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Appeal of Violation of Regulation O (First Quarter 2012)

Background

A community bank appealed a violation of Regulation O under 12 C.F.R. § 215.4(a)(1)(i), identified during the most recent examination.  The violation was based on preferential terms extended to an insider.  

The transaction involved the bank’s purchase of the insider’s residential mortgage loan from an affiliate.  The affiliate granted the home purchase loan to the insider at an adjustable rate and structured it on a 30-year amortization with interest only monthly payments for the first 15 years.  

Discussion

The bank’s appeal was based on the premise that when the loan was granted to the insider by the affiliate, the terms were not more favorable, and the loan product offered was also available to qualified individuals in the general public.  The bank’s appeal also asserted that the loan did not deviate from credit policy underwriting guidelines when the insider loan was originated by the affiliate, the standards were not less stringent than the standards that would apply to any other customers, and the loan did not involve more than the normal risk of repayment than other similar credits.  

As proof that the insider loan was made on substantially the same terms as those to non-insiders, the bank submitted a loan purchased from another affiliate.  The terms of the loan transactions are as follows:

  • Insider:  $637,500 purchase money residential first mortgage loan purchased by the bank from an affiliate; 30-year amortization; monthly interest-only payments for the first 15 years with monthly principal and interest payments due thereafter; adjustable rate for the full term based on LIBOR plus a margin of 1.90%, adjusting monthly.
  • Non-insider:  $220,500 purchase money residential first mortgage loan purchased by the bank from a different affiliate; 30-year amortization; monthly interest-only payments for first 10 years based on a fixed rate of 5.625%; monthly principal and interest payments due thereafter based on LIBOR plus a margin of 2.75%, adjusting semi-annually.  

The Supervisory Office determined the bank violated Regulation O when it made a loan to an insider on terms not substantially the same as those granted to non-insiders.  Management was unable to provide evidence of comparable transactions on substantially the same terms with non-insiders.  

12 C.F.R. § 215.4(a)(1)(i) states no member bank may extend credit to any insider of the bank or insider of its affiliates unless the extension of credit is made on substantially the same terms (including interest rates and collateral) as, and following credit underwriting procedures that are not less stringent than, those prevailing at the time for comparable transactions by the bank with other persons that are not covered by this part and who are not employed by the bank.

Conclusion

The ombudsman conducted a comprehensive review of information submitted by the bank and the supervisory office.  The ombudsman relied on 12 C.F.R. Part 215 – Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks (Regulation O) in making the determination.  The ombudsman made the following determinations:

  • The bank entered into a binding commitment to extend credit to the insider when it purchased and booked the loan from its affiliate.  Therefore, this is the date for which compliance with Regulation O is required.
  • The bank was unable to demonstrate that the insider loan was made on substantially the same terms as those prevailing at the time for comparable transactions by the bank with non-insiders.  The insider loan is not substantially similar to the bank’s non-insider loan example based on material differences in the loan amount, the length of the interest-only period, the interest terms (fully adjustable for 30 years vs. fixed for 10 years), and the margin.
  • The bank failed to provide documentation of any underwriting analysis of the insider’s credit when the loan was purchased.  Absent such documentation, the bank cannot confirm the loan underwriting procedures were not less stringent than those prevailing at the time for comparable transactions with non-insiders.

Based on these facts, the ombudsman concluded the supervisory office appropriately supported the violation of 12 C.F.R. § 215.4(a)(1)(i).   Accordingly, the ombudsman directed the bank to contact the supervisory office to determine the appropriate corrective action.