Perspectives: Accounting

OCTOBER 16, 2017
Understanding discounted cash flow modeling as an option for CECL  
By Brandon Quinones, Risk Management Consultant, Sageworks

One of the main impetuses for changing the prevailing model for estimation of the allowance for loan and lease losses (ALLL) was the FASB’s view that reliance on historic information to determine “incurred-but-not-realized” losses in reserve calculations did not allow institutions to adjust reserve levels given a reasonable and supportable expectation of future events. Thus, a new standard requiring institutions to “… estimate expected credit losses over the contractual term of the financial asset(s)…” and “…consider available information relevant to assessing the collectability of cash flows. This information may include internal information, external information, or a combination of both relating to past events, current conditions, and reasonable and supportable forecasts.”1

Contractual v. Expected Cash Flows
When estimating losses using a discounted cash flow (DCF) approach, expected cash flow models are appropriate for reserve calculation under the new standard. A few material differences between the two calculations are modeling factors such as prepayment, default estimates, loss estimates and recovery activities that otherwise would not be used in a contractual cash flow calculation.

Track movement of loans by segment
to identify trends in portfolio growth
Approach
To calculate and apply these tendencies, the following inputs are critical to the calculation of discounted cash flow:



Of all the portfolio assumptions noted in the table, perhaps the most important to calculate are the Probability of Default (PD) and Loss Given Default (LGD).

PD and LGD are parameters that can be leveraged by institutions in a standalone measurement. Institutions currently using a PD and LGD approach for current GAAP may make an effort to calculate a lifetime PD and a symmetrical LGD to determine a rate for loss in an attempt to accomplish life-of-loan requirements as part of the new standard.

BENEFITS
Long-Term Assets
Calculating and understanding the average life and/or prepayment rate of a loan/loan type (e.g., CRE, Mortgages, C&I) is mandatory when calculating the expected credit losses.

An institution calculating its life-of-loan loss experience utilizing methodologies such as Vintage Analysis, Migration, PD and LGD, and/or Static Pool analysis will require look-back periods sufficient to cover the expected life of the pool. For example, if a loan pool has an average life of four years, an institution would need four years of data to conduct a single four-year observation of losses, and such a data set would only be inclusive of loans that were on the balance sheet four years prior.

A DCF approach can employ recent, shorter-term observations for deployment in a forward-looking amortization schedule. DCF is, and will be, a preferred methodology for calculating the reserve of longer-lived assets.

Readily Available Industry/Peer Data
In instances where loan pools lack loan-counts to be statistically relevant, haven’t experienced a material amount of defaults/losses during periods where data is available and/or have new portfolios that are more analogous to industry/peer experience, a DCF best accommodates alternative measurements while maintaining institution-specific risk.

In using DCF, financial institutions may deploy industry-level PD, LGD and CPR (Conditional Prepayment Rate) toward their own loan structures for a reasonable and possibly more relevant expectation of life-of-loan loss.

Forecasting
The CECL standard frequently references concepts related to making adjustments based on reasonable and supportable forecasts2, concepts that are most logically addressed by using a DCF methodology. In projecting expected cash flows, each period within a forward-looking amortization schedule can/will vary slightly based on future expectations of external/economic data.

CHALLENGES
By its very nature, executing an expected cash flow schedule for each loan every month/quarter may not be practical in a spreadsheet environment. On the other hand, institutions utilizing a third-party provider may run into challenges recording the loan data required to build an accurate amortization schedule.

The process starts and ends with developing policies and procedures around the ongoing maintenance of loan-level data. Every institution should begin to define rules for storage and/or maintenance of data. By taking steps now, financial institutions will find themselves in a position to calculate a reasonable and supportable reserve.

1 ASU 326-20-30-6
2 ASU 326-20-30-7


Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Brandon Quinones, Risk Management Consultant, Sageworks
Brandon Quinones is a Risk Management Consultant in the Bank Division at Sageworks, where he primarily focuses on helping community banks and credit unions manage their allowance for loan and lease loss (ALLL) provisions.




FEBRUARY 2, 2017
FOMC opts to hold steady amid improving conditions  
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

Following a two-day policy meeting in Washington, Federal Reserve officials unanimously held their benchmark rate steady in a range between 0.50% and 0.75%, while noting in a statement some recent improvements in the economy.

The Fed provided little direction on when it might next raise borrowing costs, as officials debate the impacts of policy changes with the new administration. The central bank currently projects three rate hikes for 2017, though committee members differ on how proposed tax cuts and regulatory changes may boost growth and inflation.

Looking Ahead
“Measures of consumer and business sentiment have improved of late,” the Federal Open Market Committee said in its statement Wednesday. Policy makers reiterated their expectations for moderate economic growth, “some further strengthening” in the labor market and a return to 2% inflation.

The FOMC also repeated that it anticipates interest rates will rise gradually. The statement said job gains “remained solid” and the unemployment rate “stayed near its recent low,” a tweak from December’s language that the rate “has declined.”

“Inflation increased in recent quarters but is still below the committee’s two percent longer-run objective,” the Fed said. Market-based measures of inflation compensation are “still low,” the central bank said, after suggesting in December that such measures had “moved up considerably.”

The committee left unchanged its stated intention to continue reinvesting its maturing debt holdings until “normalization” of the benchmark rate is “well under way.” The Fed’s balance sheet stands at about $4.5 trillion.
Fed Chair Janet Yellen, who didn’t have a press conference scheduled after this meeting, will have the opportunity to discuss the decision further during her semiannual monetary-policy testimony to Congress in mid-February. The FOMC next meets on March 14-15.

Before the latest statement, investors saw a roughly 38% chance that the first rate increase of 2017 would come at the Fed’s March meeting, based on trading in federal funds futures. The odds rose to about 52% for the subsequent gathering in early May and 75% for mid-June. The market forecast is currently calling for two hikes in the next two years and one in 2019. This would bring the overnight rate to 1.12% for December 2017, 1.62% at year-end 2018 and 1.87% for 2019. 

Tough Decisions
With bond yields still near historic lows, investors in fixed-income securities face a dilemma. Short-term bonds offer sub-par yields, but provide reinvestment opportunities in a rising rate environment. On the other hand, longer-term bonds secure a higher yield, but present larger losses if market rates rise.
 
Ten-year Treasury notes currently yield about 2.50%, not a great return given the interest rate risk in holding the security over the next decade. If yields were to climb 100 basis points to 3.50%, the price would drop almost 9%.  In this scenario, a five-year Treasury issue yielding 1.9% would lose 4.6%, and a 1.2% two-year note would drop 2%.  Even if bonds are held to maturity, experiencing price losses only on paper, the investor still foregoes the opportunity to earn higher returns if yields rise. 

The opposite would occur if rates fall, resulting in a sharp rally and producing sizeable unrealized gains. If this were to happen, the investor benefits from having locked in above-market yields. The investor is faced with the challenge of managing a portfolio structured to perform in either scenario.

One solution is to create a “bond ladder.” A laddered portfolio consists of securities that mature in successive years, starting in a few years and extending out to five years or longer. Assembling a stable basket of cash flows avoids locking in all of one’s funds at “low” yields, while enabling the investor to pick up some additional income. 

The benefit of a ladder is that as rates move higher, bonds coming due in the near term can provide funds for reinvestment when the alternatives may be more attractive. Depending on the investor’s preference and individual situation, the principal can be put to work at the desired maturity. If current yields are higher than the bonds rolling off, the investor is able to increase overall returns and boost portfolio performance.

At the close of every year, it seems the market prognosticators predict higher rates for the ensuing twelve months. Heeding these warnings, many investors flock to ultra-short-term bonds, sacrificing income. According to academic studies, by investing the bulk of the portfolio in short-term, low-yield bonds, investors are exposed to a different risk over time: earning low yields. There is an opportunity cost of sitting at near zero and waiting for higher rates, as the conventional wisdom about bonds does not always play out. Just as a well-balanced portfolio consists of several types of investments, so too should it contain a well-structured schedule of maturities.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Robert B. Segal, CFA, Founder/CEO, Atlantic Capital Strategies, Inc.
Robert B. Segal, CFA is founder and chief executive officer with Atlantic Capital Strategies, Inc. Bob has been in the banking industry since 1982, having worked in several community banks with roles in mortgage banking, sales and trading, and asset liability management. He is a frequent speaker at industry events and contributes to many regional and national finance publications. His firm provides investment advisory services to community-based institutions. Bob can be reached at bob@atlanticcapitalstrategies.com or 781-276-4966.




OCTOBER 26, 2016
Three Approaches to Small Business Lending that Drive Growth
By Mary Ellen Biery, Research Specialist, Sageworks

Business lending has been an important source of growth for banks and credit unions since the financial crisis, and it will continue to be a critical driver in the quarters ahead. In a September 2016 survey of bankers, 81% indicated that CRE and C&I will be their focus for growth.

Given the current market’s pressure to ‘grow or go,’ many banks will look toward loan growth, which is seen by many banks as a way to scale, helping them outpace rising costs of compliance while expanding their reach into their communities. Financial institutions effectively growing their business loan portfolios are tapping into an underutilized opportunity for loan growth – loans to smaller businesses – and are implementing changes that transform the customer experience.

Loans to operating businesses have historically tended to flow toward larger institutions. But financial institutions focused solely on large commercial loans are missing an immense opportunity to grow the loan portfolio and retain or attract customers. Large enterprises make up less than 1% of the nearly 29 million businesses in the U.S. Most businesses are actually sole proprietorships or small businesses.

“Small businesses don’t want to go to online lenders, but it’s easier for many of them and they often can get the money quickly,” says Peter Brown, a senior consultant at Sageworks. “There’s a huge opportunity because those small businesses need funding, perhaps more than many other businesses.”

Common Approaches Driving Growth
Institutions already growing their commercial loan portfolios profitably are doing so by taking action to upend some of the traditional pain points – for the borrower and the lender – related to business lending. These three approaches, often driven by technology, can offer a better customer experience.

1. Speed of application
Technology is helping institutions make the application process faster and easier for borrowers while streamlining the underwriting process for the financial institution. For example, file-hosting technology allows applicants to share electronic files of supporting documentation for loan applications, and electronic signatures also move the process along more quickly. A new technology for banks and credit unions can automatically import financial data from electronic tax returns directly into the loan application. This saves the borrower from time-consuming and error-prone data entry while simultaneously transferring the necessary information into the bank’s system for credit analysis, loan administration and life-of-loan management.

2. Faster decisions and transparency
The search costs involved in small business lending are high for both borrowers and lenders. In recent years, financial institutions have streamlined loan approval processes by implementing technology that automates credit analysis, decisioning and the annual updates to financial statements of current borrowers. Even if the application process has been streamlined as described above, the decisioning stages can also be expedited to increase turnaround times for borrowers.

With loan decisioning technology, the institution can choose how much of the process to automate while still maintaining and supporting the human element provided by experienced analysts. For example, with the right technology and process in place, lenders can be responsible for much of the application process, and with that information in the system technology can make a recommendation for approval, rejection or further review. For smaller exposure loans, these efficiency gains mean the institution’s trained analysts are focused on the loans or borrowers that most demand their attention, and business borrowers benefit from faster loan decisions and a more transparent process.

3. Competitive rates
Pricing a loan to match a competitor’s rate may win the new business, but financial institutions understand that doing so can come at a huge cost if the institution doesn’t take into account the risk level and whether the loan will meet the institution’s profitability goals. Technology makes lending operations more efficient and scalable and can provide greater insight into which changes to rates, fees or terms are advantageous to both the borrower and lender.

Conclusion
Financial institutions growing their commercial portfolios profitably use technology to provide superior customer experiences while fundamentally changing the risks and costs associated with lending to businesses. These institutions that have the ability to underwrite smaller loans to businesses efficiently and accurately stand to tap into important growth markets while more effectively meeting the needs of current members and clients.

Technology in these cases doesn’t replace the relationship that a financial institution has with a business borrower; rather, the goal is to replace the administrative touches. In doing so, lenders, relationship managers and portfolio managers can spend more time talking to customers about their needs rather than the administrative requirements for the institution.

After all, the customer doesn’t care about the institution’s administrative requirements – that small business just wants its money.

1 “Sageworks Summit Poll: CRE loans top focus in loan portfolio”, 10/4/2016. https://www.sageworks.com/datareleases.aspx?article=396&title=Sageworks-Summit-Poll:-CRE-loans-top-focus-in-loan-portfolio&date=October-5-2016

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Mary Ellen Biery, Research Specialist, Sageworks
Mary Ellen Biery is a research specialist at Sageworks, where she produces accounting and banking content for the company’s blogs and websites, as well as for other outlets. She is a veteran financial reporter whose work has appeared in The Wall Street Journal and on Dow Jones Newswires, CNN.com, MarketWatch.com, CNBC.com and other sites.






NOVEMBER 10, 2016
A Review of Swap Hedge Accounting 
By Brian Matochik, Senior Vice President, FTN Financial Derivative Products Group

Hedge accounting is a set of accounting rules established by FASB that standardizes and governs the way swap transactions are accounted for. To those of us who are not accountants (and maybe even to some of us that are), this term may seem daunting and complicated. However, hedge accounting is actually very beneficial for financial institutions that are looking make longer-term loans and hedge the risk by using interest rate swaps.

The purpose of hedge accounting is to not only establish guidelines and consistency for how swaps should be accounted for, but also to reduce the potential earnings volatility in derivative transactions that qualify for this type of accounting treatment. Because interest rate swaps are required to be marked to market, income volatility could arise if their market value changed significantly and had to be taken into earnings. For example, the market value of a pay-fixed swap will move similarly, but inversely, to the market value of a bullet bond with similar par amount and term. Therefore, a swap’s price volatility can be substantial, which is why hedge accounting is certainly worth considering.

There are two types of hedge accounting treatment, as outlined in the table below:



Fair Value Hedge
For a fair value hedge, the swap will be recorded as an asset or liability on the balance sheet with an offsetting value adjustment to the hedged asset or liability. As long as the structure of the hedge and the item being hedged are closely matched, there is little to no earnings impact. This is especially useful for institutions that use swaps to hedge long-term fixed-rate commercial loans (loan swaps executed with individual borrowers, i.e. back-to-back swaps, do not require hedge accounting treatment).

Cash Flow Hedge
For a cash flow hedge, the swap will be recorded as an asset or liability on the balance sheet with an offsetting value recorded in OCI (Other Comprehensive Income). Cash flow hedge accounting is comparable to how banks account for AFS securities, where the value of a hedge is offset as a component of equity. Similar to a fair value hedge, as long as the structure of the hedge and the item being hedged are closely matched, there is little to no earnings impact. Cash flow hedges are useful for hedging trust preferred securities, FHLB advances and other floating-rate liabilities.

Some institutions choose to bypass hedge accounting treatment and simply mark swaps to market in earnings, which is the alternative option to hedge accounting. In these cases, institutions will often move an asset to a trading account to help offset swap market values. However, since hedge accounting reduces the potential earnings volatility that would come from changes in the swap’s market value, it is beneficial for institutions to consider this approach first when exploring any hedge strategies.

There are, of course, certain documentation requirements and steps involved in order to be able to elect hedge accounting treatment, and it is important for institutions to partner with a knowledgeable counterparty for full accounting support to ensure compliance. However, when used properly, hedge accounting is an important tool that institutions can use to reduce earnings volatility from hedging instruments.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Brian Matochik, Senior Vice President, FTN Financial Derivative Products Group
As a Senior Vice President in the Derivative Products Group at FTN Financial, Brian is responsible for customer hedging strategy development and hedge accounting support, as well as derivative trade execution, management and implementation, with a focus on hedging strategies for community banks.  He is involved in all aspects of FTN Financial’s Hedging Program including loan structuring, pricing, trade execution and client support. Mr. Matochik graduated summa cum laude from the University of Memphis with a B.A. in International Studies and also holds an M.B.A. from the University of Memphis Fogelman College of Business and Economics.  






OCTOBER 17, 2016
FMS Quick Poll: Social Media
By Financial Managers Society

What constitutes a “community?”

Whereas a clear designator such as geographic proximity might have definitively answered that question in the past, the notion isn’t quite as clearly cut these days. The explosive growth of social media has redefined both what a community is and where it is – shifts that are proving profound for personal and business relationships alike.

What is the impact on a community institution, for example, if the community it serves begins to migrate to the virtual world of social media? How does a bank or credit union continue to reach out to its community to connect, communicate and engage when those customers are more likely to log on than walk in? We were curious as to how FMS members were using social media and how it was affecting engagement with their customers. With close to 125 responses in our latest Quick Poll, it certainly appears as though members are attempting to reach out to their customers via social media, but the details lie in the degree to which they are committed to that effort.

Of the 122 respondents in the poll – 104 from banks and 18 from credit unions – 56% consider their institution to be either a highly active (multiple posts per week, dedicated staff, regular interaction with customers) or somewhat active (a post at least every week, occasional interaction with customers) social media user (see Figure I). Meanwhile, 21% of poll participants maintain a social media presence but don’t consider themselves particularly active, and 23% aren’t on social media at all, for reasons ranging from compliance concerns to lack of resources to a belief that their customers just aren’t interested.

FMS Quick Poll

For those who have chosen to maintain a social media presence, has the effort proven fruitful in terms of engaging their communities? The answer is somewhat, but perhaps not as much as they would like. Only 7% of respondents describe the level of interaction with their customers via social media as vibrant, while 36% consider their social media efforts worthwhile but not a terribly high priority, and another 30% note that their customers rarely engage with the institution on social media (see Figure II).

FMS Quick Poll

In terms of where FMS members spend their time and resources on social media, Facebook is far and away the most frequently utilized platform at 44% among poll respondents (see Figure III), followed by LinkedIn (24%) and Twitter (19%). Members see far less value, however, in posting photos to Instagram or videos on YouTube (6% each).



Across these and other platforms, poll respondents are clearly trying to highlight their standing in their communities, with 36% frequently sharing local news and events (see Figure IV). Another common social media use is posting basic announcements regarding branch hours, closings, etc. (29%), while less common uses include product promotions (20%) and personal finance advice/articles (14%).

FMS Quick Poll

Responses across asset sizes were fairly consistent, though larger institutions ($500 million and up) reported greater levels of social media interaction with their customers than their smaller peers. It is interesting, however, that even among the larger institutions a “vibrant” level of engagement was hard to come by.

Thanks again to everyone who participated in our latest FMS Quick Poll. If you didn’t have a chance to complete the poll, be sure to weigh in with your views on social media in the comments section below or on FMS Connect!




SEPTEMBER 22, 2016
Fed Elects to Punt: Eyeing the End of the Year, FOMC Leaves Rate Unchanged Again
By Robert B. Segal, CFA, Atlantic Capital Strategies, Inc.

The Federal Reserve left its policy rate unchanged for a sixth straight meeting, saying it would wait for more evidence of progress toward its goals, while projecting that an increase is still likely by year-end.

“Near-term risks to the economic outlook appear roughly balanced,” the FOMC said in its statement after a two-day meeting in Washington. “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

Three officials, meanwhile, dissented in favor of a quarter-point hike. Esther George, president of the Kansas City Fed, voted against the decision for a second straight meeting. She was joined by Cleveland Fed President Loretta Mester and Eric Rosengren, head of the Boston Fed.

The central bank’s “dot plot” showed that officials expect one quarter-point rate increase this year. Officials scaled back expectations for hikes in 2017 and over the longer run. Policymakers see two rate hikes next year, down from their June median projection of three. They see the Fed funds rate settling in at 2.9%, down from a 3% guess in June.

“Our decision does not reflect a lack of confidence in the economy,” Fed Chair Janet Yellen said at the press conference. “Since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future.” She noted that a “cautious” approach is all the more appropriate given that short-term rates are still near zero, and therefore the Committee can more effectively respond to inflation pressures by raising rates than to falling inflation by cutting rates.

At this time, markets place the chance of a rate increase by year-end at 60%, down slightly from 65% after the Fed’s April 27th meeting. This compares with only 10%, however, at the end of June. The yield on the benchmark 10-year Treasury note traded recently at 1.65%, compared with 1.85% at the end of May.

In its latest banking profile, the FDIC said community banks reported net interest income of $17.5 billion during first quarter 2016, up $1.3 billion (8.2 percent) from the prior year. Net interest margin of 3.56% was up two basis points from the year earlier, as asset yields increased two basis points and funding costs were unchanged. Going forward, however, margins are projected to trend downward as asset yields are under pressure while funding costs remain near floors.

In this environment, some institutions may wish to consider a more active investment style. A number of organizations limit their investment allocation to a few areas in which they are comfortable, such as mortgage securities or agencies. With this approach, however, the institution may be sacrificing income as well as increasing balance sheet risk.

In fact, portfolio managers at many banks have been busy realigning their investment distributions. With the decline in rates in recent quarters, portfolio cash flow has spiked and according to industry reports, the destination for this cash has largely been municipal and other non-agency bullet securities.

This shift should not come as a surprise, as organizations continue to struggle with margin challenges in the face of a flatter yield curve. Depositories choose these types of securities to provide additional yield and position the portfolio more appropriately for the current rate environment. The predictable cash flow feature makes them an attractive alternative even with the longer duration.

Investment sectors often become overvalued. Investors concerned about rising rates have flocked to short-duration mortgages and floating-rate notes, driving up prices and pushing down yields. At the same time, the market tends to punish entire sectors during times of stress. In these cases, investment officers should consider selling the “rich” securities and moving into the undervalued ones.

Earlier this year, corporate bond spreads widened dramatically as energy prices fell and the stock market plunged. This affected most corporate issuers regardless of credit quality. Apple Inc., for example, issued five-year notes at a spread of 100 basis points to Treasuries, about double the normal spread. This happened in spite of Apple’s strong balance sheet, consistent profitability and ample liquidity.

Investors moving out of short-duration mortgage securities and into high-quality corporate bonds at this time could have realized higher levels of current income and more stable portfolio cash flow characteristics. While corporate bonds are not appropriate for all investors, the same strategy can be utilized with other securities that offer favorable total return potential.

Maintaining flexibility for managing the investment portfolio can reduce overall rate sensitivity through a range of tactical and strategic transactions. An active manager tends to spread exposures to a variety of higher-returning sectors, while moving out of market segments that become expensive.  Successful active management also entails a willingness to think independently in terms of position and sector weightings. When properly implemented, active management strategies can lessen an institution’s exposure to declining margins, helping to offset the impact of a challenging investment landscape.

About the Author

Robert B. Segal, CFA, Founder/CEO, Atlantic Capital Strategies, Inc.
Robert B. Segal, CFA is founder and chief executive officer with Atlantic Capital Strategies, Inc. Bob has been in the banking industry since 1982, having worked in several community banks with roles in mortgage banking, sales and trading, and asset liability management. He is a frequent speaker at industry events and contributes to many regional and national finance publications. His firm provides investment advisory services to community-based institutions. Bob can be reached at bob@atlanticcapitalstrategies.com or 781-276-4966.

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.




AUGUST 29, 2016
How Hard is it for a Small Lender to Make a Qualified Balloon Mortgage 
By Tim Tedrick, Partner, Wipfli LLP

With the ongoing changes by the Consumer Financial Protection Bureau (CFPB), some lenders are still not sure about whether they can easily make qualified balloon mortgages.

The first step is to determine whether the creditor is eligible for the small portfolio lender balloon qualified mortgage exception contained in 12 CFR 1026.43(f). There are three standards that need to be met:

1. Together with all affiliates who regularly extend first-lien mortgages, total assets were less than $2.060 billion (adjusts annually)
2. Together with affiliates, the creditor originated 2,000 or fewer mortgages during the prior calendar year (loans originated and kept in the portfolio are not counted among the 2,000)
3. The creditor extended at least one first-lien covered mortgage secured by a property located in a rural or underserved area during the prior calendar year

For all three of these conditions, if the application is received before April 1 of the current year, then each condition must have been met for at least one of the two preceding calendar years.

Once the creditor has determined eligibility for the small portfolio lender balloon qualified mortgage exception, the next step is to ensure the loan product meets the regulatory limitations and protections. There can be no interest rate increases, no negative amortization, no interest-only payments and the loan term can be no less than five years and no more than 30 years. The creditor generally needs to keep the loan in the portfolio for three years.

The creditor should also make sure the loan is not a higher-priced mortgage loan (HPML), because for these loans the creditor would have a rebuttable qualified mortgage, not a safe harbor qualified mortgage (assuming the loan meets the qualified mortgage requirements in the table below). For the HPML limit, the APR cannot exceed the APOR by 3.5% or more. As of August 22, 2016, that would have required an APR of less than 6.42% for a five-year balloon.

The creditor should also ensure the points and fees do not exceed the various thresholds based on the loan amount, and these numbers adjust annually.



Finally, for underwriting purposes, the creditor must consider the consumer’s debt-to-income ratio. Because there is no specific percentage prescribed in the regulation, however, it is incumbent on the creditor to set its own
debt-to-income ratio.

The creditor must also verify the debt obligations and income used in the underwriting, but is not required to verify employment – only to consider this factor in the underwriting. The use of a credit report is also not specifically required, but the creditor may consider this factor when underwriting the debt and determining the debt-to-income ratio. The only items to verify specifically are income, debt, alimony and child support, if applicable, along with debt-to-income or residual income.

In conclusion, eligible small rural creditors looking to make a five-year balloon loan should keep the following factors in mind:

1. Keep the points and fees within limits
2. Keep the APR below the limits
3. Underwrite the loan reasonably
4. Verify the income and debt

If a creditor does not meet the small creditor balloon QM criteria, the creditor could still originate a balloon loan as long as the loan complies with the ability-to-repay requirements – it just would not be a qualified mortgage. 

Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not necessarily reflect the official policy or position of the Financial Managers Society.

About the Author

Tim Tedrick, Partner, Wipfli LLP
Tim Tedrick is a partner with the accounting firm of Wipfli LLP. He has over 40 years of experience, the first eleven with a bank and the remaining with Wipfli, where he heads up the compliance team. A graduate of the ABA National Graduate Compliance School in Norman, Oklahoma, he is also a Certified Regulatory Compliance Manager and a Certified Risk Professional.