the installment
loan which it placed in its reserve account, less a fee. In other
situations, the loan broker made no such promise.
Once the individual made two installments on the
24-month note (the first payment being taken at the time of the
application), the bank would extend a credit card line to the
individual. The loan broker extended its limited guarantee to both
the installment loan and the credit card line.
Summary
of Programs. These programs ran in tandem with the bank's own
pre-existing credit card program; however, the bank offered
guaranteed credit cards only to borrowers who applied through the
loan broker. The interest rates and fees earned by the bank on its
own cards versus those generated by the loan broker were somewhat
different, although the bank did not feel they were significantly
different.
Discussion and
Conclusions
Each of the two issues will be discussed
separately.
Violation
of Law Resulting in Relationship between Closed-End and Open-End
Credit
A violation of 12 CFR 226.5 General Disclosure
Requirements (Open-End Credit) was cited in the ROE. This
section of the regulations states:
(c)
Basis of disclosures and use of estimates. Disclosures shall reflect the
terms of the legal obligation between the parties. If any
information necessary for accurate disclosure is unknown to the
creditor, it shall make the disclosure based on the best information
reasonably available and shall state clearly that the disclosure is
an estimate.
In addition, a violation of 12 CFR 226.6(a)
Initial Disclosure Statement was cited. This section
states:
The creditor shall disclose to the consumer, in
terminology consistent with that to be used on the periodic
statement, each of the following items, to the extent
applicable:
(a)
Finance charge. The circumstances under which a finance
charge will be imposed and an explanation of how it will be
determined, as follows:
(4) An explanation of how the amount of any
finance charge will be determined, including a description of
how any finance charge other than the periodic rate will be
determined. In the ROE these violations stated that for
open-end credit in the installment loan version of the program, the
finance charge must also include the principal amount of the
installment loan required to obtain the credit card, less the
membership dues.
The bank's appeal states that the bank disclosed
the closed-end transactions and the open-end transactions as if
they were unrelated to one another. The appeal goes on to state that
the bank does not believe the OCC has a legal justification to take
a position that the closed-end and the open-end transactions should
have reflected one another. The bank summarizes its arguments as
follows:
"There is no law directly on point. Neither the
statute, regulation, case law nor the commentary directly addresses
the issue. However, with respect to credit sales, the commentary
does address related transactions stating as follows:
16. Number of transactions.
Creditors have flexibility in handling credit extensions
that may be viewed as multiple transactions. For example:
- When a
creditor finances the credit sale of a radio and a television on
the same day, the creditor may disclose the sales as either one or
two credit transactions;
- When a
creditor finances a loan along with a credit sale of health
insurance, the creditor may disclose in one of several ways: a
single credit sale transaction, a single loan transaction, or a
loan and a credit sale transaction.
- The separate financing of a down payment
in a credit sale transaction may, but need not, be disclosed as
two transactions (a credit sale and a separate transaction for the
financing of a down payment).
We continue to believe that this is the best law
on the subject of related transactions. If a creditor in a credit
sale transaction is afforded the flexibility to separately structure
related transactions, we cannot see why the OCC is refusing to allow
the bank similar consideration in related loan
transactions."
The Office of the Ombudsman found that the
violations of law should remain in the ROE. As acknowledged in the
bank's letter, none of the above examples (from Section 16 of 12 CFR
Part 226.17(c)(1) of the Official Staff Commentary) specifically
match the situation at the bank. The example closest to the bank's
situation is the third example; however, it does not specifically
address the situation where closed-end and open-end transactions are
directly linked by a bank, but instead deal with two closed-end
transactions. More significantly, it does not appear that the
credit sale borrowers in the example were required to finance the
down payment at the same institution. The closed-end
transactions in the example could legitimately be considered
separate for disclosure purposes. In contrast, if a customer
did not choose to secure his or her credit card by cash or the cash
value on a life insurance policy, then the customer was required to
obtain the closed-end credit as a pre-condition for the open-end
credit. If the customer chose the installment loan plan, he or she
had no choice but to obtain a closed-end credit from the bank.
Therefore, the bank's consumers were undertaking essentially
one transaction.
The three examples say nothing about the content
of the disclosures, only that they may be done separately. The
ombudsman agrees that the bank's decision to make separate
disclosures was not a violation. The violations were cited because
the content of the disclosure on the open-end credit was
incorrect. It did not include the closed-end credit as a finance
charge for the open-end credit. The violation did not depend on
whether the two transactions were disclosed separately or together,
but whether the disclosures accurately reflected the substance of
the transaction.
The underlying purpose of the Truth in Lending
Act (TILA) is to help consumers make informed credit decisions
by guaranteeing accurate and meaningful disclosure of the costs
of credit. The finding that the bank imposed the closed-end
transaction as a requirement for the open-end credit, it
follows that the closed-end credit costs would have to be disclosed
as part of the open-end credit cost in order to "reflect the terms
of the legal obligation."
Loan
Classification
The Assets Subject to Criticism page in the ROE
classified the balance outstanding on all the secured credit
cards as substandard. The bank did not appeal the classification but
included in its appeal the following:
We are unable to understand the OCC's thought
process in classifying the secured credit card related loan
classifications. In our view, the loan classifications by the
examiners were unnecessarily inflated. A major change in the
credit card related credits occurred in December 1993, when the bank
rescinded the loans in progress and debited the pool account. The
examiners were well aware of this fact.
Although the bank did not disagree with the
substandard classification, the manner in which the
classification figures were determined was not understood.
The manner in which the examiners arrived at the
classified portion of the program is tied to their determination of
the "passed" portion of the program representing cash
collateral. The examiners determined the entire credit card program
(outstanding extensions of credit and contingent liabilities) to be
a substandard bank asset and criticized it as such. The difference
between the amount classified as substandard and the size of the
program consisted of the portion of the credit card deposit account
that provided partial security for the program. This portion was
excluded from the classification because the security was in
the form of cash. The bank was given credit for 30 percent of the
total amount in the credit card program (including outstandings and
unfunded amounts on issued credit card and installment loans). The
"passed" amount was split proportionately between the
outstanding installment loan portfolio (58 percent) and credit card
portfolio (42 percent). The "passed" amount was split
proportionately instead of applying it all against one portfolio
because the examiners did not want to appear to be classifying one
portfolio and not the other. There was no conscious effort to
classify contingency credit more severely than outstanding credit.
The examiners' intent was to reflect that a portion of the whole
program was not subject to criticism because of the cash in the pool
account.
The ombudsman concluded that the ROE overstated
the classified amounts of the extensions of credit related to the
credit card program. Although examiners typically use financial
information as of the examination date, if material events occur
(either positive or negative) while the examiners are in the bank,
the numbers are adjusted. Because the rescissions took place
after the examination team left the bank, the level of credit-card-
program-related classified assets was not adjusted. Because these
rescissions were completed and all refunds made before the ROE was
mailed, the ombudsman felt the classification numbers should
have reflected these actions.
The appropriate supervisory
office provided the bank with an amended Assets Subject to Criticism
and Summary of Assets Subject to Criticism report pages to reflect
the above changes.