Identifying Impaired Loans

Hatz’s Hamburger Stand missed the last three payments on its loan to Small Bank.  The original loan was for \$100,000, and the current balance is \$90,000.  Although the collateral for the loan, the restaurant building itself, has an appraised value of \$107,000, the management of Small Bank believes the bank will be lucky to find a buyer who will pay \$100,000.  Management estimates that the building may take as long as a year to sell.  The utilities for the building are projected to be about \$200 a month.  To improve the chances of a sale, the bank will have the building’s exterior repainted, for a cost of \$6,000.  The bank will also have to pay a realtor a 10 percent commission to sell the building, the going rate for commercial property sales. Finally, management believes that the bank would have earned an 8 percent return on the money tied up in the building if it had been available to lend.

 Is the Hatz’s Hamburger Stand loan impaired? YES NO Because the loan is not performing according to contractual terms, it is impaired.

 If the loan is impaired, how much should Small Bank increase its provision to cover the expected loss on the loan? Assume the loan is categorized as collateral dependent for your analysis. A. \$8,400 B. \$15,600 The correct answer is \$8,400. This is the appraised value \$107,000; less \$7,000 (the bank believes it can only get \$100,000 out of the building because it is the seller); less \$2,400 for utilities for a year; less \$6,000 for a paint job; less \$10,000 sales commission = \$81,600.  With a loan balance of \$90,000, the amount of expected loss is thus \$8,400 (\$90,000-81,600).  The lost interest income is not used in the loss calculation. C. \$6,000 D. \$8,600

Increasing the Provision for Loan and Lease Losses

 Small Bank has six collateral-dependent business inventory loans to different borrowers that it has valued separately as part of its ALLL analysis.  If Small Bank increases its provision for loan loss to cover its expected losses, how much should it provide? Expected loss Current loan Balance Expected recovery on sale of collateral Expected Loss Loan 1 \$55,000 \$47,500 Loan 2 \$27,500 \$22,500 Loan 3 \$67,500 \$75,000 Loan 4 \$49,000 \$47,500 Loan 5 \$88,000 \$88,000 Loan 6 \$91,000 \$99,500
 A. \$0 B. \$14,000 The correct answer is \$14,000. The expected loss in Loan 1 is \$7,500.  The expected loss in Loan 2 is \$5,000 and \$1,500 in Loan 4.   The sum of expected losses is \$14,000.  There is no expected loss in Loans 3, 5, and 6 because collateral values are expected to cover the outstanding balances on these loans.  As a result they are not included in the loss calculations. C. \$11,500 D. \$-2,500

The Effect of Previously Charged-off Loans on the ALLL Balance

Loan losses and recoveries on previously charged-off loans can affect the ALLL balance as well as decisions regarding how much to provide out of income to keep the ALLL at an appropriate level.  There are two rules of thumb to remember:

• Charge-off of uncollectible loans reduce the ALLL balance.
• Recovery on previously charged-off loans are added to the ALLL, increasing the ALLL balance.

Assume that Bank A has a loan and lease portfolio totaling \$100 million at the end of year one and an ALLL of \$1.25 million; thus, its outstanding loan less the ALLL or net loans is reported on its balance sheet as \$98.75 million. Based on its most recent analysis, Bank A has determined that an ALLL of \$1.5 million is necessary to cover its estimated loan losses at the end of the fourth quarter.

 Bank A’s ALLL balance is not adequate to cover estimated loan losses. What amount should Bank A take as a provision for loan and lease losses to have an appropriate ALLL balance? A. \$250,000 B. \$1.25 million The correct answer is \$250,000. The estimated amount for an appropriate ALLL balance is \$1,500,000.  The current balance is \$1,250,000.  There is a short fall of \$250,000.  This shortfall is the minimum amount the Bank 2 should provide out of income to bring the ALLL balance to an appropriate level. C. \$125,000 D. Need More                Info.

Assume that Bank A brought its ALLL balance up to \$1.5 million, the amount necessary to cover estimated loan losses.  During the first quarter of year two, Bank A identifies \$750,000 in uncollectible loans. Assume further that in the same first quarter of year two, Bank A receives \$100,000 in cash recoveries on previously charged off loans.

 What will be Bank A’s ALLL balance, assuming no additional provision for loan loss at this point, at the end of the second quarter? A. \$750,000 B. \$650,000 The correct answer is \$850,000. The charge-off of uncollectible loans reduce the \$1.5 million ALLL amount by \$750,000, or half, which results in an ALLL balance of \$750,000.  The recoveries of \$100,000 are added to the ALLL during the quarter.  Thus, in the first quarter of year two, Bank A’s ALLL, which began the year at \$1.5 million, will have been reduced to \$850,000 (\$1,500,000 -\$750,000 + \$100,000 = \$850,000) C. \$1.25 million D. \$850,000
 Assuming at the end of the second quarter, Bank A's analysis indicates that an ALLL of \$1.2 million is necessary to absorb estimated credit losses. (The ALLL from the first quarter is \$850,000.) What will Bank A have to provide out of income to bring the ALLL to an appropriate level? A. \$350,000 B. \$450,000 The correct answer is \$350,000. Bank A must make a provision for loan and lease losses of \$350,000 (\$1,200,000 - \$850,000) to bring its ALLL up to the estimated amount needed at the end of the first quarter of year two. C. \$500,000 D. \$750,000