Key Considerations Related to the Valuation of Net Assets Obtained in a FDIC-Facilitated Transaction

Many banks have been seizing the opportunity to be active with FDIC-facilitated transactions. These strategic transactions generally involve the acquisition of certain assets and liabilities through a purchase and assumption arrangement

In addition, the FDIC generally provides a guarantee on certain assets pursuant to a loss-sharing arrangement (LSA), acting like an insurance plan for the acquiring institution. Many of these transactions have resulted in an accounting gain (bargain purchase gain) for the winning bidders.

Accounting Standards Codification (ASC) Topic 805, Business Combinations, (previously FAS 141R), requires that all acquired assets and liabilities are recorded at fair value. Determining the fair value of the loans and deposits acquired, the related indemnification asset if there is a LSA and a core deposit intangible includes various complexities and challenges that are not common with normal bank mergers and acquisitions. The proper use of current market interest rates and credit related factors have a significant impact on the value of the loans, the indemnification asset, the potential bargain purchase gain and regulatory capital. The following provides an overview of some key considerations when valuing net assets obtained in a FDIC-facilitated transaction.

Complications in dealing with a failed institution
There are many inherent challenges that are involved with participating in an FDIC-facilitated transaction. Compared to most bank mergers and acquisitions, these transactions occur at a very rapid pace with limited time and information available for due diligence. Accordingly, due diligence continues subsequent to the closing on a FDIC-facilitated transaction. The results of pre-diligence and post-diligence efforts need to be properly integrated into the fair value modeling of net assets acquired.

Loan concerns
Because it is a failed institution, many loans are not in good shape. When determining fair value in healthy times, loans may receive a minor fair value adjustment, but with failed institutions, even performing loans are typically worth materially less than their book value. Moreover, non-performing loans are usually worth substantially less than their book value. A discounted cash flow method is typically used to determine the fair value of the loans and key assumptions include expected default and prepayment rates, and remaining term, as well as interest rate and market discount rates. For non-accrual loans, typically the fair value of the collateral and related expenses are also taken into account. As noted above, it is important to ensure that the fair values properly integrate the results of due diligence efforts, especially as it relates to expected credit loss, including probability of default and expected loss, given default, by loan type and quality.

The LSA between the FDIC and the acquiring institution is accounted for as an indemnification asset pursuant to ASC Topic 805. There is a correlation between the fair value of the loans and the LSA, as the expected credit loss assumed in valuing the loans, as well as the timing of the loss, is taken in account in determining the fair value of this indemnification asset.

Core deposit intangible
As with any valuation, the value of intangible assets must be determined. Assets such as the trade name are not as valuable with a distressed institution, but the core deposit intangible (CDI) is typically the key intangible asset. The CDI represents the value of the core deposit customer relationships.

CDI values are significantly lower than they were a few years ago due to the current interest rate market. With a failed institution, the premium is usually even lower due to higher expected attrition. A discounted cash flow method is also typically used to value a CDI, which reflects the cost savings the core deposits provide to the bank. Key assumptions include expected initial account run-off, annual attrition rate, current market interest rates, non-interest income, operating expenses attributable to core deposits and the alternative cost of borrowing, such as FHLB advance rates or brokered CD rates. In determining expected attrition rates, historical performance is considered, as well as the impact if it is assumed that interest rates will be reset. CDs are not typically included as core deposits for purposes of calculating the CDI due to their rate sensitivity.

Deposits
The institution’s deposits themselves must be also valued, specifically the time deposits. Typically the book value represents the fair value of the demand deposits given a bank’s ability to change the interest rates. Under the current rate market, the fair value of time deposits is typically higher than their book value, implying a premium. In an FDIC-facilitated transaction, the assuming bank may have the ability to reset the interest rate on certificates of deposits, negating some of the premium.

There are always many factors to consider when valuing the net assets in a bank merger or acquisition. However, when acquiring the net assets of a failed institution, there are often more complications and less time to manage them. Having a thorough knowledge of common issues at the outset of your transaction could eliminate difficulties and allow your purchase accounting efforts to progress more smoothly.

For more information on issues pertaining to troubled institution transactions, please read Tax Consequences of Amounts Received by the Acquiring Bank in an FDIC Assisted Transaction as well as The Effect of FAS 141R on Bargain Purchases.

Suzanne Marra, ASA, is a director at McGladrey. She can be contacted at 847.413.6965 or at suzanne.marra@mcgladrey.com.