Banco Sabadell Investor Relations

Spanish banks A spotter’s guide to real estate accounting

This document has been prepared by: Investor Relations at Banco Sabadell - [email protected]

Disclaimer: This document is an objective simplified explanation of the Spanish regulation regarding real estate transactions and is not illustrative of any specific company.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Real estate accounting for banks In every turn of the cycle, Spanish financial institutions become more active on real estate transactions. This document illustrates the accounting procedures for two frequent real estate-related events: Event 1 - Mortgage-secured loan becomes an NPL (pages 3-14) For this event this document explains the following stages: RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Event 2 - Real estate assets bought to developers (pages 15-20) For this event this document explains the following stages: ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

It must be noted that under Event1 the customer stops paying but under Event2 the loan is a performing loan. This has different consequences for provisioning accounting (generic and specific) as well as impacts on NPL ratios, as explained later. Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Reclassifying a loan as NPL When an instalment on a loan is not paid by the customer, it becomes NPL after 90 days and it is reclassified as such. Note that the Total net loans amount does not change.

Reclassifying aa loan Reclassifying loan as asNPL NPL Bal.Sheet " " "

Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b) NPL and country risk provisions Total net loans

year 0

entry

year 1

1000 0 1000 *-12 988

-1000 +1000

0 1000 1000 -12 988

*In this example the generic provision is 1.2% of the loan amount (12) but it will depend on the risk profile of the loan. See Appendix 1 on page 21 for more details on generic provision levels.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Provisioning for the loan When a loan becomes NPL, the generic provision is cancelled and the specific provision is set up. This affects both P&L and balance sheet. Provisioning the Provisioning for loan the loan P&L " Bal.Sheet " " " "

Generic provision charge Specific provision charge Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b) NPL and country risk provisions Total net loans

year 1

entry

year 2

+12 *-274 0 1000 1000 -12 988

**-262

0 1000 1000 -274 726

* The specific provision will depend on the calendar. Here we assume a fast calendar for a full 12 months (27.4%). The different calendars can be seen on Appendix 2 on page 22. ** -262 is the net of -274 of specific provision charge and +12 of generic provision release.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

4

Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

The client resumes payment If the customer resumes payments the specific provision is unwound, the generic is set up again and the loan is removed from NPLs. pays the the loan loan Client pays P&L " Bal.Sheet " " " "

Bal.Sheet " "

Specific provision charge Generic provision charge (1,2%*) Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b) NPL and country risk provisions Total net loans

year 2

entry

year 3

+274 *-7 0 1000 **-400 1000 -274 ***+267 726

0 600 600 *-7 593

Reclassifying loan as performing Reclassify as performing

year 2

0

year 3

Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b)

0 600 600

600 -600

600 0 600

* The generic provision is 1.2% of the pending loan (600x1.2%=7.2). This calculation is done on a monthly basis. **-400 is the amount of the loan paid back. *** +267 is the net number of +274 release of specific provision and -7 charge of generic provision.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

5

Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Repossession. Valuation considerations (1) There are two different accounting treatments depending on the nature of the real estate guarantee: A – if the guarantee is other than finished residential property (land, warehouse..). B – if the guarantee is a finished residential property (to live in it). A A

Accounting of real estate other than finished property.

In this case the value of the real estate asset will be the lowest of: Market value (MV): Appraisal value minus selling costs or Book value (BV): Debt value minus specific provisions If MV > BV then the value of the real estate asset will be its BV. If BV > MV then: a) if the recovery process is over, the value of the real estate asset will be MV and a loss will be booked for the difference b) if the recovery process can continue, the value of the real estate asset will be MV. The loss is not booked and the unpaid debt remains on balance sheet. Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Repossession. Valuation considerations (2) B Accounting of real estate which is finished property: In this case the regulation allows to unwind the specific provisioning built up on that debt if specific circumstances are met: If MV > BV then a) if 70% of Appraisal value > Debt value, the difference between the two can be unwinded from the specific provision. The repossessed asset will be valued at Debt value. b) if 70% of Appraisal value < Debt value, the specific provision cannot be unwinded. The repossessed asset will be valued at Book value (Debt value minus specific provisions). Example: Debt value Scenario 1

100 Debt value

Scenario 2

100

Specific provision

50 (50%) Specific provision

50 (50%)

Appraisal value

200 Appraisal value

100

70% of 200 = 140; 140 > 100 CAN RELEASE 40 FROM SPECIFIC PROV.

70% of 100 = 70; 70 < 100 CANNOT RELEASE ANY SPECIFIC PROV.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Repossession. Valuation considerations (3) B Accounting of real estate which is finished property: If BV > MV then: a) if the recovery process is over, the value of the real estate asset will be MV and a loss will be booked for the difference b) if the recovery process can continue, the value of the real estate asset will be MV. The loss is not booked and the unpaid debt remains on balance sheet.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

The real estate asset is repossessed The example below shows the entries in an example where the specific provision is not recovered and the entire loan disappears from the balance sheet (the recovery process is over). The property is repossessed Property is repossessed

"

Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b) NPL and country risk provisions Total net loans

"

Option A: market value ≥ book value

Bal.Sheet " " "

" " P&L Bal.Sheet

year 2

0 1000 1000 -274 726

entry

-1000 O P T I O N

+274

A

A

Non-current assets for sale

year 3

0

+1000

0

-200 +800

O P T I O N

B

0 0 0 0 0 1000

B market value < book value (v.g. 800) Option B.

Losses in asset value Non-current assets for sale

800

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Impairment test. Preliminary considerations

• According to the regulation, the frequency for impairment tests on real estate-related assets is 3-5 years, but should there be market evidence of price fluctuations, a shorter term will prevail (effectively once a year).

• The impairment test can only be done via a third party appraisal company. This company must be approved by Bank of Spain. The list of approved appraisal companies is available at the following link: http://www.atasa.com/index.php?es,asociados,codigo

• If the outcome of the impairment test implies a loss, this loss will be taken directly to the P&L, but if it implies a gain, the gain can only be booked up to the amount of a previously accounted loss and the difference can only be realised when the asset is sold. Example: Initial book value (year 1)

1st appraisal (year 2)

2nd appraisal (year 3)

Value = 100

Value = 70

Value = 110

loss to P&L = 30

implicit gain = 40 (110-70)

The maximum gain to be accounted for in year 3 without selling the asset is 30, not 40

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Impairment test The example below shows the entries in the case of an impairment test when the market value is higher than book value (and there are no previous losses to offset against the potential gains) and when the market value has dropped below book value (in that case the losses must be booked). Impairment test Impairment test If market value ≥ book value Bal.Sheet

Non-current assets for sale

year n

entry

1000

year n+1

1000

If market value < book value (v.g. 700) P&L Bal.Sheet

Losses in asset value Non-current assets for sale

1000

-300 -300

700

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

11

Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

When the real estate asset is sold: Upon its sale, the property will generate a gain or a loss depending on whether the selling price is above or below the book value.

Asset sale Property is sold Bal.Sheet

Non-current assets for sale

year n

1000

year n+1

-1000

0

If selling price > book value (v.g. 1200) P&L

Extraordinary income

+200

If selling price < book value (v.g. 800) P&L

Extraordinary loss

-200

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 1 - A mortgage-secured loan becomes NPL RECLASSIFYING

PROVISIONING

RESUME PAYMENT

REPOSSESSION

Outcome 1

Outcome 2

IMPAIRMENT TEST

ASSET SALE

WRITE-OFF

Writing off a loan: For ilustration purposes and independently from the previous scenarios, we show here the entries related to a loan which is written off. • Writing off a loan does not put an end to the legal right of the bank to claim the unpaid debt to the customer. • The timing for writing off is subjective and it comes down to when the recoveries department considers that all has been done to recover the debt; as a reference on average it could be after 10 years of the debt becoming NPL. the the loanloan off The bank writes writes-off P&L Bal.Sheet " " " "

Specific provision charge Gross loans to customers (a) Non-performing loans (b) Total gross loans (a+b) NPL and country risk provisions Total net loans

year 1

0 1000 1000 -950 50

entry

*-50 -1000 -50+1000

year 2

0 0 0 0 0

*This example would be a 1000 loan which has been 95% provisioned. The specific provision is completed to 100% of the loan (-50), and the loan is removed from the balance sheet. Net and gross loans are reduced to zero.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

Acquiring the land/property Typically the property/land is acquired via a swap between the developer and the bank´s real estate company. The bank’s real estate company subrogates the payment of the loan. Property Developer ASSETS Property

LIABILITIES Loan

BANK’S REAL ESTATE CO.

ASSETS Property

LIABILITIES Loan

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

Accounting for the land/property The acquired property has mainly two possible destinations within the balance sheet: Inventories: When the asset is in the process of being sold, typically less than one year Fixed assets / real estate investment: When the asset will be used to generate a return for the bank (v.g. for rental) It is up to the bank to justify the reason why it classifies the asset in one caption or the other It must be noted that the impairment test (explained later) takes place regardless of where the asset sits on the balance sheet

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

Cancelling the existing loan The loan is then cancelled out as the bank consolidates its real estate company globally. Therefore the property stays within the bank. In most occasions, the loan is a perfoming loan. Since it is a performing loan, there is no specific provision related to it.

BANK ASSETS Loan

BANK + BANK’S REAL ESTATE CO.

BANK’S REAL ESTATE CO.

ASSETS Property

Consolidated

ASSETS Property Loan

LIABILITIES Loan

LIABILITIES Loan

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

Impairment test The impairment test procedure for these type of assets is the same as the one described on pages 10 and 11 Impairment test Impairment test If market value ≥ book value Bal.Sheet

Non-current assets for sale

year n

entry

1000

year n+1

1000

If market value < book value (v.g. 700) P&L Bal.Sheet

Losses in asset value Non-current assets for sale

1000

-300 -300

700

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

ASSET SALE

IMPACT ON CAPITAL

Selling the property The asset sale procedure for these type of assets is the same as the one described on pages 12 Asset sale Property is sold Bal.Sheet

Non-current assets for sale

year n

1000

year n+1

-1000

0

If selling price > book value (v.g. 1200) P&L

Extraordinary income

+200

If selling price < book value (v.g. 800) P&L

Extraordinary loss

-200

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

SELLING THE PROPERTY

IMPACT ON CAPITAL

Impact on capital (1)

• If the bank’s subsidiary acquiring the real estate assets is considered a financial company it will be included in the consolidation perimeter of the bank for capital calculation purposes. In that case, the rule states that the real estate asset be classified as fixed asset for the company and therefore will have a risk weighting of 100% (as fixed assets do).

• If the bank’s subsidiary is considered a non-financial company, it is excluded from the consolidation perimeter for capital calculation purposes. The capital impact in that case will depend on the balance sheet structure of the bank’s real estate subsidiary, but in most cases the capital consumption will be larger.

Banco Sabadell Investor Relations - Spotter’s guide to real estate accounting - January 2009

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Event 2 – Acquiring real estate from developers ACQUIRING

CANCELLING LOAN

IMPAIRMENT TEST

SELLING THE PROPERTY

IMPACT ON CAPITAL

Impact on capital (2) So does Event 2 improve the capital situation of the banking group overall? • Since the company is buying real estate assets and cancelling loans that are perfoming loans on which the weighting is normally 100%, there is no capital benefit from these real estate acquisitions. Other asset weightings involving real estate (for information purposes): • If the real estate asset comes from repossession then it is non-performing and then the weighting is 150% except if the specific provision is ≥20%, in which case the weighting is 100%. • If the real estate asset comes from repossession of residential property then the weighting is 100% and if the specific provision is ≥20% then the weighting is 50%. • Performing residential mortgages are weighted at 35% if LTV is