Bank Regulators Adopt Guidance on Prudent Commercial Real Estate Loan Workouts
On October 30, 2009, the Federal Financial Institutions Examination Council (FFIEC) issued a policy statement that was adopted by the OCC, the Fed, the FDIC and the Office of Thrift Supervision as Guidance on Prudent Commercial Real Estate Loan Workouts (FFIEC's Guidance under the OCC Bulletin 2009-32). The policy replaced the Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans that banks have been operating under since November 1995. (For a copy of the policy statement, see our earlier posting [link].)
OVERALL TONE
The overall tone of the Guidance is to provide prudent but pragmatic guidance on risk assessment, allowing financial institutions in the present environment to actively engage in CRE workouts without undue fear of reclassification by examiners. For example, the Guidance states:
"Financial institutions that implement prudent loan workout arrangements after performing a comprehensive review of a borrower's financial condition will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classification."
While there are a few hard and fast prohibitions in the OCC bulletin, as a general matter its cornerstone is flexibility and pragmatism in working out distressed commercial real estate credits. Institutions are encouraged to consider both the asset and Borrower/Sponsor capacity for repayment of the credit.
The Guidance establishes protocols encouraging institutions to apply prospective, "forward thinking" to the cash flow analysis of distressed real estate projects. Additionally, it discourages "second guessing" by examiners on such items as assumed cap rates, lease renewal assumptions, lease-up periods and other forward looking market conditions. The Guidance also reinforces, and in some cases clarifies regulatory and GAAP reporting requirements.
KEY POINTS
The Guidance includes the following key points:
- Renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined below the loan balance.
- In general, renewals of maturing loans to responsible borrowers who, because of the present financial crisis, cannot locate a source of refinancing, should not suffer adverse classification.
- Separating a single loan into an "A/B" note structure (with impairment and/or non-accrual hitting the B note only) receives a regulatory "stamp of approval" under appropriate circumstances illustrated in the Guidance.
- Troubled debt restructuring (TDR) contains a two-prong test in which both prongs must be met: (a) the borrower is experiencing financial difficulties (examples of what this means are provided in attachment one of the Guidance) AND (b) the lender grants a concession that it would not ordinarily grant except for the status of the real estate and/or economic conditions.
- "Fair value" vs. "Market value" - Fair value is still required under impairment situations (pursuant to FASB 114) and for properties deemed to be TDR. "Market value" (i.e. predictable future values) can be considered if consistent with the facts and circumstances of the workout.
- Clarifies Allowances for Loan and Lease Losses (ALLL) calculations utilizing fair value; existing guidance remains in place.
- The concepts of "market interest rate" become of paramount importance in: (i) classifying or reclassifying the credit, (ii) going on or off of accrual basis, and (iii) booking losses (examples of what is considered and not considered "market rate" are illustrated in Attachment One to the Guidance). Market interest rate calculations should:
- Take a forward-looking view at the cash flows, rent rolls and property type analysis
- Be influenced by the credit quality of both the borrower and the real estate
- Be adjusted (positively or negatively) by the existence of quality loan guaranties utilizing current financial information
- "Interest only" concessions for periods beyond one year in order to allow the property's cash flow to service the debt will be frowned upon, and likely not deemed "market."
- Generally "second guessing" by examiners is discouraged and will be viewed as inappropriate in the analysis of certain specified forward-looking circumstances.
- Overall, the Guidance encourages bank institutions to be proactive and forward thinking in applying their analytics at the property level.
In summary, the Guidance stresses the need to examine each commercial real estate loan on its own merits; examining borrower, sponsor and guarantor credit and payment capacity, as well as the current and projected quality and durability of asset level cash flows. The examples contained in Attachment One to the Guidance demonstrate that this process will inevitably involve subjective judgments. Although there is a definite change of tone, the regulatory construct remains fundamentally unchanged.
It will be interesting to see how banking institutions and their examiners react to the October 30th announcement. Given the general and subjective nature of the subject matter, and that guidance is provided largely through examples, implementation may well prove to be uneven among banking institutions.
As we move into the next phase and begin to work with the Guidance, we encourage you to share your comments and experiences.
