A recent Securities and Exchange Commission order settling charges against Malvern Bancorp and its former CFO for failing to properly account for troubled real estate loans is a cautionary tale for banks, according to a report from the law firm of Arnold & Porter.
Under the SEC order earlier this month the Pennsylvania bank holding company — acquired last month by New Jersey-based First Bank in a stock and cash transaction valued at about $129.7 million — and its ex-finance chief, Joseph Gangemi, agreed to pay, $350,000 and $40,000, respectively, to settle charges.
The charges centered on Malvern’s failure to recognize restructurings, loan impairment and charge offs related to problem loans in a timely way. The order cited instances related to three different loans totaling $37.4 million tied to retail properties that resulted in “material misstatements” of Malvern’s financial statements for several quarters.
Attorneys from Arnold & Porter led by partners Robert C. Azarow and Daniel M. Hawke, flagged the order and advised financial institutions to take several precautionary steps with regard to how they handle commercial real estate loans.
“We anticipate that accounting for expected credit losses will be a high priority for bank examiners and the staff of the SEC,” the report states. “The accurate measurement of expected credit losses requires a bona fide evaluation of borrowers’ credit, the timely ordering of refreshed appraisals and other valuations, and objectivity in selecting and weighting different appraisals and relevant scenarios.”
The case has come to light as a number of regulatory bodies have indicated they are prioritizing commercial real estate debt. The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve system and the Federal Deposit Insurance Corporation have recently pointed to commercial real estate as one of the top areas of risk for financial institutions, according to the report.
It also comes as the Financial Accounting Standards Board is revisiting generally accepted accounting standards for the expected credit losses standard. Known as CECL, it grew out of a FASB effort to encourage timelier reporting of losses after the 2008 financial crisis prompted criticism around delays in companies reporting deteriorated asset values.
In light of the Malvern order, the report warns financial institutions to proceed cautiously with CRE matters and to:
- Evaluate a borrowers’ credit, using current information including recent appraisals and recognize losses when they occur “to avoid the appearance of delaying such recognition to improve earnings.”
- Brace for heightened SEC and federal banking regulator scrutiny and enforcement activity with respect to valuations and disclosures of CRE loans.
- Be cautious about challenging regulatory examiners about loan classifications and their “resulting allowance calculations and allocations.”
- Watch for the SEC to enforce the clawback of an executive compensation should an executive be found to have been involved in accounting that manipulates income or expense recognition.
The rising expectation of regulatory crackdowns comes as banks like Wells Fargo and other firms have been grappling with changes in asset values stemming from the shift toward remote work and e-commerce, which has weighed on brick and mortar retail and office buildings.
At a conference in June Wells Fargo CFO Michael P. Santomassimo said Wells Fargo was “spending a lot of time" thinking about commercial real estate and may need to increase its reserves in connection with it.
“As more and more time goes by you get some more information and we can refine some of the dials in the model and as we refine those dials we’ll have to likely reserve a bit more to hopefully get ahead of whatever losses could come over time,” Santomassimo said.
The total volume of distrissed commercial real estate grew $8 billion in the second quarter, the biggest quarterly increase since the second quarter of 2020, The Wall Street Journal reported.
