I. INTRODUCTION
The Federal Financial Institutions Examination Council (FFIEC) has issued a policy statement supporting prudent commercial real estate (CRE) loan workouts. The policy statement provides guidance for examiners and for financial institutions that are working with CRE borrowers who are experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties. The financial regulators recognize that prudent loan workouts are often in the best interest of both financial institutions and borrowers, particularly during difficult economic conditions. The policy statement details risk-management practices for loan workouts that support prudent and pragmatic credit and business decision making within the framework of financial accuracy, transparency, and timely loss recognition.
Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications. In addition, performing loans, including those renewed or restructured on reasonable modified terms, made to creditworthy borrowers will not be subject to adverse classification solely because the value of the underlying collateral declined.
The policy statement includes examples of CRE loan workouts. The examples, provided for illustrative purposes only, reflect examiners’ analytical processes for credit classifications and assessments of institutions’ accounting and reporting treatments for restructured loans. The policy statement reiterates existing guidance that examiners are expected to take a balanced approach in assessing institutions’ risk-management practices for loan workout activities.
II. RISK MANAGEMENT ELEMENTS FOR LOAN WORKOUT PROGRAMS
An institution’s risk management practices for renewing and restructuring CRE loans should be appropriate for the complexity and nature of its lending activity and should be consistent with safe and sound lending practices and relevant regulatory reporting requirements. These practices should address:
III. LOAN WORKOUT ARRANGEMENTS
Loan workouts can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions. A renewal or restructuring should improve the lender’s prospects for repayment of principal and interest and be consistent with sound banking, supervisory, and accounting practices. Institutions should consider loan workouts after analyzing a borrower’s repayment capacity, evaluating the support provided by guarantors, and assessing the value of the collateral pledged on the debt. Loan workout arrangements need to be designed to help ensure that the institution maximizes its recovery potential. Further, renewed or restructured loans to borrowers who have the ability to repay their debts under reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.
While institutions may enter into restructurings with borrowers that result in an adverse classification, an institution will not be criticized for engaging in loan workout arrangements so long as management has:
A. Analyzing Repayment Capacity of the Borrower
The primary focus of an examiner’s review of a commercial loan, including binding commitments, is an assessment of the borrower’s ability to repay the loan. The major factors that influence this analysis are the borrower’s willingness and capacity to repay the loan under reasonable terms and the cash flow potential of the underlying collateral or business. When analyzing a commercial borrower’s repayment ability, examiners should consider the following factors:
B. Evaluating Guarantees
The support provided by guarantees is a consideration in determining the credit classification for a workout. The presence of a guarantee from a financially responsible guarantor may improve the prospects for repayment of the debt obligation and may be sufficient to preclude classification or reduce the severity of classification. The attributes of a financially responsible guarantor include:
The institution should have sufficient information on the guarantor’s global financial condition, income, liquidity, cash flow, contingent liabilities, and other relevant factors (including credit ratings, when available) to demonstrate the guarantor’s financial capacity to fulfill the obligation. This assessment includes consideration of the total number and amount of guarantees currently extended by a guarantor in order to assess whether the guarantor has the financial capacity to fulfill the contingent claims that exist.
Examiners should consider whether a guarantor has demonstrated its willingness to fulfill all current and previous obligations, has sufficient economic incentive, and has a significant investment in the project. An important consideration will be whether previously required performance under guarantees was voluntary or the result of legal or other actions by the lender to enforce the guarantee.
C. Assessing Collateral Values
As the primary sources of loan repayment decline, the importance of the collateral’s value as a secondary repayment source increases in analyzing credit risk and developing an appropriate workout plan. The institution is responsible for reviewing current collateral valuations (i.e., an appraisal or evaluation) to ensure that their assumptions and conclusions are reasonable. Further, the institution should have policies and procedures that dictate when collateral valuations should be updated as part of its ongoing credit review, as market conditions change, or a borrower’s financial condition deteriorates.
For CRE loans involved in a workout situation, a new or updated appraisal or evaluation, as appropriate, should address current project plans and market conditions that were considered in the development of the workout plan. The consideration should include whether there has been material deterioration in the following factors: the performance of the project; conditions for the geographic market and property type; variances between actual conditions and original appraisal assumptions; changes in project specifications (e.g., changing a planned condominium project to an apartment building); loss of a significant lease or a take-out commitment; or increases in pre-sales fallout. A new appraisal may not be necessary in instances where an internal evaluation by the institution appropriately updates the original appraisal assumptions to reflect current market conditions and provides an estimate of the collateral’s fair value for impairment analysis.
The market value in a collateral valuation and the fair value in an impairment analysis are based on similar valuation concepts. However, the market valuation may differ from the collateral’s fair value for regulatory reporting purposes. For example, differences may result if the market value and the fair value estimates are determined as of different dates or the fair value estimate reflects different assumptions than those in the market valuation. Such situations may occur as a result of changes in market conditions and property use since the “as of” date of the appraisal.
The documentation on the collateral’s market value should demonstrate a full understanding of the property’s current “as is” condition (considering the property’s highest and best use) and other relevant risk factors affecting value. Collateral valuations of commercial properties typically contain more than one value conclusion and could include an “as is” market value, a prospective “as complete” market value, and a prospective “as stabilized” market value. The institution should use the market value conclusion (and not the fair value) that corresponds to the workout plan and the loan commitment. For example, if the institution intends to work with the borrower to get a project to stabilized occupancy, then the institution can consider the “as stabilized” market value in its collateral assessment for credit risk grading after reviewing the reasonableness of the appraisal’s assumptions and conclusions. Conversely, if the institution intends to foreclose, then the institution should use the fair value (less costs to sell) of the property in its current “as is” condition in its collateral assessment.
Examiners will analyze collateral values based on the institution’s original appraisal or internal evaluation, any subsequent updates, additional information, and relevant market conditions. An examiner should review the appropriateness of the major facts, assumptions, and valuation approaches in the collateral valuation and in the institution’s internal credit review and impairment analysis.
If weaknesses are noted in the institution’s supporting documentation, appraisal, or evaluation review process, examiners should direct the institution to address the weaknesses, which may require the institution to obtain a new collateral valuation. However, if the institution is unable or unwilling to address these deficiencies in a timely manner, examiners will have to assess the degree of protection that the collateral affords in analyzing and classifying a credit. This may result in examiners making adjustments, if applicable, to the collateral’s value to reflect current market conditions and events. When reviewing the reasonableness of the facts and assumptions associated with the value of an income-producing property, examiners should evaluate:
Assumptions, when recently made by qualified appraisers (and, as appropriate, by the institution) and when consistent with the discussion above, should be given a reasonable amount of deference by examiners. Examiners also should use the appropriate market value conclusion in their collateral assessments. For example, when the institution plans to provide the resources to complete a project, examiners can consider the project’s prospective market value and the committed loan amount in their analysis.
Examiners generally are not expected to challenge the underlying valuation assumptions, including discount rates and capitalization rates, used in appraisals or evaluations when these assumptions differ only in a limited way from norms that would generally be associated with the collateral under review. The estimated value of the underlying collateral may be adjusted for credit analysis purposes when the examiner can establish that any underlying facts or assumptions are inappropriate or can support alternative assumptions.
Many CRE borrowers may have other indebtedness secured by other business assets such as furniture, fixtures, equipment, inventory, and accounts receivable. For these commercial loans, the institution should have appropriate policies and practices for quantifying the value of such assets, determining the acceptability of the collateral, and perfecting its security interest. The institution also should have appropriate procedures for ongoing monitoring of the value of its collateral interests and security protection.
IV. CLASSIFICATION OF LOANS
Loans that are adequately protected by the current sound worth and debt service capacity of the borrower, guarantor, or the underlying collateral generally are not adversely classified. Similarly, loans to sound borrowers that are renewed or restructured in accordance with prudent underwriting standards should not be adversely classified or criticized unless well-defined weaknesses exist that jeopardize repayment. Further, loans should not be adversely classified solely because the borrower is associated with a particular industry that is experiencing financial difficulties. When an institution’s restructurings are not supported by adequate analysis and documentation, examiners are expected to exercise reasonable judgment in reviewing and determining loan classifications until such time as the institution is able to provide information to support management’s conclusions and internal loan grades.
The NCUA does not require credit unions to adopt a uniform regulatory classification schematic of loss, doubtful, substandard or special mention. A credit union should apply an internal loan grade based on its evaluation of credit risk. The term “classify” within the credit union industry has typically meant “individually review to apply a percentage reserve” for ALLL purposes. As used in this paper, “classify” and “classification” in relation to a credit union’s evaluation of a credit for risk mean “grade” and “assign a credit risk grade.”
The federal bank and thrift regulatory agencies utilize the following definitions for assets adversely classified for supervisory purposes as well as those assets listed as special mention:
Substandard Assets: A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
Doubtful Assets: An asset classified doubtful has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.
Loss Assets: Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future.
Special Mention: A special mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special mention assets are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.
A. Loan Performance Assessment for Classification Purposes
The loan’s record of performance to date should be considered when determining whether a loan should be classified. As a general principle, examiners should not adversely classify or require the recognition of a partial charge-off on a performing commercial loan solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. However, it is appropriate to classify a performing loan when well-defined weaknesses exist that will jeopardize repayment.
One perspective of loan performance is based upon an assessment as to whether the borrower is contractually current on all principal and interest payments. In many cases, this definition is sufficient for a particular credit relationship and accurately portrays the status of the loan. In other cases, being contractually current on payments can be misleading as to the credit risk embedded in the loan. This situation can occur when the loan’s underwriting structure or the liberal use of extensions and renewals mask credit weaknesses and obscure a borrower’s inability to meet reasonable repayment terms.
For example, in many acquisition, development and constructions loans, it is common for a loan to be structured with an “interest reserve” for the construction phase of the project. The interest reserve is established at the time the loan is originated as a portion of the initial loan commitment. The lender recognizes interest income from the reserve during the construction phase. Proceeds from the sale of lots, homes, or buildings or permanent financing based on stabilized occupancy are used for the repayment of principal, which includes any draws from the interest reserve that have been capitalized into the loan balance.
However, if the development project stalls for any number of reasons and management fails to evaluate the collectability of the loan, interest income will continue to be recognized from the initial interest reserve and capitalized into the loan balance even though the project is not generating sufficient cash flows to repay the principal. In such cases, the loan will be contractually current due to the interest payments being funded from the reserve, but the repayment of principal may be in jeopardy, especially when expected leases or sales have not occurred as projected and property values have dropped below the market value reported in the original collateral valuation. In these situations, adverse classification of the loan may be appropriate.
B. Classification of Renewals or Restructurings of Maturing Loans
Loans to commercial borrowers can have short maturities, including short-term working capital loans to businesses, financing for CRE construction projects, or loans to finance recently completed CRE projects for the period to achieve stabilized occupancy. Many borrowers whose loans mature in the midst of an economic crisis have difficulty obtaining short-term financing or adequate sources of long-term credit due to deterioration in collateral values despite their current ability to service the debt.
In such cases, institutions may determine that the most appropriate and prudent course is to restructure or renew loans to existing borrowers who have demonstrated an ability to pay their debts, but who may not be in a position, at the time of the loan’s maturity, to obtain long-term financing. The regulators recognize that prudent loan workout agreements or restructurings are generally in the best interest of both the institution and the borrower.
Restructured workout loans typically present an elevated level of credit risk as the borrowers are not able to perform according to the original contractual terms. The assessment of each credit should be based upon the fundamental characteristics affecting the collectability of the particular credit. In general, renewals or restructurings of maturing loans to commercial borrowers who have the ability to repay on reasonable terms will not be subject to adverse classification, but should be identified in the institution’s internal credit grading system and may warrant close monitoring. However, adverse classification of a restructured loan would be appropriate, if, after the restructuring, well-defined weaknesses exist that jeopardize the orderly repayment of the loan in accordance with reasonable modified terms.
C. Classification of Troubled CRE Loans Dependent on the Sale of Collateral for Repayment
As a general classification principle, for a troubled CRE loan that is dependent on the sale of the collateral for repayment, any portion of the loan balance that exceeds the amount that is adequately secured by the market value of the real estate collateral less the costs to sell should be classified as “loss.” This principle applies when repayment of the debt will be provided solely by the sale of the underlying real estate collateral and there are no other available and reliable sources of repayment.
The portion of the loan balance that is adequately secured by the fair value of the real estate collateral less the costs to sell generally should be adversely classified no worse than “substandard.” The amount of the loan balance in excess of the fair value of the real estate collateral, or portions thereof, should be adversely classified “doubtful” when the potential for full loss may be mitigated by the outcomes of certain pending events, or when loss is expected but the amount of the loss cannot be reasonably determined. If warranted by the underlying circumstances, an examiner may use a “doubtful” classification on the entire loan balance. However, examiners should use a “doubtful” classification infrequently and for a limited time period to permit the pending events to be resolved.
D. Classification and Accrual Treatment of Restructured Loans with a Partial Charge-off
Based on consideration of all relevant factors, an assessment may indicate that a credit has well-defined weaknesses that jeopardize collection in full and may result in a partial charge-off as part of a restructuring. When well-defined weaknesses exist, and a partial charge-off has been taken, the remaining recorded balance for the restructured loan generally should be classified no more severely than “substandard.” A more severe classification than “substandard” for the remaining recorded balance would be appropriate if the loss exposure cannot be reasonably determined. Such situations may occur where significant risk exposures are perceived, such as a borrower’s bankruptcy or a loan collateralized by a property subject to environmental hazards.
A restructuring may involve a multiple note structure in which, for example, a troubled loan is restructured into two notes. Lenders may separate a portion of the current outstanding debt into a new legally enforceable note (i.e., the first note) that is reasonably assured of repayment and performance according to prudently modified terms. This note may be placed back on accrual status in certain situations. In returning the loan to accrual status, sustained historical payment performance for a reasonable time prior to the restructuring may be taken into account. The portion of the debt that is not reasonably assured of repayment (i.e., the second note) should be adversely classified and charged-off as appropriate.
In contrast, the loan should remain or be placed on nonaccrual status if the lender does not split the loan into separate notes, but internally recognizes a partial charge-off. A partial charge-off would indicate that the institution does not expect full repayment of the amounts contractually due. If facts change after the charge-off is taken such that the full amounts contractually due, including the amount charged-off, are expected to be collected and the loan has been brought contractually current, the remaining balance of the loan may be returned to accrual status without having to first receive payment of the charged-off amount. The institution should have well-documented support for its credit assessment of the borrower’s financial condition and the prospects for full repayment.
V. REGULATORY REPORTING AND ACCOUNTING CONSIDERATIONS
Institution management is responsible for preparing regulatory reports in accordance with GAAP and regulatory reporting requirements and supervisory guidance. Management also is responsible for establishing and maintaining an appropriate governance and internal control structure over the preparation of regulatory reports. This structure includes written policies and procedures that provide clear guidelines on accounting matters. Accurate regulatory reports are critically important to enhancing the transparency of an institution’s risk profile and financial position and imperative for effective supervision. Decisions related to loan workout arrangements may affect regulatory reporting, particularly interest accruals, troubled debt restructuring treatment, and credit loss estimates. Management should ensure that loan workout staff appropriately communicate with the accounting and regulatory reporting staff concerning the institution’s loan restructurings and that the reporting consequences of restructurings are presented accurately in regulatory reports.
In addition to evaluating credit risk management processes and validating the accuracy of internal credit grades, examiners are responsible for reviewing management’s processes related to accounting and regulatory reporting. While similar data is used for credit risk monitoring, accounting, and reporting systems, this information does not necessarily produce identical outcomes. For example, loss classifications may not be equivalent to impairment measurements. Examiners need to have a clear understanding of the differences between the credit risk management, accounting, and regulatory reporting concepts (such as accrual status, restructurings, and the ALLL) when assessing the adequacy of the institution’s reporting practices. The following sections provide a summary of these reporting topics. However, examiners should refer to regulatory reporting instructions and guidance and applicable GAAP for further information.
A. Implications for Interest Accrual
For a restructured loan that is not already in nonaccrual status before the restructuring, the institution needs to consider whether the loan should be placed in nonaccrual status to ensure that income is not materially overstated. A loan that has been restructured so as to be reasonably assured of repayment and of performance according to prudent modified terms need not be maintained in nonaccrual status, provided the restructuring and any charge-off taken on the loan are supported by a current, well-documented credit assessment of the borrower’s financial condition and prospects for repayment under the revised terms. Otherwise, the restructured loan must remain in nonaccrual status.
The assessment of accrual status should include consideration of the borrower’s sustained historical repayment performance for a reasonable period prior to the date on which the loan is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. A restructuring should improve the collectability of the loan in accordance with a reasonable repayment schedule and does not relieve the institution from the responsibility to promptly charge off all identified losses. For more detailed criteria about placing a loan in nonaccrual status and returning a nonaccrual loan to accrual status, see the FFIEC Call Report, TFR, and NCUA 5300 Call Report instructions.
B. Restructured Loans
The restructuring of a loan or other debt instrument should be undertaken in ways which improve the likelihood that the credit will be repaid in full under the modified terms in accordance with a reasonable repayment schedule. All restructured loans should be evaluated to determine whether the loan should be reported as a TDR. For reporting purposes, a restructured loan is considered a TDR when the institution, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower in modifying or renewing a loan that the institution would not otherwise consider. To make this determination, the lender assesses whether (a) the borrower is experiencing financial difficulties, and (b) the lender has granted a concession. Guidance on reporting TDRs, including characteristics of modifications, is included in the FFIEC Call Report, TFR, and NCUA 5300 Call Report instructions.
The determination of whether a restructured loan is a TDR requires consideration of all of the facts and circumstances surrounding the modification. No single factor, by itself, is determinative of whether a restructuring is a TDR. An overall general decline in the economy or some deterioration in a borrower’s financial condition does not automatically mean that the borrower is experiencing financial difficulties. Accordingly, lenders and examiners should use judgment in evaluating whether a modification is a TDR.
C. Allowance for Loan and Lease Losses (ALLL)
Guidance for the institution’s estimate of loan losses and examiners’ responsibilities to evaluate these estimates is presented in Interagency Policy Statement on the Allowance for Loan and Lease Losses (December 2006) and Interagency Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions (July 2001).
Institutions are required to estimate credit losses based on a loan-by-loan assessment for certain loans and on a group basis for the remaining loans in the held-for-investment loan portfolio. All loans that are reported as TDRs are deemed to be impaired and should generally be evaluated on an individual loan basis in accordance with FASB ASC 310-40, Receivables -Troubled Debt Restructurings by Creditorsand FASB ASC 310-10-35-2 through 30, Receivables – Overall - Subsequent Measurement – Impairment. Generally, if the recorded amount of an individually assessed loan that is impaired, but is not collateral dependent, exceeds the present value of expected future cash flows, discounted at the original loan’s effective interest rate, this excess is reported as a valuation allowance.
For an individually evaluated impaired collateral dependent loan, the regulators require that if the recorded amount of the loan exceeds the fair valueof the collateral (less costs to sell if the costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan), this excess is included when estimating the ALLL. However, some or all of this difference may represent a confirmed loss, which should be charged against the ALLL in a timely manner. Institutions also should consider the need to recognize an allowance for estimated credit losses on off-balance sheet credit exposures, such as loan commitments, in other liabilities consistent with FASB ASC 825-10-35- 1 through 3, Financial Instruments – Overall - Subsequent Measurement - Credit Losses on Financial Instruments with Off-Balance-Sheet Credit Risk.
For performing CRE loans, supervisory policies do not require automatic increases in the ALLL solely because the value of the collateral has declined to an amount that is less than the loan balance. However, declines in collateral values should be considered when calculating loss rates for affected groups of loans when estimating loan losses under the FASB ASC 450-20, Loss Contingencies.
VI. EXAMPLES OF CRE LOAN WORKOUTS
The policy statement contains examples of CRE workouts illustrating application of the statement to credit classification, determination of accrual versus non-accrual status, and identification and reporting of troubled debt restructurings. The examples can be reviewed at http://www.ffiec.gov/guidance/cre103009.pdf.