Foreclosed Assets after the 2008 Credit Crisis

As a result of the 2008 Credit Crisis in conjunction with the worldwide recession, most financial institutions have dealt with an unprecedented amount of foreclosures on real estate secured loans.  In the last 2 years, both commercial and residential real estate values have dropped significantly, coupled along with the rise in unemployment and staggering jobless rates.  This has caused borrowers to suffer extreme financial distress and trouble keeping up with their mortgage payments.  One way in which a borrower can try to retain their property is by requesting a modification through President Obama’s “Making Homes Affordable Plan”.  There are many factors a borrower must consider to qualify for this program.  However, the four most important factors necessary for qualification are that the home is the primary residence, the mortgage must be less than $729,750, the payment including real estate taxes must be greater than 31% of the loan and, lastly, the borrower must be experiencing difficulty making payments. 

In many cases the residential borrower does not qualify for this plan and still cannot afford to make their payments.  Currently, there is no plan for commercial real estate loans, therefore many of these borrowers are also forced to “walk away” from their properties.  The result is that the financial institution is left with real estate at a significantly lower value than the loan that was issued.  As we all know, this has contributed to the drop in stock values and/or failures of many financial institutions.  Even institutions that have not had to deal with foreclosures in the past have had a significant number of loans go into the foreclosure process since the credit crisis began. 

If the fact that many financial institutions have experienced more foreclosures than ever before wasn’t bad enough, the complex accounting procedures for these assets makes it even more difficult for these institutions.  The simple definition of forecloses assets, also referred to as “Other Real Estate Owned” (OREO) is real estate acquired and held by the financial institution because of either full or partial defaulting of a loan balance by the borrower.  

The rules on how to record OREO property are specific and must be reviewed closely as Federal and State Regulators are focusing more of their attention to these assets due to concerns surrounding troubled debt restructurings. Generally accepted accounting principles (GAAP) require the transfer of the OREO property to take place when the financial institution initiates the foreclosure process, even if state and local laws do not allow the institution to take possession of the property.  In addition, if the institution takes possession of a property before initiating the foreclosure proceedings, the transfer in the institution’s books should take place at that time.  Once the transfer is initiated, GAAP requires a new cost basis to be established for the property.  This new cost basis would be the fair value at the time the foreclosure process begins less any anticipated costs to sell the property.  Based on these rules, very often the financial institution will record a loss on the property thereby diminishing the earnings for the period. 

An example of this would be if a customer of a financial institution had a secured loan of $400,000 for a home whose value was originally $500,000.  In this example, the customer could not afford the payments and the institution began foreclosure proceedings.  At the time these proceedings began the value of the home was assessed at $350,000.  In addition, the institution estimated selling costs of $50,000 for the real estate commission and other various costs to maintain the property.  In this example, the institution would record the property on its books in OREO at $300,000 ($350,000-$50,000), thereby establishing a valuation reserve of $100,000 and taking a charge against income of $100,000.

Once the new value of the OREO property has been recorded, the institution is required to monitor the property’s value and adjust a valuation allowance specific to this property for changes in value on a periodic basis.  As has been the case in this economy, if the value of the property continues to decrease, the institution must take a charge against income to lower the value of the property to the revised fair value.  Using the previous example, assume a new appraisal was performed 6 months after the property was transferred into OREO.  The value of this appraisal was $300,000.  The financial institution would have to charge $50,000 against income for the decrease in value of the OREO property. The $300,000 value less $50,000 of selling costs for a new value of the OREO property of $250,000.  The value of the property when it was transferred into OREO was $300,000 so the institution would charge $50,000 to net income to reduce the property to its new value.

As discussed, the information above can significantly impact the financial statements of a financial institution, yet the Internal Revenue Service does not allow the institution to deduct the “write-down” of this asset until the asset is actually sold.  This could result in institution having reportable taxable income even when they have properties classified as foreclosed real estate.

Since the rules in relation to foreclosed real estate can be complex and are subject to constantly changing legislation it is important to have an accounting firm with the proper experience to help guide your institution in this challenging economy.

Robert Posner is a Principal for the firm Albrecht, Viggiano, Zureck & Company, P.C. (AVZ), located in Hauppauge and Manhattan.  AVZ is one of Long Island’s premier public accounting firms providing business solutions to the private, public and governmental sectors.  AVZ has affiliations in principal cities around the world through membership in BKR International.  For more information, please call (631) 434-9500 or email rposner@avz.com.