[Federal Register Volume 87, Number 178 (Thursday, September 15, 2022)]
[Notices]
[Pages 56658-56677]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-19940]


=======================================================================
-----------------------------------------------------------------------

FEDERAL RESERVE SYSTEM

[Docket No. OP-1779]


Policy Statement on Prudent Commercial Real Estate Loan 
Accommodations and Workouts

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Proposed policy statement with request for comment.

-----------------------------------------------------------------------

SUMMARY: The Board of Governors of the Federal Reserve System (Board) 
is inviting comment on a proposed policy statement for prudent 
commercial real estate loan accommodations and workouts (proposed 
statement), which would be relevant to all financial institutions 
supervised by the Board. The proposed statement was developed jointly 
by the Board, the Office of the Comptroller of the Currency (OCC), the 
Federal Deposit Insurance Corporation (FDIC), and the National Credit 
Union Administration (NCUA) in consultation with state bank and credit 
union regulators and is identical in content to the proposal issued by 
the OCC, FDIC, and NCUA on August 2, 2022. The proposed statement would 
build on existing guidance on the need for financial institutions to 
work prudently and constructively with creditworthy borrowers during 
times of financial stress, update existing interagency guidance on 
commercial real estate loan workouts, and add a new section on short-
term loan accommodations. The proposed statement would also address 
recent accounting changes on estimating loan losses and provide updated 
examples of how to classify and account for loans subject to loan 
accommodations or loan workout activity. The proposed statement is 
timely in the post-pandemic era, as trends such as increased remote 
working may shift historic patterns of demand for commercial real 
estate in ways that adversely affect the financial condition and 
repayment capacity of CRE borrowers.

DATES: Comments must be received by November 14, 2022.

ADDRESSES: Interested parties are encouraged to submit written 
comments.
    Comments should be directed to:
     Agency Website: http://www.federalreserve.gov. Follow the 
instructions for submitting comments https://www.federalreserve.gov/foia/about_foia.htm, choose ``Proposals for Comment''.
     Email: [email protected]. Include the 
docket number in the subject line of the message.
     FAX: (202) 452-3819 or (202) 452-3102.
     Mail: Ann E. Misback, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue NW, 
Washington, DC 20551.
    Instructions: All public comments are available from the Board's 
website at https://www.federalreserve.gov/foia/readingrooms.htm as 
submitted. Accordingly, comments will not be edited to remove any 
identifying or contact information. Public comments may also be viewed 
electronically or in paper in Room M-4365A, 2001 C Street NW, 
Washington, DC 20551, between 9:00 a.m. and 5:00 p.m. during Federal 
business weekdays. For security reasons, the Board requires that 
visitors make an appointment to inspect comments by calling (202) 452-
3684. Upon arrival, visitors will be required to present valid 
government-issued photo identification and to submit to security 
screening in order to inspect and photocopy comments. For users of TTY-
TRS, please call 711 from any telephone, anywhere in the United States.

FOR FURTHER INFORMATION CONTACT: Juan Climent, Assistant Director, 
(202) 872-7526; Kathryn Ballintine, Manager, (202) 452-2555; Carmen 
Holly, Lead Financial Institution Policy Analyst, (202) 973-6122; Ryan 
Engler, Senior Financial Institution Policy Analyst I, (202) 452-2050; 
Kevin Chiu, Senior Accounting Policy Analyst, (202) 912-4608, the 
Division of Supervision and Regulation; Jay Schwarz, Assistant General 
Counsel, (202) 452-2970; Gillian Burgess, Senior Counsel, (202) 736-
5564, Legal Division, Board of Governors of the Federal Reserve System, 
20th and C Streets NW, Washington, DC 20551. For users of TTY-TRS, 
please call 711 from any telephone, anywhere in the United States.

SUPPLEMENTARY INFORMATION: 

I. Background

    On October 30, 2009, the Board, along with the OCC, FDIC, NCUA, 
Federal Financial Institutions Examination Council (FFIEC) State 
Liaison Committee, and the former Office of Thrift Supervision, adopted 
the Policy Statement on Prudent Commercial Real Estate Loan Workouts, 
which was issued by the FFIEC (2009 statement).\1\ The Board views the 
2009 statement as being useful for both agency staff and financial 
institutions in understanding risk management and accounting practices 
for commercial real estate (CRE) loan workouts.
---------------------------------------------------------------------------

    \1\ See FFIEC Press Release, October 30, 2009, available at: 
https://www.ffiec.gov/press/pr103009.htm; See Federal Reserve 
Supervision and Regulation (SR) letter 09-7 (October 30, 2009).
---------------------------------------------------------------------------

    The Board is proposing to update and expand the 2009 statement by 
incorporating recent policy guidance on loan accommodations and 
accounting developments for estimating loan losses. The Board developed 
the proposed statement with the OCC, FDIC, and NCUA and consulted with 
state bank and credit union regulators. If finalized, the proposed 
statement would supersede the 2009 statement for all supervised 
financial institutions.\2\
---------------------------------------------------------------------------

    \2\ For purposes of this guidance, financial institutions are 
those supervised by the Board.
---------------------------------------------------------------------------

II. Overview of the Proposed Statement

    The proposed statement discusses the importance of working 
constructively with CRE borrowers who are experiencing financial 
difficulty and would be appropriate for all supervised financial 
institutions engaged in CRE lending that apply U.S. generally accepted 
accounting principles (GAAP). The proposed statement addresses 
supervisory expectations with respect to a financial institution's 
handling of loan accommodations and loan workouts on matters including 
(1) risk management elements, (2) classification of loans, (3) 
regulatory reporting, and (4) accounting considerations. While focused 
on CRE loans, the proposed statement includes general principles that 
are relevant to a financial institution's commercial loans that are 
collateralized by either real property or other business assets (e.g., 
furniture, fixtures, or equipment) of a borrower. Additionally, the 
proposed statement would include updated references to supervisory 
guidance \3\ and

[[Page 56659]]

would revise language to incorporate current industry terminology.
---------------------------------------------------------------------------

    \3\ Supervisory guidance outlines the Board's supervisory 
practices or priorities and articulates the Board's general views 
regarding appropriate practices for a given subject area. The Board 
has adopted regulation setting forth Statements Clarifying the Role 
of Supervisory Guidance. See 12 CFR 262, appendix A.
---------------------------------------------------------------------------

    Prudent CRE loan accommodations and workouts are often in the best 
interest of both the financial institution and the borrower. As such, 
and consistent with safety and soundness standards, the proposed 
statement reaffirms two key principles from the 2009 statement: (1) 
financial institutions that implement prudent CRE loan accommodation 
and 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 these arrangements result in 
modified loans that have weaknesses that result in adverse credit 
classification; and (2) modified loans to borrowers who have the 
ability to repay their debts according to reasonable 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.
    The proposed statement includes the following changes: (1) a new 
section on short-term loan accommodations; (2) information about recent 
changes in accounting principles; and (3) revisions and additions to 
examples of CRE loan workouts.

Short-Term Loan Accommodations

    The Board recognizes that financial institutions may benefit from 
the proposed statement's inclusion of a discussion on the use of short-
term and less complex CRE loan accommodations before a loan requires a 
longer term or more complex workout scenario. The proposed statement 
would identify short-term loan accommodations as a tool that can be 
used to mitigate adverse effects on borrowers and would encourage 
financial institutions to work prudently with borrowers who are or may 
be unable to meet their contractual payment obligations during periods 
of financial stress. This section of the proposed statement would 
incorporate principles consistent with existing interagency guidance on 
accommodations.\4\
---------------------------------------------------------------------------

    \4\ See Joint Statement on Additional Loan Accommodations 
Related to COVID-19. SR Letter 20-18. See also Interagency Statement 
on Loan Modifications and Reporting for Financial Institutions 
Working With Customers Affected by the Coronavirus (Revised); Joint 
Press Release April 7, 2020.
---------------------------------------------------------------------------

Accounting Changes

    The proposed statement also would reflect changes in GAAP since 
2009, including those in relation to current expected credit losses 
(CECL).\5\ The discussion would align with existing regulatory 
reporting guidance and instructions that have also been updated to 
reflect current accounting requirements under GAAP.\6\ In particular, 
the section for Regulatory Reporting and Accounting Considerations 
would be modified to include CECL references. Appendices 5 and 6 of the 
proposed statement would address the relevant accounting and regulatory 
guidance on estimating loan losses for financial institutions that use 
the CECL methodology, or incurred loss methodology, respectively.
---------------------------------------------------------------------------

    \5\ The Financial Accounting Standards Board's (FASB's) 
Accounting Standards Update 2016-13, Financial Instruments--Credit 
Losses (Topic 326): Measurement of Credit Losses on Financial 
Instruments and subsequent amendments issued since June 2016 are 
codified in Accounting Standards Codification (ASC) Topic 326, 
Financial Instruments--Credit Losses (FASB ASC Topic 326). FASB ASC 
Topic 326 revises the accounting for the allowances for credit 
losses (ACLs) and introduces CECL.
    \6\ For FDIC-insured depository institutions, the FFIEC 
Consolidated Reports of Condition and Income (FFIEC Call Report).
---------------------------------------------------------------------------

    The Board also notes that the Financial Accounting Standards Board 
(FASB) has issued ASU 2022-02, ``Financial Instruments--Credit Losses 
(Topic 326): Troubled Debt Restructurings and Vintage Disclosures,'' 
which amended ASC Topic 326, Financial Instruments--Credit Losses. Once 
adopted, ASU 2022-02 will eliminate the need for financial institutions 
to identify and account for loan modifications as troubled debt 
restructuring (TDR) and will enhance disclosure requirements for 
certain modifications by creditors when a borrower is experiencing 
financial difficulty.\7\ The Board plans to remove the TDR 
determination from the examples once all financial institutions are 
required to report in accordance with ASU 2022-02 and ASC Topic 326 by 
year-end 2023. In the interim, the Board has modified sections of the 
proposed statement to reflect recent updates that have occurred 
pertaining to TDR accounting for financial institutions that are still 
required to report TDRs.
---------------------------------------------------------------------------

    \7\ Financial institutions may only early adopt ASU 2022-02 if 
ASC Topic 326 is adopted. Financial institutions that have not 
adopted ASC Topic 326 will continue to report TDRs and will only 
report in accordance with ASU 2022-02 concurrently with the adoption 
of ASC Topic 326.
---------------------------------------------------------------------------

CRE Workout Examples

    The proposed statement would include updated information about 
current industry loan workout practices and revisions to examples of 
CRE loan workouts. The examples in the proposed statement are intended 
to illustrate the application of existing guidance on (1) credit 
classification, (2) determination of nonaccrual status, and (3) 
determination of TDR status. The proposed statement also would revise 
the 2009 statement to provide Appendix 2, which contains an updated 
summary of selected references to relevant supervisory guidance and 
accounting standards for real estate lending, appraisals, restructured 
loans, fair value measurement, and regulatory reporting matters such as 
a loan's nonaccrual status.
    The proposed statement would retain information in Appendix 3 about 
valuation concepts for income-producing real property included in the 
2009 statement. Further, Appendix 4 of the proposed statement restates 
the Board's long-standing special mention and classification 
definitions that are referenced and applied in the examples in Appendix 
1.
    The proposed statement would be consistent with the Interagency 
Guidelines Establishing Standards for Safety and Soundness issued by 
the Board,\8\ which articulates safety and soundness standards for 
insured depository institutions to establish and maintain prudent 
credit underwriting practices and to establish and maintain systems to 
identify problem assets and manage deterioration in those assets 
commensurate with a financial institution's size and the nature and 
scope of its operations.
---------------------------------------------------------------------------

    \8\ 12 CFR part 208 appendix D-1.
---------------------------------------------------------------------------

III. Request for Comment

    The Board requests comments on all aspects of the proposed 
statement and responses to the questions set forth below:
    Question 1: To what extent does the proposed statement reflect safe 
and sound practices currently incorporated in a financial institution's 
CRE loan accommodation and workout activities? Should the Board add, 
modify, or remove any elements, and, if so, which and why?
    Question 2: What additional information, if any, should be included 
to optimize the guidance for managing CRE loan portfolios during all 
business cycles and why?
    Question 3: Some of the principles discussed in the proposed 
statement are appropriate for Commercial & Industrial (C&I) lending 
secured by personal property or other business assets. Should the Board 
further address C&I lending more explicitly, and if so, how?
    Question 4: What additional loan workout examples or scenarios 
should

[[Page 56660]]

the Board include or discuss? Are there examples in Appendix 1 of the 
proposed statement that are not needed, and if so, why not? Should any 
of the examples in the proposed statement be revised to better reflect 
current practices, and if so, how?
    Question 5: To what extent do the TDR examples continue to be 
relevant in 2023 given that ASU 2022-02 eliminates the need for a 
financial institution to identify and account for a new loan 
modification as a TDR?

IV. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3521) states 
that no agency may conduct or sponsor, nor is the respondent required 
to respond to, an information collection unless it displays a currently 
valid Office of Management and Budget (OMB) control number. The Board 
has determined that this proposed policy statement does not create any 
new, or revise any existing, collections of information pursuant to the 
Paperwork Reduction Act. Consequently, no information collection 
request will be submitted to the OMB for review.

V. Proposed Guidance

    The text of the proposed Statement is as follows:

Policy Statement on Prudent Commercial Real Estate Loan Accommodations 
and Workouts

    The Board of Governors of the Federal Reserve System (Board) 
recognizes that financial institutions \1\ face significant challenges 
when working with commercial real estate (CRE) \2\ borrowers who are 
experiencing diminished operating cash flows, depreciated collateral 
values, prolonged sales and rental absorption periods, or other issues 
that may hinder repayment. While borrowers may experience deterioration 
in their financial condition, many continue to be creditworthy and have 
the willingness and capacity to repay their debts. In such cases, 
financial institutions may find it beneficial to work constructively 
with borrowers. Such constructive efforts may involve loan 
accommodations \3\ or more extensive loan workout arrangements.\4\
---------------------------------------------------------------------------

    \1\ For the purposes of this statement, financial institutions 
are those supervised by the Board.
    \2\ Consistent with the Board, FDIC and OCC joint guidance on 
Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices (December 2006), CRE loans include loans 
secured by multifamily property, and nonfarm nonresidential property 
where the primary source of repayment is derived from rental income 
associated with the property (that is, loans for which 50 percent or 
more of the source of repayment comes from third party, 
nonaffiliated, rental income) or the proceeds of the sale, 
refinancing, or permanent financing of the property. CRE loans also 
include land development and construction loans (including 1- to 4-
family residential and commercial construction loans), other land 
loans, loans to real estate investment trusts (REITs), and unsecured 
loans to developers.
    \3\ For the purposes of this statement, an accommodation 
includes any agreement to defer one or more payments, make a partial 
payment, forbear any delinquent amounts, modify a loan or contract 
or provide other assistance or relief to a borrower who is 
experiencing a financial challenge.
    \4\ Workouts can take many forms, including a renewal or 
extension of loan terms, extension of additional credit, or a 
restructuring with or without concessions.
---------------------------------------------------------------------------

    This statement provides a broad set of principles relevant to CRE 
loan accommodations and workouts in all business cycles, particularly 
in challenging economic environments. A variety of factors can drive 
challenging economic environments, including economic downturns, 
natural disasters, and local, national, and international events. This 
statement also describes how examiners will review CRE loan 
accommodation and workout arrangements and provides examples of CRE 
workout arrangements as well as useful references in the appendices.
    The Board has found that prudent CRE loan accommodations and 
workouts are often in the best interest of the financial institution 
and the borrower. Examiners are expected to take a balanced approach in 
assessing the adequacy of a financial institution's risk management 
practices for loan accommodation and workout activities. Consistent 
with the Interagency Guidelines Establishing Standards for Safety and 
Soundness,\5\ (safety and soundness standards), financial institutions 
that implement prudent CRE loan accommodation and 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 these arrangements result in modified loans that have 
weaknesses that result in adverse classification. In addition, modified 
loans to borrowers who have the ability to repay their debts according 
to reasonable 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 outstanding loan balance.
---------------------------------------------------------------------------

    \5\ See 12 CFR part 208 appendix D-1.
---------------------------------------------------------------------------

I. Purpose

    Consistent with the safety and soundness standards, this statement 
updates and supersedes existing supervisory guidance to assist 
financial institutions' efforts to modify CRE loans to borrowers who 
are, or may be, unable to meet a loan's current contractual payment 
obligations or fully repay the debt.\6\ This statement is intended to 
promote supervisory consistency among examiners, enhance the 
transparency of CRE loan accommodation and workout arrangements, and 
ensure that supervisory policies and actions do not inadvertently 
curtail the availability of credit to sound borrowers.
---------------------------------------------------------------------------

    \6\ This statement replaces the interagency Policy Statement on 
Prudent Commercial Real Estate Loan Workouts (October 2009).
---------------------------------------------------------------------------

    This statement addresses prudent risk management practices 
regarding short-term accommodations, risk management elements for loan 
workout programs, long-term loan workout arrangements, classification 
of loans, and regulatory reporting and accounting requirements and 
considerations. The statement also includes selected references and 
materials related to regulatory reporting.\7\ The statement does not, 
however, affect existing regulatory reporting requirements or guidance 
provided in relevant interagency statements issued by the Board or 
accounting requirements under U.S. generally accepted accounting 
principles (GAAP). Certain principles in this statement are also 
generally applicable to commercial loans that are secured by either 
real property or other business assets of a commercial borrower.
---------------------------------------------------------------------------

    \7\ For banks, the FFIEC Consolidated Reports of Condition and 
Income (FFIEC Call Report).
---------------------------------------------------------------------------

    Six appendices are incorporated into this statement:
     Appendix 1 contains examples of CRE loan workout 
arrangements illustrating the application of this statement to 
classification of loans, and determination of accrual treatment.
     Appendix 2 lists selected relevant rules as well as 
supervisory and accounting guidance for real estate lending, 
appraisals, allowance methodologies,\8\ restructured loans, fair value 
measurement, and regulatory reporting matters such as nonaccrual 
status. This statement is intended to be used in conjunction with 
materials identified in Appendix 2 to reach appropriate conclusions 
regarding loan classification and regulatory reporting.
---------------------------------------------------------------------------

    \8\ The allowance methodology refers to the allowance for credit 
losses (ACL) under Financial Accounting Standards Board (FASB) 
Accounting Standards Codification (ASC) Topic 326, Financial 
Instruments--Credit Losses; or allowance for loan and lease losses 
(ALLL) under ASC 310, Receivables and ASC Subtopic 450-20, 
Contingencies--Loss Contingencies, as applicable.
---------------------------------------------------------------------------

     Appendix 3 discusses valuation concepts for income-
producing real property.\9\
---------------------------------------------------------------------------

    \9\ Valuation concepts applied to regulatory reporting processes 
also should be consistent with ASC Topic 820, Fair Value 
Measurement.

---------------------------------------------------------------------------

[[Page 56661]]

     Appendix 4 provides the classification definitions used by 
the Board.
     Appendices 5 and 6 address the relevant accounting and 
supervisory guidance on estimating loan losses for financial 
institutions that use the current expected credit losses (CECL) 
methodology, or incurred loss methodology, respectively.

II. Short-Term Loan Accommodations

    The Board encourages financial institutions to work prudently with 
borrowers who are, or may be, unable to meet their contractual payment 
obligations during periods of financial stress. Such actions may entail 
loan accommodations that are generally short-term or temporary in 
nature but occur before a loan reaches a workout scenario. These 
actions can mitigate long-term adverse effects on borrowers by allowing 
them to address the issues affecting repayment capacity and are often 
in the best interest of financial institutions and their borrowers.
    When entering into an accommodation with a borrower, it is prudent 
for the financial institution to provide clear, accurate, and timely 
information about the arrangement to the borrower and any guarantor. 
Any such accommodation must be consistent with applicable laws and 
regulations. Further, a financial institution should employ prudent 
risk management practices and appropriate internal controls over such 
accommodations. Failed or imprudent risk management practices and 
internal controls can adversely affect borrowers, and expose a 
financial institution to increases in credit, compliance, operational, 
or other risks. Imprudent practices that are widespread at a financial 
institution may also pose risk to its capital adequacy.
    Prudent risk management practices and internal controls will enable 
financial institutions to identify, measure, monitor, and manage the 
credit risk of accommodated loans. Prudent risk management practices 
include developing appropriate policies and procedures, updating and 
assessing financial and collateral information, maintaining appropriate 
risk grading, and ensuring proper tracking and accounting for loan 
accommodations. Prudent internal controls related to loan 
accommodations include comprehensive policies and practices, proper 
management approvals, and timely and accurate reporting and 
communication.

III. Loan Workout Programs

    When short-term accommodation measures are not sufficient or have 
not been successful to address credit problems, the financial 
institutions could proceed into longer-term or more complex loan 
arrangements with borrowers under a formal workout program. Loan 
workout arrangements can take many forms, including, but not limited 
to:
     Renewing or extending loan terms;
     Granting additional credit to improve prospects for 
overall repayment; or
     Restructuring \10\ with or without concessions.
---------------------------------------------------------------------------

    \10\ A restructuring involves a formal, legally enforceable 
modification in the loan's terms.
---------------------------------------------------------------------------

    A financial institution's risk management practices for 
implementing workout arrangements should be appropriate for the scope, 
complexity, and nature of the financial institution's lending activity. 
Further, these practices should be consistent with safe-and-sound 
lending policies and guidance, real estate lending standards,\11\ and 
relevant regulatory reporting requirements. Examiners will evaluate the 
effectiveness of practices, which typically address:
---------------------------------------------------------------------------

    \11\ See 12 CFR 208.51 and part 208, appendix C.
---------------------------------------------------------------------------

     A prudent workout policy that establishes appropriate loan 
terms and amortization schedules and that permits the financial 
institution to reasonably adjust the workout plan if sustained 
repayment performance is not demonstrated or if collateral values do 
not stabilize;
     Management infrastructure to identify, measure, and 
monitor the volume and complexity of workout activity;
     Documentation standards to verify a borrower's 
creditworthiness, including financial condition, repayment capacity, 
and collateral values;
     Management information systems and internal controls to 
identify and track loan performance and risk, including impact on 
concentration risk and the allowance;
     Processes designed to ensure that the financial 
institution's regulatory reports are consistent with regulatory 
reporting requirements;
     Loan collection procedures;
     Adherence to statutory, regulatory, and internal lending 
limits;
     Collateral administration to ensure proper lien perfection 
of the financial institution's collateral interests for both real and 
personal property; and
     An ongoing credit risk review function.

IV. Long-Term Loan Workout Arrangements

    An effective loan workout arrangement should improve the lender's 
prospects for repayment of principal and interest, be consistent with 
sound banking and accounting practices, and comply with applicable laws 
and regulations. Typically, financial institutions consider loan 
workout arrangements after analyzing a borrower's repayment capacity, 
evaluating the support provided by guarantors, and assessing the value 
of any collateral pledged.
    Consistent with safety and soundness standards, while loans in 
workout arrangements may be adversely classified, a financial 
institution will not be criticized for engaging in loan workout 
arrangements so long as management has:
     For each loan, developed a well-conceived and prudent 
workout plan that supports the ultimate collection of principal and 
interest and that is based on key elements such as:
    [rtarr8] Updated and comprehensive financial information on the 
borrower, real estate project, and all guarantors and sponsors;
    [rtarr8] Current valuations of the collateral supporting the loan 
and the workout plan;
    [rtarr8] Appropriate loan structure (e.g., term and amortization 
schedule), covenants, and requirements for curtailment or re-margining; 
and
    [rtarr8] Appropriate legal analyses and agreements, including those 
for changes to loan terms;
     Analyzed the borrower's global debt \12\ service coverage 
that reflects a realistic projection of the borrower's available cash 
flow;
---------------------------------------------------------------------------

    \12\ Global debt represents the aggregate of a borrower's or 
guarantor's financial obligations, including contingent obligations.
---------------------------------------------------------------------------

     Analyzed the available cash flow of guarantors;
     Demonstrated the willingness and ability to monitor the 
ongoing performance of the borrower and guarantor under the terms of 
the workout arrangement;
     Maintained an internal risk rating or loan grading system 
that accurately and consistently reflects the risk in the workout 
arrangement; and
     Maintained an allowance methodology that calculates (or 
measures) an allowance in accordance with GAAP for loans that have 
undergone a workout arrangement and recognizes loan losses in a timely

[[Page 56662]]

manner through provision expense and enacting appropriate charge-
offs.\13\
---------------------------------------------------------------------------

    \13\ Additionally, if applicable, financial institutions should 
recognize in other liabilities an allowance for estimated credit 
losses on off-balance sheet credit exposures related to restructured 
loans (e.g., loan commitments) and should reverse interest accruals 
on loans that are deemed uncollectible.
---------------------------------------------------------------------------

A. Supervisory Assessment of Repayment Capacity of Commercial Borrowers

    The primary focus of an examiner's review of a CRE 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:
     The borrower's character, overall financial condition, 
resources, and payment history;
     The nature and degree of protection provided by the cash 
flow from business operations or the collateral on a global basis that 
considers the borrower's total debt obligations;
     Market conditions that may influence repayment prospects 
and the cash flow potential of the business operations or underlying 
collateral; and
     The prospects for repayment support from guarantors.

B. Supervisory Assessment of Guarantees and Sponsorships

    Examiners should review the financial attributes of guarantees and 
sponsorships in considering the loan classification. The presence of a 
legally enforceable 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. A financially responsible guarantor possesses the 
financial capacity, the demonstrated willingness, and the incentive to 
provide support for the loan through ongoing payments, curtailments, or 
re-margining.
    Examiners also review the financial attributes and economic 
incentives of sponsors that support a loan. Even if not legally 
obligated, financially responsible sponsors are similar to guarantors 
in that they may also possess the financial capacity, the demonstrated 
willingness, and may have an incentive to provide support for the loan 
through ongoing payments, curtailments, or re-margining.
    Financial institutions that 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) are better able to determine the guarantor's 
financial capacity to fulfill the obligation. An effective assessment 
includes consideration of whether the guarantor has the financial 
capacity to fulfill the total number and amount of guarantees currently 
extended by the guarantor. A similar analysis should be made for any 
material sponsors that support the loan.
    Examiners should consider whether a guarantor has demonstrated the 
willingness to fulfill all current and previous obligations, has 
sufficient economic incentive, and has a significant investment in the 
project. An important consideration is whether any previous performance 
under its guarantee(s) was voluntary or the result of legal or other 
actions by the lender to enforce the guarantee(s).

C. Supervisory Assessment of Collateral Values

    As the primary sources of loan repayment decline, the importance of 
collateral value as another repayment source increases when analyzing 
credit risk and developing an appropriate workout plan. Examiners will 
analyze real estate collateral values based on the financial 
institution's original appraisal or evaluation, any subsequent updates, 
additional pertinent information (e.g., recent inspection results), and 
relevant market conditions. An examiner will assess the major facts, 
assumptions, and valuation approaches in the collateral valuation and 
their influence in the financial institution's credit and allowance 
analyses.
    The Board's appraisal regulations require financial institutions to 
review appraisals for compliance with the Uniform Standards of 
Professional Appraisal Practice.\14\ As part of that process, and when 
reviewing evaluations, financial institutions should ensure that 
assumptions and conclusions used are reasonable. Further, financial 
institutions typically have policies \15\ and procedures that dictate 
when collateral valuations should be updated as part of their ongoing 
credit monitoring processes, as market conditions change, or as a 
borrower's financial condition deteriorates.\16\
---------------------------------------------------------------------------

    \14\ See 12 CFR part 208, subpart E, and 12 CFR part 225, 
subpart G.
    \15\ See 12 CFR part 208.51(a).
    \16\ For further reference, see Interagency Appraisal and 
Evaluation Guidelines, 75 FR 77450 (December 10, 2010).
---------------------------------------------------------------------------

    CRE loans in workout arrangements consider current project plans 
and market conditions in a new or updated appraisal or evaluation, as 
appropriate. In determining whether to obtain a new appraisal or 
evaluation, a prudent financial institution considers 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-sale fallout. A new appraisal 
may not be necessary when an evaluation prepared by the financial 
institution appropriately updates the original appraisal assumptions to 
reflect current market conditions and provides a reasonable estimate of 
the collateral's fair value.\17\ If new money is advanced, financial 
institutions should refer to the Federal financial institution 
supervisory agencies' appraisal regulations to determine whether a new 
appraisal is required.\18\
---------------------------------------------------------------------------

    \17\ According to the FASB ASC Master Glossary, ``fair value'' 
is ``the price that would be received to sell an asset or paid to 
transfer a liability in an orderly transaction between market 
participants at the measurement date.''
    \18\ See footnote 18.
---------------------------------------------------------------------------

    The market value provided by an appraisal and the fair value for 
accounting purposes are based on similar valuation concepts.\19\ The 
analysis of the collateral's market value reflects the financial 
institution's understanding of the property's current ``as is'' 
condition (considering the property's highest and best use) and other 
relevant risk factors affecting value. Valuations of commercial 
properties may contain more than one

[[Page 56663]]

value conclusion and could include an ``as is'' market value, a 
prospective ``as complete'' market value, and a prospective ``as 
stabilized'' market value.
---------------------------------------------------------------------------

    \19\ The term ``market value'' as used in an appraisal is based 
on similar valuation concepts as ``fair value'' for accounting 
purposes under GAAP. For both terms, these valuation concepts about 
the real property and the real estate transaction contemplate that 
the property has been exposed to the market before the valuation 
date, the buyer and seller are well informed and acting in their own 
best interest (that is, the transaction is not a forced liquidation 
or distressed sale), and marketing activities are usual and 
customary (that is, the value of the property is unaffected by 
special financing or sales concessions). The market value in an 
appraisal may differ from the collateral's fair value if the values 
are determined as of different dates or the fair value estimate 
reflects different assumptions from those in the appraisal. This may 
occur as a result of changes in market conditions and property use 
since the ``as of'' date of the appraisal.
---------------------------------------------------------------------------

    Financial institutions typically use the market value conclusion 
(and not the fair value) that corresponds to the workout plan objective 
and the loan commitment. For example, if the financial institution 
intends to work with the borrower so that a project will achieve 
stabilized occupancy, then the financial institution can consider the 
``as stabilized'' market value in its collateral assessment for credit 
risk grading after confirming that the appraisal's assumptions and 
conclusions are reasonable. Conversely, if the financial institution 
intends to foreclose, then it is more appropriate for the financial 
institution to use the fair value (less costs to sell) \20\ of the 
property in its current ``as is'' condition in its collateral 
assessment.
---------------------------------------------------------------------------

    \20\ Costs to sell are used when the loan is dependent on the 
sale of the collateral. Costs to sell are not used when the 
collateral-dependent loan is dependent on the operation of the 
collateral.
---------------------------------------------------------------------------

    If weaknesses are noted in the financial institution's supporting 
documentation or appraisal or evaluation review process, examiners 
should direct the financial institution to address the weaknesses, 
which may require the financial institution to obtain a new collateral 
valuation. However, if the financial institution is unable or unwilling 
to address deficiencies in a timely manner, examiners will have to 
assess the degree of protection that the collateral affords when 
analyzing and classifying the loan. In performing this assessment of 
collateral support, examiners may adjust 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 evaluate:
     Current and projected vacancy and absorption rates;
     Lease renewal trends and anticipated rents;
     Effective rental rates or sale prices, considering sales 
and financing concessions;
     Time frame for achieving stabilized occupancy or sellout;
     Volume and trends in past due leases;
     Net operating income of the property as compared with 
budget projections, reflecting reasonable operating and maintenance 
costs; and
     Discount rates and direct capitalization rates (refer to 
Appendix 3 for more information).
    Assumptions, when recently made by qualified appraisers (and, as 
appropriate, by the financial institution) and when consistent with the 
discussion above, should be given reasonable deference by examiners. 
Examiners should also use the appropriate market value conclusion in 
their collateral assessments. For example, when the financial 
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 
assumptions, including discount rates and capitalization rates, used in 
appraisals or evaluations when these assumptions differ only marginally 
from norms generally associated with the collateral under review. The 
estimated value of the collateral may be adjusted for credit analysis 
purposes when the examiner can establish that any underlying facts or 
assumptions are inappropriate and when the examiner can support 
alternative assumptions.
    Many CRE borrowers may have their commercial loans secured by owner 
occupied real estate or other business assets, such as inventory and 
accounts receivable, or may have CRE loans also secured by furniture, 
fixtures, and equipment. For these loans, the financial institution 
should have appropriate policies and practices for quantifying the 
value of such collateral, determining the acceptability of the assets 
as collateral, and perfecting its security interests. The financial 
institution also should have appropriate procedures for ongoing 
monitoring of this type of collateral and the financial institution's 
interests and security protection.

V. 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 modified in accordance with prudent 
underwriting standards should not be adversely classified unless well-
defined weaknesses exist that jeopardize repayment. However, such loans 
could be flagged for management's attention or other designated ``watch 
lists'' of loans that management is more closely monitoring.
    Further, examiners should not adversely classify loans solely 
because the borrower is associated with a particular industry that is 
experiencing financial difficulties. When a financial institution's 
loan modifications 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 financial institution is able to provide information to support 
management's conclusions and internal loan grades. Refer to Appendix 4 
for the classification definitions.

A. Loan Performance Assessment for Classification Purposes

    The loan's record of performance to date should be one of several 
considerations when determining whether a loan should be adversely 
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 jeopardize repayment.
    One perspective of loan performance is based upon an assessment as 
to whether the borrower is contractually current on principal or 
interest payments. For many loans, this definition is sufficient 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 may occur when the loan's underwriting 
structure or the liberal use of extensions and renewals masks credit 
weaknesses and obscures a borrower's inability to meet reasonable 
repayment terms.
    For example, for many acquisition, development, and construction 
projects, the loan is structured with an ``interest reserve'' for the 
construction phase of the project. At the time the loan is originated, 
the lender establishes the interest reserve as a portion of the initial 
loan commitment. During the construction phase, the lender recognizes 
interest income from the interest reserve and capitalizes the interest 
into the loan balance. After completion of the construction, the lender 
recognizes the proceeds from the sale of lots, homes, or buildings for 
the repayment of principal, including any of the capitalized interest. 
For a commercial construction loan where the property has achieved 
stabilized occupancy, the lender uses the proceeds from permanent 
financing for repayment of the construction loan or converts the 
construction loan to an amortizing loan.

[[Page 56664]]

    However, if the development project stalls and management fails to 
evaluate the collectability of the loan, interest income may continue 
to be recognized from the interest reserve and capitalized into the 
loan balance, even though the project is not generating sufficient cash 
flows to repay the loan. 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 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.
    A second perspective for assessing a loan's classification is to 
consider the borrower's expected performance and ability to meet its 
obligations in accordance with the modified terms over the loan's 
tenure. Therefore, the loan classification is meant to measure risk 
over the term of the loan rather than just reflecting the loan's 
payment history. As a borrower's expected performance is dependent upon 
future events, examiners' credit analyses should focus on:
     The borrower's financial strength as reflected by its 
historical and projected balance sheet and income statement outcomes; 
and
     The prospects for a CRE property in light of events and 
market conditions that reasonably may occur during the term of the 
loan.

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. When there has 
been deterioration in collateral values, a borrower with a maturing 
loan amid an economic downturn may have difficulty obtaining short-term 
financing or adequate sources of long-term credit, despite their 
demonstrated and continued ability to service the debt. In such cases, 
financial institutions may determine that the most appropriate course 
is to restructure or renew the loans. Such actions, when done 
prudently, are often in the best interest of both the financial 
institution and the borrower.
    A restructured loan typically reflects an elevated level of credit 
risk, as the borrower may not be, or has not been, able to perform 
according to the original contractual terms. The assessment of each 
loan should be based upon the fundamental characteristics affecting the 
collectability of that loan. In general, renewals or restructurings of 
maturing loans to commercial borrowers who have the ability to repay on 
reasonable terms will not automatically be subject to adverse 
classification by examiners. However, consistent with safety and 
soundness standards, such loans are identified in the financial 
institution's internal credit grading system and may warrant close 
monitoring. Adverse classification of a renewed or restructured loan 
would be appropriate, if, despite the renewal or restructuring, well-
defined weaknesses exist that jeopardize the orderly repayment of the 
loan pursuant to 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 fair value of the real estate collateral less the costs to sell 
should be classified ``loss.'' This principle applies to loans that are 
collateral dependent based on the sale of the collateral in accordance 
with GAAP and there are no other available reliable sources of 
repayment such as a financially capable guarantor.\21\
---------------------------------------------------------------------------

    \21\ Under ASC Topic 310, applicable for financial institutions 
reporting an ALLL, a loan is collateral dependent if repayment of 
the loan is expected to be provided solely by sale or operation of 
the collateral. Under ASC Topic 326, applicable for financial 
institutions reporting an ACL, a loan is collateral dependent when 
the repayment is expected to be provided substantially through the 
operation or sale of the collateral when the borrower is 
experiencing financial difficulty based on the entity's assessment 
as of the reporting date.
---------------------------------------------------------------------------

    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 loan has well-defined weaknesses that jeopardize 
collection in full of all amounts contractually due 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 remaining risk 
exposures are identified but are not quantified, such as bankruptcy or 
a loan collateralized by a property with potential environmental 
concerns.
    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., Note A) 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. 
Additionally, a properly structured and performing ``Note A'' generally 
would not be adversely classified by examiners. The portion of the debt 
that is not reasonably assured of repayment (i.e., Note B) must be 
adversely classified and charged-off.
    In contrast, the loan should remain on, 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 financial 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

[[Page 56665]]

amount.\22\ In these cases, examiners should assess whether the 
financial institution has well-documented support for its credit 
assessment of the borrower's financial condition and the prospects for 
full repayment.
---------------------------------------------------------------------------

    \22\ The charged-off amount should not be reversed or re-booked, 
under any condition, to increase the recorded investment in the loan 
or its amortized costs, as applicable, when the loan is returned to 
accrual status. However, expected recoveries, prior to collection, 
are a component of management's estimate of the net amount expected 
to be collected for a loan under ASC Topic 326. Refer to relevant 
regulatory reporting instructions for guidance on returning a loan 
to accrual status.
---------------------------------------------------------------------------

VI. Regulatory Reporting and Accounting Considerations

    Financial institution management is responsible for preparing 
regulatory reports in accordance with GAAP and regulatory reporting 
requirements. Management also is responsible for establishing and 
maintaining an appropriate governance and internal control structure 
over the preparation of regulatory reports. The Board has observed this 
governance and control structure commonly includes policies and 
procedures that provide clear guidelines on accounting matters. 
Accurate regulatory reports are critical to the transparency of a 
financial institution's financial position and risk profile and 
imperative for effective supervision. Decisions related to loan workout 
arrangements may affect regulatory reporting, particularly interest 
accruals, and loan loss estimates. Therefore, it is important that loan 
workout staff appropriately communicate with the accounting and 
regulatory reporting staff concerning the financial 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 loan grades, examiners are 
responsible for reviewing management's processes related to accounting 
and regulatory reporting. While similar data are used for loan risk 
monitoring, accounting, and reporting systems, this information does 
not necessarily produce identical outcomes. For example, loss 
classifications may not be equivalent to the associated allowance 
measurements.

A. Allowance for Credit Losses

    Examiners need to have a clear understanding of the differences 
between credit risk management and accounting and regulatory reporting 
concepts (such as accrual status, restructurings, and the allowance) 
when assessing the adequacy of the financial institution's reporting 
practices for on- and off-balance sheet credit exposures. Refer to the 
appropriate Appendix that provides a summary of the allowance standards 
under the incurred loss methodology (Appendix 6) or the CECL 
methodology for institutions that have adopted ASC Topic 326, Financial 
Instruments--Credit Losses (Appendix 5). Examiners should also refer to 
regulatory reporting instructions in the FFIEC Call Report guidance and 
applicable GAAP for further information.

B. Implications for Interest Accrual

    A financial institution needs to consider whether a loan that was 
accruing interest prior to the loan restructuring should be placed in 
nonaccrual status at the time of modification to ensure that income is 
not materially overstated. Consistent with Call Report Instructions, a 
loan that has been restructured so as to be reasonably assured of 
repayment and performance according to prudent modified terms need not 
be placed in nonaccrual status. Therefore, for a loan to remain on 
accrual status, the restructuring and any charge-off taken on the loan 
have to be supported by a current, well-documented credit assessment of 
the borrower's financial condition and prospects for repayment under 
the revised terms. Otherwise, in accordance with outstanding Call 
Report instructions, the restructured loan must be placed in nonaccrual 
status.
    A restructured loan placed in nonaccrual status should not be 
returned to accrual status until the borrower demonstrates a period of 
sustained 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. It may 
also include historical periods prior to the date of the loan 
restructuring. While an appropriately designed restructuring should 
improve the collectability of the loan in accordance with a reasonable 
repayment schedule, it does not relieve the financial institution from 
the responsibility to promptly charge off all identified losses. For 
more detailed instructions about placing a loan in nonaccrual status 
and returning a nonaccrual loan to accrual status, refer to the 
instructions for the FFIEC Call Report.

Appendix 1

Examples of CRE Loan Workout Arrangements

    The examples in this Appendix are provided for illustrative 
purposes only and are designed to demonstrate an examiner's 
analytical thought process to derive an appropriate classification 
and evaluate implications for interest accrual and appropriate 
regulatory reporting, such as whether a loan should be reported as a 
troubled debt restructuring (TDR).\23\ Although not discussed in the 
examples below, examiners consider the adequacy of a lender's 
supporting documentation, internal analysis, and business decision 
to enter into a loan workout arrangement. The examples also do not 
address the effect of the loan workout arrangement on the allowance 
and subsequent reporting requirements.
---------------------------------------------------------------------------

    \23\ The Board views that the accrual treatments in these 
examples as falling within the range of acceptable practices under 
regulatory reporting instructions.
---------------------------------------------------------------------------

    Examiners should use caution when applying these examples to 
``real-life'' situations, consider all facts and circumstances of 
the loan being evaluated, and exercise judgment before reaching 
conclusions related to loan classifications, accrual treatment, and 
TDR reporting.\24\
---------------------------------------------------------------------------

    \24\ In addition, estimates of the fair value of collateral 
require the use of assumptions requiring judgment and should be 
consistent with measurement of fair value in ASC Topic 820, Fair 
Value Measurement; see Appendix 2.
---------------------------------------------------------------------------

    The TDR determination requires consideration of all of the facts 
and circumstances surrounding the modification. No single factor, by 
itself, is determinative of whether a modification is a TDR. To make 
this determination, the lender assesses whether (a) the borrower is 
experiencing financial difficulties and (b) the lender has granted a 
concession. For purposes of these examples, if the borrower was not 
experiencing financial difficulties, the example does not assess 
whether a concession was granted. However, in distressed situations, 
lenders may make concessions because borrowers are experiencing 
financial difficulties. Accordingly, lenders and examiners should 
exercise judgment in evaluating whether a restructuring is a TDR. In 
addition, some examples refer to disclosures of TDRs, which pertain 
only to the reporting in Schedules RC-C or RC-N of the Call Report 
and not the applicable measurement in determining an appropriate 
allowance pursuant to the accounting standards.

A. Income Producing Property--Office Building

    Base Case: A lender originated a $15 million loan for the 
purchase of an office building with monthly payments based on an 
amortization of 20 years and a balloon payment of $13.6 million at 
the end of year five. At origination, the loan had a 75 percent 
loan-to-value (LTV) based on an appraisal reflecting a $20 million 
market value on an ``as stabilized'' basis, a debt service coverage 
(DSC) ratio of 1.30x, and a market interest rate. The lender 
expected to renew the loan

[[Page 56666]]

when the balloon payment became due at the end of year five. Due to 
technological advancements and a workplace culture change since the 
inception of the loan, many businesses switched to hybrid work-from-
home arrangements to reduce longer-term costs and improve employee 
retention. As a result, the property's cash flow declined as the 
borrower has had to grant rental concessions to either retain its 
existing tenants or attract new tenants, since the demand for office 
space has decreased.
    Scenario 1: At maturity, the lender renewed the $13.6 million 
loan for one year at a market interest rate that provides for the 
incremental risk and payments based on amortizing the principal over 
the remaining 15 years. The borrower had not been delinquent on 
prior payments and has sufficient cash flow to service the loan at 
the market interest rate terms with a DSC ratio of 1.12x, based on 
updated financial information.
    A review of the leases reflects that most tenants are stable 
occupants, with long-term leases and sufficient cash flow to pay 
their rent. The major tenants have not adopted hybrid work-from-home 
arrangements for their employees given the nature of the businesses. 
A recent appraisal reported an ``as stabilized'' market value of 
$13.3 million for the property for an LTV of 102 percent. This 
reflects current market conditions and the resulting decline in cash 
flow.
    Classification: The lender internally graded the loan pass and 
is monitoring the credit. The examiner agreed, because the borrower 
has the ability to continue making loan payments based on reasonable 
terms, despite a decline in cash flow and in the market value of the 
collateral.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The borrower has demonstrated the ability to make the 
regularly scheduled payments and, even with the decline in the 
borrower's creditworthiness, cash flow appears sufficient to make 
these payments, and full repayment of principal and interest is 
expected. The examiner concurred with the lender's accrual 
treatment.
    TDR Treatment: The lender determined that the renewed loan 
should not be reported as a TDR. While the borrower is experiencing 
some financial deterioration, the borrower has sufficient cash flow 
to service the debt and has no record of payment default; therefore, 
the borrower is not experiencing financial difficulties. The 
examiner concurred with the lender's TDR treatment.
    Scenario 2: At maturity, the lender renewed the $13.6 million 
loan at a market interest rate that provides for the incremental 
risk and payments based on amortizing the principal over the 
remaining 15 years. The borrower had not been delinquent on prior 
payments. Current projections indicate the DSC ratio will not drop 
below 1.12x based on leases in place and letters of intent for 
vacant space. However, some leases are coming up for renewal, and 
additional rental concessions may be necessary to either retain 
those existing tenants or attract new tenants. The lender estimates 
the property's current ``as stabilized'' market value is $14.5 
million, which results in a 94 percent LTV, but a current valuation 
has not been ordered. In addition, the lender has not asked the 
borrower or guarantors to provide current financial statements to 
assess their ability to support any cash flow shortfall.
    Classification: The lender internally graded the loan pass and 
is monitoring the credit. The examiner disagreed with the internal 
grade and listed the credit as special mention. While the borrower 
has the ability to continue to make payments based on leases 
currently in place and letters of intent for vacant space, there has 
been a declining trend in the property's revenue stream, and there 
is most likely a reduced collateral margin. In addition, there is 
potential for further deterioration in the cash flow as more leases 
will expire in the upcoming months, while absorption for office 
space in this market has slowed. Lastly, the examiner noted that the 
lender failed to request current financial information and to obtain 
an updated collateral valuation,\25\ representing administrative 
weaknesses.
---------------------------------------------------------------------------

    \25\ In relation to comments on valuations within these 
examples, refer to the appraisal regulations of the applicable 
Federal financial institution supervisory agency to determine 
whether there is a regulatory requirement for either an evaluation 
or appraisal. See footnote 18.
---------------------------------------------------------------------------

    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The borrower has demonstrated the ability to make regularly 
scheduled payments and, even with the decline in the borrower's 
creditworthiness, cash flow is sufficient at this time to make 
payments, and full repayment of principal and interest is expected. 
The examiner concurred with the lender's accrual treatment.
    TDR Treatment: The lender determined that the renewed loan 
should not be reported as a TDR. While the borrower is experiencing 
some financial deterioration, the borrower is not experiencing 
financial difficulties as the borrower has sufficient cash flow to 
service the debt, and there is no history of default. The examiner 
concurred with the lender's TDR treatment.
    Scenario 3: At maturity, the lender restructured the $13.6 
million loan on a 12-month interest-only basis at a below market 
interest rate. The borrower has been sporadically delinquent on 
prior principal and interest payments. The borrower projects a DSC 
ratio of 1.10x based on the restructured interest-only terms. A 
review of the rent roll, which was available to the lender at the 
time of the restructuring, reflects the majority of tenants have 
short-term leases, with three leases expected to expire within the 
next three months. According to the lender, leasing has not improved 
since the restructuring as market conditions remain soft. Further, 
the borrower does not have an update as to whether the three 
expiring leases will renew at maturity; two of the tenants have 
moved to hybrid work-from-home arrangements. A recent appraisal 
provided a $14.5 million ``as stabilized'' market value for the 
property, resulting in a 94 percent LTV.
    Classification: The lender internally graded the loan pass and 
is monitoring the credit. The examiner disagreed with the internal 
grade and classified the loan substandard due to the borrower's 
limited ability to service a below market interest rate loan on an 
interest-only basis, sporadic delinquencies, and an increase in the 
LTV based on an updated appraisal. In addition, there is lease 
rollover risk because three of the leases are expiring soon, which 
could further limit cash flow.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status due to the positive cash flow and collateral margin. The 
examiner did not concur with this treatment as the loan was not 
restructured with reasonable repayment terms, and the borrower has 
not demonstrated the ability to amortize the loan and has limited 
capacity to service a below market interest rate on an interest-only 
basis. After a discussion with the examiner on regulatory reporting 
requirements, the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the borrower is experiencing financial difficulties (the 
project's ongoing ability to generate sufficient cash flow to 
service the debt is questionable as lease income is declining, loan 
payments have been sporadic, leases are expiring with uncertainty as 
to renewal or replacement, and collateral values have declined) and 
the lender granted a concession by reducing the interest rate to a 
below market level and deferring principal payments. The examiner 
concurred with the lender's TDR treatment.

B. Income Producing Property--Retail Properties

    Base Case: A lender originated a 36-month, $10 million loan for 
the construction of a shopping mall. The construction period was 24 
months with a 12-month lease-up period to allow the borrower time to 
achieve stabilized occupancy before obtaining permanent financing. 
The loan had an interest reserve to cover interest payments over the 
three-year term. At the end of the third year, there is $10 million 
outstanding on the loan, as the shopping mall has been built and the 
interest reserve, which has been covering interest payments, has 
been fully drawn.
    At the time of origination, the appraisal reported an ``as 
stabilized'' market value of $13.5 million for the property. In 
addition, the borrower had a take-out commitment that would provide 
permanent financing at maturity. A condition of the take-out lender 
was that the shopping mall had to achieve a 75 percent occupancy 
level.
    Due to weak economic conditions and a shift in consumer behavior 
to a greater reliance on e-commerce, the property only reached a 55 
percent occupancy level at the end of the 12-month lease up period. 
As a result, the original takeout commitment became void. In 
addition, there has been a considerable tightening of credit for 
these types of loans, and the borrower has been unable to obtain 
permanent financing elsewhere since the loan matured. To date, the 
few interested lenders are demanding significant equity 
contributions and much higher pricing.
    Scenario 1: The lender renewed the loan for an additional 12 
months to provide the

[[Page 56667]]

borrower time for higher lease-up and to obtain permanent financing. 
The extension was made at a market interest rate that provides for 
the incremental risk and is on an interest-only basis. While the 
property's historical cash flow was insufficient at a 0.92x debt 
service ratio, recent improvements in the occupancy level now 
provide adequate coverage based on the interest-only payments. 
Recent events include the signing of several new leases with 
additional leases under negotiation; however, takeout financing 
continues to be tight in the market.
    In addition, current financial statements reflect that the 
builder, who personally guarantees the debt, has cash on deposit at 
the lender plus other unencumbered liquid assets. These assets 
provide sufficient cash flow to service the borrower's global debt 
service requirements on a principal and interest basis, if 
necessary, for the next 12 months. The guarantor covered the initial 
cash flow shortfalls from the project and provided a good faith 
principal curtailment of $200,000 at renewal, reducing the loan 
balance to $9.8 million. A recent appraisal on the shopping mall 
reports an ``as is'' market value of $10 million and an ``as 
stabilized'' market value of $11 million, resulting in LTVs of 98 
percent and 89 percent, respectively.
    Classification: The lender internally graded the loan as a pass 
and is monitoring the credit. The examiner disagreed with the 
lender's internal loan grade and listed it as special mention. While 
the project continues to lease up, cash flows cover only the 
interest payments. The guarantor has the ability, and has 
demonstrated the willingness, to cover cash flow shortfalls; 
however, there remains considerable uncertainty surrounding the 
takeout financing for this type of loan.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status as the guarantor has sufficient funds to cover the borrower's 
global debt service requirements over the one-year period of the 
renewed loan. Full repayment of principal and interest is reasonably 
assured from the project's and guarantor's cash resources, despite a 
decline in the collateral margin. The examiner concurred with the 
lender's accrual treatment.
    TDR Treatment: The lender concluded that while the borrower has 
been affected by declining economic conditions and a shift to e-
commerce, the deterioration has not led to financial difficulties. 
The borrower was not experiencing financial difficulties because the 
borrower and guarantor have the ability to service the renewed loan, 
which was underwritten at a market interest rate, plus the 
borrower's other obligations on a timely basis. In addition, the 
lender expects to collect the full amount of principal and interest 
from the borrower's or guarantor's cash sources (i.e., not from 
interest reserves). Therefore, the lender is not treating the loan 
renewal as a TDR. The examiner concurred with the lender's rationale 
that the loan renewal is not a TDR.
    Scenario 2: The lender restructured the loan on an interest-only 
basis at a below market interest rate for one year to provide 
additional time to increase the occupancy level and, thereby, enable 
the borrower to arrange permanent financing. The level of lease-up 
remains relatively unchanged at 55 percent, and the shopping mall 
projects a DSC ratio of 1.02x based on the preferential loan terms. 
At the time of the restructuring, the lender used outdated financial 
information, which resulted in a positive cash flow projection. 
However, other file documentation available at the time of the 
restructuring reflected that the borrower anticipates the shopping 
mall's revenue stream will further decline due to rent concessions, 
the loss of a tenant, and limited prospects for finding new tenants.
    Current financial statements indicate the builder, who 
personally guarantees the debt, cannot cover any cash flow 
shortfall. The builder is highly leveraged, has limited cash or 
unencumbered liquid assets, and has other projects with delinquent 
payments. A recent appraisal on the shopping mall reports an ``as 
is'' market value of $9 million, which results in an LTV ratio of 
111 percent.
    Classification: The lender internally classified the loan as 
substandard. The examiner disagreed with the internal grade and 
classified the amount not protected by the collateral value, $1 
million, as loss and required the lender to charge-off this amount. 
The examiner did not factor costs to sell into the loss 
classification analysis, as the current source of repayment is not 
reliant on the sale of the collateral. The examiner classified the 
remaining loan balance, based on the property's ``as is'' market 
value of $9 million, as substandard given the borrower's uncertain 
repayment capacity and weak financial support.
    Nonaccrual Treatment: The lender determined the loan did not 
warrant being placed in nonaccrual status. The examiner did not 
concur with this treatment because the partial charge-off is 
indicative that full collection of principal is not anticipated, and 
the lender has continued exposure to additional loss due to the 
project's insufficient cash flow and reduced collateral margin and 
the guarantor's inability to provide further support. After a 
discussion with the examiner on regulatory reporting requirements, 
the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because (a) the borrower is experiencing financial difficulties 
as evidenced by the high leverage, delinquent payments on other 
projects, and inability to meet the proposed exit strategy because 
of the inability to lease the property in a reasonable timeframe; 
and (b) the lender granted a concession as evidenced by the 
reduction in the interest rate to a below market interest rate. The 
examiner concurred with the lender's TDR treatment.
    Scenario 3: The loan has become delinquent. Recent financial 
statements indicate the borrower and the guarantor have minimal 
other resources available to support this loan. The lender chose not 
to restructure the $10 million loan into a new single amortizing 
note of $10 million at a market interest rate because the project's 
projected cash flow would only provide a 0.88x DSC ratio as the 
borrower has been unable to lease space. A recent appraisal on the 
shopping mall reported an ``as is'' market value of $7 million, 
which results in an LTV of 143 percent.
    At the original loan's maturity, the lender restructured the $10 
million debt into two notes. The lender placed the first note of $7 
million (i.e., the Note A) on monthly payments that amortize the 
debt over 20 years at a market interest rate that provides for the 
incremental risk. The project's DSC ratio equals 1.20x for the $7 
million loan based on the shopping mall's projected net operating 
income. The lender then charged-off the $3 million note due to the 
project's lack of repayment capacity and to provide reasonable 
collateral protection for the remaining on-book loan of $7 million. 
The lender also reversed accrued but unpaid interest. The lender 
placed the second note (i.e., the Note B) consisting of the charged-
off principal balance of $3 million into a 2 percent interest-only 
loan that resets in five years into an amortizing payment. Since the 
restructuring, the borrower has made payments on both loans for more 
than six consecutive months and an updated financial analysis shows 
continued ability to repay under the new terms.
    Classification: The lender internally graded the on-book loan of 
$7 million as a pass loan due to the borrower's demonstrated ability 
to perform under the modified terms. The examiner agreed with the 
lender's grade as the lender restructured the original obligation 
into Notes A and B, the lender charged off Note B, and the borrower 
has demonstrated the ability to repay Note A. Using this multiple 
note structure with charge-off of the Note B enables the lender to 
recognize interest income and limit the amount reported as a TDR in 
future periods.
    Nonaccrual Treatment: The lender placed the on-book loan (Note 
A) of $7 million loan in nonaccrual status at the time of the 
restructure. The lender later restored the $7 million to accrual 
status as the borrower has the ability to repay the loan, has a 
record of performing at the revised terms for more than six months, 
and full repayment of principal and interest is expected. The 
examiner concurred with the lender's accrual treatment. Interest 
payments received on the off-book loan have been recorded as 
recoveries because full recovery of principal and interest on this 
loan (Note B) was not reasonably assured.
    TDR Treatment: The lender considered both Note A and Note B as 
TDRs because the borrower is experiencing financial difficulties and 
the lender granted a concession. The lender reported the 
restructured on-book loan (Note A) of $7 million as a TDR, while the 
second loan (Note B) was charged off. The financial difficulties are 
evidenced by the borrower's high leverage, delinquent payments on 
other projects, inability to lease the property in a reasonable 
timeframe, and the unlikely collectability of the charged-off loan 
(Note B). The concessions on Note A include extending the on-book 
loan beyond expected timeframes.
    The lender plans to stop disclosing the on-book loan as a TDR 
after the regulatory reporting defined time period expires because 
the loan was restructured with a market interest rate and is in 
compliance

[[Page 56668]]

with its modified terms.\26\ The examiner agreed with the lender's 
TDR treatment.
---------------------------------------------------------------------------

    \26\ Refer to the guidance on ``Troubled debt restructurings'' 
in the FFIEC Call Report.
---------------------------------------------------------------------------

    Scenario 4: Current financial statements indicate the borrower 
and the guarantor have minimal other resources available to support 
this loan. The lender restructured the $10 million loan into a new 
single note of $10 million at a market interest rate that provides 
for the incremental risk and is on an amortizing basis. The 
project's projected cash flow reflects a 0.88x DSC ratio as the 
borrower has been unable to lease space. A recent appraisal on the 
shopping mall reports an ``as is'' market value of $9 million, which 
results in an LTV of 111 percent. Based on the property's current 
market value of $9 million, the lender charged-off $1 million 
immediately after the renewal.
    Classification: The lender internally graded the remaining $9 
million on-book portion of the loan as a pass loan because the 
lender's analysis of the project's cash flow indicated a 1.05x DSC 
ratio when just considering the on-book balance. The examiner 
disagreed with the internal grade and classified the $9 million on-
book balance as substandard due to the borrower's marginal financial 
condition, lack of guarantor support, and uncertainty over the 
source of repayment. The DSC ratio remains at 0.88x due to the 
single note restructure, and other resources are scant.
    Nonaccrual Treatment: The lender maintained the remaining $9 
million on-book portion of the loan on accrual, as the borrower has 
the ability to repay the principal and interest on this balance. The 
examiner did not concur with this treatment. Because the lender 
restructured the debt into a single note and had charged-off a 
portion of the restructured loan, the repayment of the principal and 
interest contractually due on the entire debt is not reasonably 
assured given the DSC ratio of 0.88x and nominal other resources. 
After a discussion with the examiner on regulatory reporting 
requirements, the lender placed the loan on nonaccrual.
    The loan can be returned to accrual status \27\ if the lender 
can document that subsequent improvement in the borrower's financial 
condition has enabled the loan to be brought fully current with 
respect to principal and interest and the lender expects the 
contractual balance of the loan (including the partial charge-off) 
will be fully collected. In addition, interest income may be 
recognized on a cash basis for the partially charged-off portion of 
the loan when the remaining recorded balance is considered fully 
collectible. However, the partial charge-off cannot be reversed.
---------------------------------------------------------------------------

    \27\ Refer to the guidance on ``nonaccrual status'' in the FFIEC 
Call Report.
---------------------------------------------------------------------------

    TDR Treatment: The lender reported the restructured loan as a 
TDR according to the requirements of its regulatory reports because 
(a) the borrower is experiencing financial difficulties as evidenced 
by the high leverage, delinquent payments on other projects, and 
inability to meet the original exit strategy because the borrower 
was unable to lease the property in a reasonable timeframe; and (b) 
the lender granted a concession as evidenced by deferring payment 
beyond the repayment ability of the borrower. The charge-off 
indicates that the lender does not expect full repayment of 
principal and interest, yet the borrower remains obligated for the 
full amount of the debt and payments, which is at a level that is 
not consistent with the borrower's repayment capacity. Because the 
borrower is not expected to be able to comply with the loan's 
restructured terms, the lender would likely continue to disclose the 
loan as a TDR. The examiner concurs with reporting the renewed loan 
as a TDR.

C. Income Producing Property--Hotel

    Base Case: A lender originated a $7.9 million loan to provide 
permanent financing for the acquisition of a stabilized 3-star hotel 
property. The borrower is a limited liability company with 
underlying ownership by two families who guarantee the loan. The 
loan term is five years, with payments based on a 25-year 
amortization and with a market interest rate. The LTV was 79 percent 
based on the hotel's appraised value of $10 million.
    At the end of the five-year term, the borrower's annualized DSC 
ratio was 0.95x. Due to competition from a well-known 4-star hotel 
that recently opened within one mile of the property, occupancy 
rates have declined. The borrower progressively reduced room rates 
to maintain occupancy rates, but continued to lose daily bookings. 
Both occupancy and Revenue per Available Room (RevPAR) \28\ declined 
significantly over the past year. The borrower then began working on 
an initiative to make improvements to the property (i.e., automated 
key cards, carpeting, bedding, and lobby renovations) to increase 
competitiveness, and a marketing campaign is planned to announce the 
improvements and new price structure.
---------------------------------------------------------------------------

    \28\ Total guest room revenue divided by room count and number 
of days in the period.
---------------------------------------------------------------------------

    The borrower had paid principal and interest as agreed 
throughout the first five years, and the principal balance had 
reduced to $7 million at the end of the five-year term.
    Scenario 1: At maturity, the lender renewed the loan for 12 
months on an interest-only basis at a market interest rate that 
provides for the incremental risk. The extension was granted to 
enable the borrower to complete the planned renovations, launch the 
marketing campaign, and achieve the borrower's updated projections 
for sufficient cash flow to service the debt once the improvements 
are completed. (If the initiative is successful, the loan officer 
expects the loan to either be renewed on an amortizing basis or 
refinanced through another lending entity.) The borrower has a 
verified, pledged reserve account to cover the improvement expenses. 
Additionally, the guarantors' updated financial statements indicate 
that they have sufficient unencumbered liquid assets. Further, the 
guarantors expressed the willingness to cover any estimated cash 
flow shortfall through maturity. Based on this information, the 
lender's analysis indicates that, after deductions for personal 
obligations and realistic living expenses and verification that 
there are no contingent liabilities, the guarantors should be able 
to make interest payments. To date, interest payments have been 
timely. The lender estimates the property's current ``as 
stabilized'' market value at $9 million, which results in a 78 
percent LTV.
    Classification: The lender internally graded the loan as a pass 
and is monitoring the credit. The examiner agreed with the lender's 
internal loan grade. The examiner concluded that the borrower and 
guarantors have sufficient resources to support the interest 
payments; additionally, the borrower's reserve account is sufficient 
to complete the renovations as planned.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status as full repayment of principal and interest is reasonably 
assured from the hotel's and guarantors cash flows, despite a 
decline in the borrower's cash flow due to competition. The examiner 
concurred with the lender's accrual treatment.
    TDR Treatment: The lender concluded that while the borrower has 
been affected by competition, the level of deterioration does not 
warrant TDR treatment. The borrower was not experiencing financial 
difficulties because the combined cash flow generated by the 
borrower and the liquidity provided by the guarantors should be 
sufficient to service the debt. Further, there was no history of 
default by the borrower or guarantors. The examiner concurred with 
the lender that the loan renewal is not a TDR.
    Scenario 2: At maturity of the original loan, the lender 
restructured the loan on an interest-only basis at a below market 
interest rate for 12 months to provide the borrower time to complete 
its renovation and marketing efforts and increase occupancy levels. 
At the end of the 12-month period, the hotel's renovation and 
marketing efforts were completed but unsuccessful. The hotel 
continued to experience a decline in occupancy levels, resulting in 
a DSC ratio of 0.60x. The borrower does not have capacity to offer 
additional incentives to lure customers from the competition. RevPAR 
has also declined. Current financial information indicates the 
borrower has limited ability to continue to make interest payments, 
and updated projections indicate that the borrower will be below 
break-even performance for the next 12 months. The borrower has been 
sporadically delinquent on prior interest payments. The guarantors 
are unable to support the loan as they have unencumbered limited 
liquid assets and are highly leveraged. The lender is in the process 
of renewing the loan again.
    The most recent hotel appraisal, dated as of the time of the 
first restructuring, reports an ``as stabilized'' appraised value of 
$7.2 million ($6.7 million for the real estate and $500,000 for the 
tangible personal property of furniture, fixtures, and equipment), 
resulting in an LTV of 97 percent. The appraisal does not account 
for the diminished occupancy, and its assumptions significantly 
differ from current projections. A new valuation is needed to 
ascertain the current value of the property.
    Classification: The lender internally classified the loan as 
substandard and is monitoring the credit. The examiner agreed

[[Page 56669]]

with the lender's treatment due to the borrower's diminished ongoing 
ability to make payments, guarantors' limited ability to support the 
loan, and the reduced collateral position. The lender is obtaining a 
new valuation and will adjust the internal classification, if 
necessary, based on the updated value.
    Nonaccrual Treatment: The lender maintained the loan on an 
accrual basis because the borrower demonstrated an ability to make 
interest payments. The examiner did not concur with this treatment 
as the loan was not restructured on reasonable repayment terms, the 
borrower has insufficient cash resources to service the below market 
interest rate on an interest-only basis, and the collateral margin 
has narrowed and may be narrowed further with a new valuation, which 
collectively indicate that full repayment of principal and interest 
is in doubt. After a discussion with the examiner on regulatory 
reporting requirements, the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the borrower is experiencing financial difficulties: the 
hotel's ability to generate sufficient cash flows to service the 
debt is questionable as the occupancy levels and resultant net 
operating income (NOI) continue to decline, the borrower has been 
delinquent, and collateral value has declined. The lender made a 
concession by extending the loan on an interest-only basis at a 
below market interest rate. The examiner concurred with the lender's 
TDR treatment.
    Scenario 3: At maturity of the original loan, the lender 
restructured the debt for one year on an interest-only basis at a 
below market interest rate to give the borrower additional time to 
complete renovations and increase marketing efforts. While the 
combined borrower/guarantors' liquidity indicated they could cover 
any cash flow shortfall until maturity of the restructured note, the 
borrower only had 50 percent of the funds to complete its 
renovations in reserve. Subsequently, the borrower attracted a 
sponsor to obtain the remaining funds necessary to complete the 
renovation plan and marketing campaign. Eight months later, the 
hotel experienced an increase in its occupancy and achieved a DSC 
ratio of 1.20x on an amortizing basis. Updated projections indicated 
the borrower would be at or above the 1.20x DSC ratio for the next 
12 months, based on market terms and rate. The borrower and the 
lender then agreed to restructure the loan again with monthly 
payments that amortize the debt over 20 years, consistent with the 
current market terms and rates. Since the date of the second 
restructuring, the borrower has made all principal and interest 
payments as agreed for six consecutive months.
    Classification: The lender internally classified the most recent 
restructured loan substandard. The examiner agreed with the lender's 
initial substandard grade at the time of the subject restructuring, 
but now considers the loan as a pass as the borrower was no longer 
having financial difficulty and has demonstrated the ability to make 
payments according to the modified principal and interest terms for 
more than six consecutive months.
    Nonaccrual Treatment: The original restructured loan was placed 
in nonaccrual status. The lender initially maintained the most 
recent restructured loan in nonaccrual status as well, but returned 
it to an accruing status after the borrower made six consecutive 
monthly principal and interest payments. The lender expects full 
repayment of principal and interest. The examiner concurred with the 
lender's accrual treatment.
    TDR Treatment: The lender reported the first restructuring as a 
TDR. With the first restructuring, the lender determined that the 
borrower was experiencing financial difficulties as indicated by 
depleted cash resources and deteriorating financial condition. The 
lender granted a concession on the first restructuring by providing 
a below market interest rate. At the time of the second 
restructuring, the borrower's financial condition had improved, and 
the borrower was no longer experiencing financial difficulty; the 
lender did not grant a concession on the second restructuring as the 
renewal was granted at a market interest rate and amortizing terms, 
thus the latest restructuring is no longer classified as a TDR. The 
examiner concurred with the lender.
    Scenario 4: The lender extended the original amortizing loan for 
12 months at a market interest rate. The borrower is now 
experiencing a six-month delay in completing the renovations due to 
a conflict with the contractor hired to complete the renovation 
work, and the current DSC ratio is 0.85x. A current valuation has 
not been ordered. The lender estimates the property's current ``as 
stabilized'' market value is $7.8 million, which results in an 
estimated 90 percent LTV. The lender did receive updated 
projections, but the borrower is now unlikely to achieve break-even 
cash flow within the 12-month extension timeframe due to the 
renovation delays. At the time of the extension, the borrower and 
guarantors had sufficient liquidity to cover the debt service during 
the twelve-month period. The guarantors also demonstrated a 
willingness to support the loan by making payments when necessary, 
and the loan has not gone delinquent. With the guarantors' support, 
there is sufficient liquidity to make payments to maturity, though 
such resources are declining rapidly
    Classification: The lender internally graded the loan as pass 
and is monitoring the credit. The examiner disagreed with the 
lender's grading and listed the loan as special mention. While the 
borrower and guarantor can cover the debt service shortfall in the 
near-term, the duration of their support may not extend long enough 
to replace lost cash flow from operations due to delays in the 
renovation work. The primary source of repayment does not fully 
cover the loan as evidenced by a DSC ratio of 0.85x. It appears that 
competition from the new hotel will continue to adversely affect the 
borrower's cash flow until the renovations are complete, and if cash 
flow deteriorates further, the borrower and guarantors may be 
required to use more liquidity to support loan payments and ongoing 
business operations. The examiner also recommended the lender obtain 
a new valuation.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The borrower and legally obligated guarantors have 
demonstrated the ability and willingness to make the regularly 
scheduled payments and, even with the decline in the borrower's 
creditworthiness, global cash resources appear sufficient to make 
these payments, and the ultimate full repayment of principal and 
interest is expected. The examiner concurred with the lender's 
accrual treatment.
    TDR Treatment: While the borrower is experiencing some financial 
deterioration, the borrower is not experiencing financial 
difficulties as the borrower and guarantors have sufficient cash 
resources to service the debt. The lender expects full collection of 
principal and interest from the borrower's operating income and 
global cash resources. The examiner concurred with the lender's 
rationale that the loan is not a TDR.

D. Acquisition, Development and Construction--Residential

    Base Case: The lender originated a $4.8 million acquisition and 
development (A&D) loan and a $2.4 million construction revolving 
line of credit (revolver) for the development and construction of a 
48-lot single-family project. The maturity for both loans is three 
years, and both are priced at a market interest rate; both loans 
also have an interest reserve. The LTV on the A&D loan is 75 percent 
based on an ``as complete'' value of $6.4 million. Up to 12 units at 
a time will be funded under the construction revolver at the lesser 
of 80 percent LTV or 100 percent of costs. The builder is allowed 
two speculative (``spec'') units (including one model). The 
remaining units must be pre-sold with an acceptable deposit and a 
pre-qualified mortgage. As units are settled, the construction 
revolver will be repaid at 100 percent (or par); the A&D loan will 
be repaid at 120 percent, or $120,000 ($4.8 million/48 units x 120 
percent). The average sales price is projected to be $500,000, and 
total construction cost to build each unit is estimated to be 
$200,000. Assuming total cost is lower than value, the average 
release price will be $320,000 ($120,000 A&D release price plus 
$200,000 construction costs).
    Estimated time for development is 12 months; the appraiser 
estimated absorption of two lots per month for total sell-out to 
occur within three years (thus, the loan would be repaid upon 
settlement of the 40th unit, or the 32nd month of the loan term). 
The borrower is required to curtail the A&D loan by six lots, or 
$720,000, at the 24th month, and another six lots, or $720,000, by 
the 30th month.
    Scenario 1: Due to issues with the permitting and approval 
process by the county, the borrower's development was delayed by 18 
months. Further delays occurred because the borrower was unable to 
pave the necessary roadways due to excessive snow and freezing 
temperatures. The lender waived both $720,000 curtailment 
requirements due to the delays. Demand for the housing remains 
unchanged.
    At maturity, the lender renewed the $4.8 million outstanding A&D 
loan balance and the $2.4 million construction revolver for 24

[[Page 56670]]

months at a market interest rate that provides for the incremental 
risk. The interest reserve for the A&D loan has been depleted as the 
lender had continued to advance funds to pay the interest charges 
despite the delays in development. Since depletion of the interest 
reserve, the borrower has made the last several payments out-of-
pocket.
    Development is now complete, and construction has commenced on 
eight units (two ``spec'' units and six pre-sold units). Combined 
borrower and guarantor liquidity show they can cover any debt 
service shortfall until the units begin to settle and the project is 
cash flowing. The lender estimates that the property's current ``as 
complete'' value is $6 million, resulting in an 80 percent LTV. The 
curtailment schedule was re-set to eight lots, or $960,000, by month 
12, and another eight lots, or $960,000, by month 18. A new 
appraisal has not been ordered; however, the lender noted in the 
file that, if the borrower does not meet the absorption projections 
of six lots/quarter within six months of booking the renewed loan, 
the lender will obtain a new appraisal.
    Classification: The lender internally graded the restructured 
loans as pass and is monitoring the credits. The examiner agreed, as 
the borrower and guarantor can continue making payments on 
reasonable terms and the project is moving forward supported by 
housing demand and is consistent with the builder's development 
plans. However, the examiner noted weaknesses in the lender's loan 
administrative practices as the financial institution did not (1) 
suspend the interest reserve during the development delay and (2) 
obtain an updated collateral valuation.
    Nonaccrual Treatment: The lender maintained the loans on accrual 
status. The project is moving forward, the borrower has demonstrated 
the ability to make the regularly scheduled payments after depletion 
of the interest reserve, global cash resources from the borrower and 
guarantor appears sufficient to make these payments, and full 
repayment of principal and interest is expected. The examiner 
concurred with the lender's accrual treatment.
    TDR Treatment: The borrower is not experiencing financial 
difficulties as the borrower and guarantor have sufficient means to 
service the debt, and there is no history of default. With the 
continued supportive housing market conditions, the lender expects 
full collection of principal and interest from sales of the lots. 
The examiner concurred with the lender's rationale that the renewal 
is not a TDR.
    Scenario 2: Due to weather and contractor issues, development 
was not completed until month 24, a year behind the original 
schedule. The borrower began pre-marketing, but sales have been slow 
due to deteriorating market conditions in the region. The borrower 
has achieved only eight pre-sales during the past six months. The 
borrower recently commenced construction on the pre-sold units.
    At maturity, the lender renewed the $4.8 million A&D loan 
balance and $2.4 million construction revolver on a 12-month 
interest-only basis at a market interest rate, with another 12-month 
option predicated upon $1 million in curtailments having occurred 
during the first renewal term (the lender had waived the initial 
term curtailment requirements). The lender also renewed the 
construction revolver for a one-year term and reduced the number of 
``spec'' units to just one, which also will serve as the model. A 
recent appraisal estimates that absorption has dropped to four lots 
per quarter for the first two years and assigns an ``as complete'' 
value of $5.3 million, for an LTV of 91 percent. The interest 
reserve is depleted, and the borrower has been paying interest out-
of-pocket for the past few months. Updated borrower and guarantor 
financial statements indicate the continued ability to cover 
interest-only payments for the next 12 to 18 months.
    Classification: The lender internally classified the loan as 
substandard and is monitoring the credit. The examiner agreed with 
the lender's treatment due to the deterioration and uncertainty 
surrounding the market (as evidenced by slower than anticipated 
sales on the project), the lack of principal reduction, and the 
reduced collateral margin.
    Nonaccrual Treatment: The lender maintained the loan on an 
accrual basis because the development is complete, the borrower has 
pre-sales and construction has commenced, and the borrower and 
guarantor have sufficient means to make interest payments at a 
market interest rate until the earlier of maturity or the project 
begins to cash flow. The examiner concurred with the lender's 
accrual treatment.
    TDR Treatment: While the borrower is experiencing some financial 
deterioration, the borrower is not experiencing financial 
difficulties as the borrower and guarantor have sufficient means to 
service the debt. The lender expects full collection of principal 
and interest from the sale of the units. The examiner concurred with 
the lender's rationale that the renewal is not a TDR.
    Scenario 3: Lot development was completed on schedule, and the 
borrower quickly sold and settled the first 10 units. At maturity, 
the lender renewed the $3.6 million A&D loan balance ($4.8 million 
reduced by the sale and settlement of the 10 units ($120,000 release 
price x 10) to arrive at $3.6 million) and $2.4 million construction 
revolver on a 12-month interest-only basis at a below market 
interest rate.
    The borrower then sold an additional 10 units to an investor; 
the loan officer (new to the financial institution) mistakenly 
marked these units as pre-sold and allowed construction to commence 
on all 10 units. Market conditions then deteriorated quickly, and 
the investor defaulted under the terms of the bulk contract. The 
units were completed, but the builder has been unable to re-sell any 
of the units, recently dropping the sales price by 10 percent and 
engaging a new marketing firm, which is working with several 
potential buyers.
    A recent appraisal estimates that absorption has dropped to 
three lots per quarter and assigns an ``as complete'' value of $2.3 
million for the remaining 28 lots, resulting in an LTV of 156 
percent. A bulk appraisal of the 10 units assigns an ``as-is'' value 
of the units of $4.0 million ($400,000/unit). The loans are cross-
defaulted and cross-collateralized; the LTV on a combined basis is 
95 percent ($6 million outstanding debt (A&D plus revolver) divided 
by $6.3 million in combined collateral value). Updated borrower and 
guarantor financial statements indicate a continued ability to cover 
interest-only payments for the next 12 months at the reduced rate; 
however, this may be limited in the future given other troubled 
projects in the borrower's portfolio that have been affected by 
market conditions.
    The lender modified the release price for each unit to net 
proceeds; any additional proceeds as units are sold will go towards 
repayment of the A&D loan. Assuming the units sell at a 10 percent 
reduction, the lender calculates the average sales price would be 
$450,000. The financial institution's prior release price was 
$320,000 ($120,000 for the A&D loan and $200,000 for the 
construction revolver). As such (by requiring net proceeds), the 
financial institution will be receiving an additional $130,000 per 
lot, or $1.3 million for the completed units, to repay the A&D loan 
($450,000 average sales price less $320,000 bank's release price 
equals $130,000). Assuming the borrower will have to pay $30,000 in 
related sales/settlement costs leaves approximately $100,000 
remaining per unit to apply towards the A&D loan, or $1 million 
total for the remaining 10 units ($100,000 times 10).
    Classification: The lender internally classified the loan as 
substandard and is monitoring the credit. The examiner agreed with 
the lender's treatment due to the borrower and guarantor's 
diminished ability to make interest payments (even at the reduced 
rate), the stalled status of the project, and the reduced collateral 
protection.
    Nonaccrual Treatment: The lender maintained the loan on an 
accrual basis because the borrower had previously demonstrated an 
ability to make interest payments. The examiner disagreed as the 
loan was not restructured on reasonable repayment terms. While the 
borrower and guarantor may be able to service the debt at a below 
market interest rate in the near term using other unencumbered 
liquid assets, other projects in their portfolio are also affected 
by poor market conditions and may require significant liquidity 
contributions, which could affect their ability to support the loan. 
After a discussion with the examiner on regulatory reporting 
requirements, the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the borrower is experiencing financial difficulties as 
evidenced by the borrower's inability to re-sell the units, their 
diminished ability to make interest payments (even at a reduced 
rate), and other troubled projects in the borrower's portfolio. The 
lender granted a concession with the interest-only terms at a below 
market interest rate. The examiner concurred with the lender's TDR 
treatment.

E. Construction Loan--Single Family Residence

    Base Case: The lender originated a $1.2 million construction 
loan on a single-family ``spec'' residence with a 15-month maturity 
to allow for completion and sale of the property. The loan required 
monthly interest-

[[Page 56671]]

only payments at a market interest rate and was based on an ``as 
completed'' LTV of 70 percent at origination. During the original 
loan construction phase, the borrower was able to make all interest 
payments from personal funds. At maturity, the home had been 
completed, but not sold, and the borrower was unable to find another 
lender willing to finance this property under similar terms.
    Scenario 1: At maturity, the lender restructured the loan for 
one year on an interest-only basis at a below market interest rate 
to give the borrower more time to sell the ``spec'' home. Current 
financial information indicates the borrower has limited ability to 
continue to make interest-only payments from personal funds. If the 
residence does not sell by the revised maturity date, the borrower 
plans to rent the home. In this event, the lender will consider 
modifying the debt into an amortizing loan with a 20-year maturity, 
which would be consistent with this type of income-producing 
investment property. Any shortfall between the net rental income and 
loan payments would be paid by the borrower. Due to declining home 
values, the LTV at the renewal date was 90 percent.
    Classification: The lender internally classified the loan 
substandard and is monitoring the credit. The examiner agreed with 
the lender's treatment due to the borrower's diminished ongoing 
ability to make payments and the reduced collateral position.
    Nonaccrual Treatment: The lender maintained the loan on an 
accrual basis because the borrower demonstrated an ability to make 
interest payments during the construction phase. The examiner did 
not concur with this treatment because the loan was not restructured 
on reasonable repayment terms. The borrower had limited capacity to 
continue to service the debt, even on an interest-only basis at a 
below market interest rate, and the deteriorating collateral margin 
indicated that full repayment of principal and interest was not 
reasonably assured. The examiner instructed the lender to place the 
loan in nonaccrual status.
    TDR Treatment: The lender reported the restructured loan as a 
TDR. The borrower was experiencing financial difficulties as 
indicated by depleted cash reserves, inability to refinance this 
debt from other sources with similar terms, and the inability to 
repay the loan at maturity in a manner consistent with the original 
exit strategy. A concession was provided by renewing the loan with a 
deferral of principal payments, at a below market interest rate 
(compared to the rate charged on an investment property) for an 
additional year when the loan was no longer in the construction 
phase. The examiner concurred with the lender's TDR treatment.
    Scenario 2: At maturity of the original loan, the lender 
restructured the debt for one year on an interest-only basis at a 
below market interest rate to give the borrower more time to sell 
the ``spec'' home. Eight months later, the borrower rented the 
property. At that time, the borrower and the lender agreed to 
restructure the loan again with monthly payments that amortize the 
debt over 20 years at a market interest rate for a residential 
investment property. Since the date of the second restructuring, the 
borrower had made all payments for over six consecutive months.
    Classification: The lender internally classified the 
restructured loan substandard. The examiner agreed with the lender's 
initial substandard grade at the time of the restructuring, but now 
considered the loan as a pass due to the borrower's demonstrated 
ability to make payments according to the reasonably modified terms 
for more than six consecutive months.
    Nonaccrual Treatment: The lender initially placed the 
restructured loan in nonaccrual status but returned it to accrual 
after the borrower made six consecutive monthly payments. The lender 
expects full repayment of principal and interest from the rental 
income. The examiner concurred with the lender's accrual treatment.
    TDR Treatment: The lender reported the first restructuring as a 
TDR. At the time of the first restructure, the lender determined 
that the borrower was experiencing financial difficulties as 
indicated by depleted cash resources and a weak financial condition. 
The lender granted a concession on the first restructuring as 
evidenced by the below market rate.
    At the second restructuring, the lender determined that the 
borrower was not experiencing financial difficulties due to the 
borrower's improved financial condition. Further, the lender did not 
grant a concession on the second restructuring as that loan is at 
market interest rate and terms. Therefore, the lender determined 
that the second restructuring is no longer a TDR. The examiner 
concurred with the lender.
    Scenario 3: The lender restructured the loan for one year on an 
interest-only basis at a below market interest rate to give the 
borrower more time to sell the ``spec'' home. The restructured loan 
has become more than 90 days past due, and the borrower has not been 
able to rent the property. Based on current financial information, 
the borrower does not have the capacity to service the debt. The 
lender considers repayment to be contingent upon the sale of the 
property. Current market data reflects few sales, and similar new 
homes in this property's neighborhood are selling within a range of 
$750,000 to $900,000 with selling costs equaling 10 percent, 
resulting in anticipated net sales proceeds between $675,000 and 
$810,000.
    Classification: The lender graded $390,000 loss ($1.2 million 
loan balance less the maximum estimated net sales proceeds of 
$810,000), $135,000 doubtful based on the range in the anticipated 
net sales proceeds, and the remaining balance of $675,000 
substandard. The examiner agreed, as this classification treatment 
results in the recognition of the credit risk in the collateral-
dependent loan based on the property's value less costs to sell. The 
examiner instructed management to obtain information on the current 
valuation on the property.
    Nonaccrual Treatment: The lender placed the loan in nonaccrual 
status when it became 60 days past due (reversing all accrued but 
unpaid interest) because the lender determined that full repayment 
of principal and interest was not reasonably assured. The examiner 
concurred with the lender's nonaccrual treatment.
    TDR Treatment: The lender reported the loan as a TDR until 
foreclosure of the property and its transfer to other real estate 
owned. The lender determined that the borrower was continuing to 
experience financial difficulties as indicated by depleted cash 
reserves, inability to refinance this debt from other sources with 
similar terms, and the inability to repay the loan at maturity in a 
manner consistent with the original exit strategy. In addition, the 
lender granted a concession by reducing the interest rate to a below 
market level. The examiner concurred with the lender's TDR 
treatment.
    Scenario 4: The lender committed an additional $48,000 for an 
interest reserve and extended the $1.2 million loan for 12 months at 
a below market interest rate with monthly interest-only payments. At 
the time of the examination, $18,000 of the interest reserve had 
been added to the loan balance. Current financial information 
obtained during the examination reflects the borrower has no other 
repayment sources and has not been able to sell or rent the 
property. An updated appraisal supports an ``as is'' value of 
$952,950. Selling costs are estimated at 15 percent, resulting in 
anticipated net sales proceeds of $810,000.
    Classification: The lender internally graded the loan as pass 
and is monitoring the credit. The examiner disagreed with the 
internal grade. The examiner concluded that the loan was not 
restructured on reasonable repayment terms because the borrower has 
limited capacity to service the debt, and the reduced collateral 
margin indicated that full repayment of principal and interest was 
not assured. After discussing regulatory reporting requirements with 
the examiner, the lender reversed the $18,000 interest capitalized 
out of the loan balance and interest income. Further, the examiner 
classified $390,000 loss based on the adjusted $1.2 million loan 
balance less estimated net sales proceeds of $810,000, which was 
classified substandard. This classification treatment recognizes the 
credit risk in the collateral-dependent loan based on the property's 
market value less costs to sell. The examiner also provided 
supervisory feedback to management for the inappropriate use of 
interest reserves and lack of current financial information in 
making that decision. The remaining interest reserve of $30,000 is 
not subject to adverse classification because the loan should be 
placed in nonaccrual status.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The examiner did not concur with this treatment. The loan 
was not restructured on reasonable repayment terms, the borrower has 
limited capacity to service a below market interest rate on an 
interest-only basis, and the reduced collateral margin indicates 
that full repayment of principal and interest is not assured. The 
lender's decision to provide a $48,000 interest reserve was not 
supported, given the borrower's inability to repay it. After a 
discussion with the examiner on regulatory reporting requirements, 
the lender placed the loan on nonaccrual, and reversed the 
capitalized interest to be consistent with

[[Page 56672]]

regulatory reporting instructions. The lender also agreed to not 
recognize any further interest income from the interest reserve.
    TDR Treatment: The lender reported the restructured loan as a 
TDR. The borrower is experiencing financial difficulties as 
indicated by depleted cash reserves, inability to refinance this 
debt from other sources with similar terms, and the inability to 
repay the loan at maturity in a manner consistent with the original 
exit strategy. A concession was provided by renewing the loan with a 
deferral of principal payments, at a below market interest rate 
(compared to other investment properties) for an additional year 
when the loan was no longer in the construction phase. The examiner 
concurred with the lender's TDR treatment.

F. Construction Loan--Land Acquisition, Condominium Construction 
and Conversion

    Base Case: The lender originally extended a $50 million loan for 
the purchase of vacant land and the construction of a luxury 
condominium project. The loan was interest-only and included an 
interest reserve to cover the monthly payments until construction 
was complete. The developer bought the land and began construction 
after obtaining purchase commitments for \1/3\ of the 120 planned 
units, or 40 units. Many of these pending sales were speculative 
with buyers committing to buy multiple units with minimal down 
payments. The demand for luxury condominiums in general has declined 
since the borrower launched the project, and sales have slowed 
significantly over the past year. The lack of demand is attributed 
to a slowdown in the economy. As a result, most of the speculative 
buyers failed to perform on their purchase contracts and only a 
limited number of the other planned units have been pre-sold.
    The developer experienced cost overruns on the project and 
subsequently determined it was in the best interest to halt 
construction with the property 80 percent completed. The outstanding 
loan balance is $44 million with funds used to pay construction 
costs, including cost overruns and interest. The borrower estimates 
an additional $10 million is needed to complete construction. 
Current financial information reflects that the developer does not 
have sufficient cash flow to pay interest (the interest reserve has 
been depleted); and, while the developer does have equity in other 
assets, there is doubt about the borrower's ability to complete the 
project.
    Scenario 1: The borrower agrees to grant the lender a second 
lien on an apartment project in its portfolio, which provides $5 
million in additional collateral support. In return, the lender 
advanced the borrower $10 million to finish construction. The 
condominium project was completed shortly thereafter. The lender 
also agreed to extend the $54 million loan ($44 million outstanding 
balance plus $10 million in new money) for 12 months at a market 
interest rate that provides for the incremental risk, to give the 
borrower additional time to market the property. The borrower agreed 
to pay interest whenever a unit was sold, with any outstanding 
balance due at maturity.
    The lender obtained a recent appraisal on the condominium 
building that reported a prospective ``as complete'' market value of 
$65 million, reflecting a 24-month sell-out period and projected 
selling costs of 15 percent of the sales price. Comparing the $54 
million loan amount against the $65 million ``as complete'' market 
value plus the $5 million pledged in additional collateral (totaling 
$70 million) results in an LTV of 77 percent. The lender used the 
prospective ``as complete'' market value in its analysis and 
decision to fund the completion and sale of the units and to 
maximize its recovery on the loan.
    Classification: The lender internally classified the $54 million 
loan as substandard due to the units not selling as planned and the 
project's limited ability to service the debt despite the 1.3x gross 
collateral margin. The examiner agreed with the lender's internal 
grade.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status due to the protection afforded by the collateral margin. The 
examiner did not concur with this treatment due to the uncertainty 
about the borrower's ability to sell the units and service the debt, 
raising doubts as to the full repayment of principal and interest. 
After a discussion with the examiner on regulatory reporting 
requirements, the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the borrower is experiencing financial difficulties, as 
demonstrated by the insufficient cash flow to service the debt, 
concerns about the project's viability, and, given current market 
conditions and project status, the unlikely possibility of 
refinance. In addition, the lender provided a concession by 
advancing additional funds to finish construction, deferring 
interest payments until a unit was sold, and deferring principal pay 
downs on any unsold units until the maturity date when any remaining 
accrued interest plus principal are due. The examiner concurred with 
the lender's TDR treatment.
    Scenario 2: A recent appraisal of the property reflects that the 
highest and best use would be conversion to an apartment building. 
The appraisal reports a prospective ``as complete'' market value of 
$60 million upon conversion to an apartment building and a $67 
million prospective ``as stabilized'' market value upon the property 
reaching stabilized occupancy. The borrower agrees to grant the 
lender a second lien on an apartment building in its portfolio, 
which provides $5 million in additional collateral support.
    In return, the lender advanced the borrower $10 million, which 
is needed to finish construction and convert the project to an 
apartment complex. The lender also agreed to extend the $54 million 
loan for 12 months at a market interest rate that provides for the 
incremental risk, to give the borrower time to lease the apartments. 
Interest payments are deferred. The $60 million ``as complete'' 
market value plus the $5 million in other collateral results in an 
LTV of 83 percent. The prospective ``as complete'' market value is 
primarily relied on as the loan is funding the conversion of the 
condominium to apartment building.
    Classification: The lender internally classified the $54 million 
loan as substandard due to the units not selling as planned and the 
project's limited ability to service the debt. The collateral 
coverage provides adequate support to the loan with a 1.2x gross 
collateral margin. The examiner agreed with the lender's internal 
grade.
    Nonaccrual Treatment: The lender determined the loan should be 
placed in nonaccrual status due to an oversupply of units in the 
project's submarket, and the borrower's untested ability to lease 
the units and service the debt, raising concerns as to the full 
repayment of principal and interest. The examiner concurred with the 
lender's nonaccrual treatment.
    TDR Treatment: The lender reported the restructured loan as a 
TDR as the borrower is experiencing financial difficulties, as 
demonstrated by the insufficient cash flow to service the debt, 
concerns about the project's viability, and, given current market 
conditions and project status, the unlikely possibility for the 
borrower to refinance at this time. In addition, the lender provided 
a concession by advancing additional funds to finish construction 
and deferring interest payments until the maturity date without a 
defined exit strategy. The examiner concurred with the lender's TDR 
treatment.

G. Commercial Operating Line of Credit in Connection With Owner 
Occupied Real Estate

    Base Case: Two years ago, the lender originated a CRE loan at a 
market interest rate to a borrower whose business occupies the 
property. The loan was based on a 20-year amortization period with a 
balloon payment due in three years. The LTV equaled 70 percent at 
origination. A year ago, the lender financed a $5 million operating 
line of credit for seasonal business operations at market terms. The 
operating line of credit had a one-year maturity with monthly 
interest payments and was secured with a blanket lien on all 
business assets. Borrowings under the operating line of credit are 
based on accounts receivable that are reported monthly in borrowing 
base reports, with a 75 percent advance rate against eligible 
accounts receivable that are aged less than 90 days old. Collections 
of accounts receivable are used to pay down the operating line of 
credit. At maturity of the operating line of credit, the borrower's 
accounts receivable aging report reflected a growing trend of 
delinquency, causing the borrower temporary cash flow difficulties. 
The borrower has recently initiated more aggressive collection 
efforts.
    Scenario 1: The lender renewed the $5 million operating line of 
credit for another year, requiring monthly interest payments at a 
market interest rate, and principal to be paid down by accounts 
receivable collections. The borrower's liquidity position has 
tightened but remains satisfactory, cash flow available to service 
all debt is 1.20x, and both loans have been paid according to the 
contractual terms. The primary repayment source for the operating 
line of credit is conversion of accounts receivable to cash. 
Although payments have slowed for some customers, most customers are 
paying within 90 days of invoice. The primary repayment source for 
the real estate loan is from business operations, which remain

[[Page 56673]]

satisfactory, and an updated appraisal is not considered necessary.
    Classification: The lender internally graded both loans as pass 
and is monitoring the credits. The examiner agreed with the lender's 
analysis and the internal grades. The lender is monitoring the trend 
in the accounts receivable aging report and the borrower's ongoing 
collection efforts.
    Nonaccrual Treatment: The lender determined that both the real 
estate loan and the renewed operating line of credit may remain on 
accrual status as the borrower has demonstrated an ongoing ability 
to perform, has the financial capacity to pay a market interest 
rate, and full repayment of principal and interest is reasonably 
assured. The examiner concurred with the lender's accrual treatment.
    TDR Treatment: The lender concluded that while the borrower has 
been affected by declining economic conditions, the renewal of the 
operating line of credit did not result in a TDR because the 
borrower is not experiencing financial difficulties and has the 
ability to repay both loans (which represent most of its outstanding 
obligations) at a market interest rate. The lender expects full 
collection of principal and interest from the collection of accounts 
receivable and the borrower's operating income. The examiner 
concurred with the lender's rationale that the loan renewal is not a 
TDR.
    Scenario 2: The lender restructured the operating line of credit 
by reducing the line amount to $4 million, at a below market 
interest rate. This action is expected to alleviate the borrower's 
cash flow problem. The borrower is still considered to be a viable 
business even though its financial performance has continued to 
deteriorate, with sales and profitability declining. The trend in 
accounts receivable delinquencies is worsening, resulting in reduced 
liquidity for the borrower. Cash flow problems have resulted in 
sporadic over advances on the $4 million operating line of credit, 
where the loan balance exceeds eligible collateral in the borrowing 
base. The borrower's net operating income has declined but reflects 
the capacity to generate a 1.08x DSC ratio for both loans, based on 
the reduced rate of interest for the operating line of credit. The 
terms on the real estate loan remained unchanged. The lender 
estimated the LTV on the real estate loan to be 90 percent. The 
operating line of credit currently has sufficient eligible 
collateral to cover the outstanding line balance, but customer 
delinquencies have been increasing.
    Classification: The lender internally classified both loans 
substandard due to deterioration in the borrower's business 
operations and insufficient cash flow to repay the debt at market 
terms. The examiner agreed with the lender's analysis and the 
internal grades. The lender will monitor the trend in the business 
operations, accounts receivable, profitability, and cash flow. The 
lender may need to order a new appraisal if the DSC ratio continues 
to fall and the overall collateral margin further declines.
    Nonaccrual Treatment: The lender reported both the restructured 
operating line of credit and the real estate loan on a nonaccrual 
basis. The operating line of credit was not renewed on market 
interest rate repayment terms, the borrower has an increasingly 
limited capacity to service the below market interest rate debt, and 
there is insufficient support to demonstrate an ability to meet the 
new payment requirements. The borrower's ability to continue to 
perform on the operating line of credit and real estate loan is not 
assured due to deteriorating business performance caused by lower 
sales and profitability and higher customer delinquencies. In 
addition, the collateral margin indicates that full repayment of all 
of the borrower's indebtedness is questionable, particularly if the 
borrower fails to continue being a going concern. The examiner 
concurred with the lender's nonaccrual treatment.
    TDR Treatment: The lender reported the restructured operating 
line of credit as a TDR because the borrower is experiencing 
financial difficulties (as evidenced by the borrower's sporadic over 
advances, an increasing trend in accounts receivable delinquencies, 
and uncertain ability to repay the loans) and the lender granted a 
concession on the line of credit through a below market interest 
rate. The lender concluded that the real estate loan should not be 
reported as TDR since that loan is performing and had not been 
restructured. The examiner concurred with the lender's TDR 
treatments.

H. Land Loan

    Base Case: Three years ago, the lender originated a $3.25 
million loan to a borrower for the purchase of raw land that the 
borrower was seeking to have zoned for residential use. The loan 
terms were three years interest-only at a market interest rate; the 
borrower had sufficient funds to pay interest from cash flow. The 
appraisal at origination assigned an ``as is'' market value of $5 
million, which resulted in a 65 percent LTV. The zoning process took 
longer than anticipated, and the borrower did not obtain full 
approvals until close to the maturity date. Now that the borrower 
successfully obtained the residential zoning, the borrower has been 
seeking construction financing to repay the land loan. At maturity, 
the borrower requested a 12-month extension to provide additional 
time to secure construction financing which would include repayment 
of the subject loan.
    Scenario 1: The borrower provided the lender with current 
financial information, demonstrating the continued ability to make 
monthly interest payments and principal curtailments of $150,000 per 
quarter. Further, the borrower made a principal payment of $250,000 
in exchange for a 12-month extension of the loan. The borrower also 
owned an office building with an ``as stabilized'' market value of 
$1 million and pledged the property as additional unencumbered 
collateral, granting the lender a first lien. The borrower's 
personal financial information also demonstrates that cash flow from 
personal assets and the rental income generated by the newly pledged 
office building are sufficient to fully amortize the land loan over 
a reasonable period. A decline in market value since origination was 
due to a change in density; the project was originally intended as 
60 lots but was subsequently zoned as 25 single-family lots because 
of a change in the county's approval process. A recent appraisal of 
the raw land reflects an ``as is'' market value of $3 million, which 
results in a 75 percent LTV when combined with the additional 
collateral and after the principal reduction. The lender 
restructured the loan into a $3 million loan with quarterly 
curtailments for another year at a market interest rate that 
provides for the incremental risk.
    Classification: The lender internally graded the loan as pass 
due to adequate cash flow from the borrower's personal assets and 
rental income generated by the office building to make principal and 
interest payments. Also, the borrower provided a principal 
curtailment and additional collateral to maintain a reasonable LTV. 
The examiner agreed with the lender's internal grade.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status, as the borrower has sufficient funds to cover the debt 
service requirements for the next year. Full repayment of principal 
and interest is reasonably assured from the collateral and the 
borrower's financial resources. The examiner concurred with the 
lender's accrual treatment.
    TDR Treatment: The lender concluded that the borrower was not 
experiencing financial difficulties because the borrower has the 
ability to service the renewed loan, which was prudently 
underwritten and has a market interest rate. The examiner concurred 
with the lender's rationale that the renewed loan is not a TDR.
    Scenario 2: The borrower provided the lender with current 
financial information that indicated the borrower is unable to 
continue to make interest-only payments. The borrower has been 
sporadically delinquent up to 60 days on payments. The borrower is 
still seeking a loan to finance construction of the project, and has 
not been able to obtain a takeout commitment; it is unlikely the 
borrower will be able to obtain financing, since the borrower does 
not have the equity contribution most lenders require as a condition 
of closing a construction loan. A decline in value since origination 
was due to a change in local zoning density; the project was 
originally intended as 60 lots but was subsequently zoned as 25 
single-family lots. A recent appraisal of the property reflects an 
``as is'' market value of $3 million, which results in a 108 percent 
LTV. The lender extended the $3.25 million loan at a market interest 
rate for one year with principal and interest due at maturity.
    Classification: The lender internally graded the loan as pass 
because the loan is currently not past due and is at a market 
interest rate. Also, the borrower is trying to obtain takeout 
construction financing. The examiner disagreed with the internal 
grade and adversely classified the loan, as discussed below. The 
examiner concluded that the loan was not restructured on reasonable 
repayment terms because the borrower does not have the capacity to 
service the debt and full repayment of principal and interest is not 
assured. The examiner classified $550,000 loss ($3.25 million loan 
balance less $2.7

[[Page 56674]]

million, based on the current appraisal of $3 million less estimated 
cost to sell of 10 percent or $300,000). The examiner classified the 
remaining $2.7 million balance substandard. This classification 
treatment recognizes the credit risk in this collateral dependent 
loan based on the property's market value less costs to sell.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The examiner did not concur with this treatment and 
instructed the lender to place the loan in nonaccrual status because 
the borrower does not have the capacity to service the debt, value 
of the collateral is permanently impaired, and full repayment of 
principal and interest is not assured.
    TDR Treatment: The lender reported the restructured loan as a 
TDR. The borrower is experiencing financial difficulties as 
indicated by the inability to refinance this debt, the inability to 
repay the loan at maturity in a manner consistent with the original 
exit strategy, and the inability to make interest-only payments 
going forward. A concession was provided by renewing the loan with a 
deferral of principal and interest payments for an additional year 
when the borrower was unable to obtain takeout financing. The 
examiner concurred with the lender's TDR designation.

I. Multi-Family Property

    Base Case: The lender originated a $6.4 million loan for the 
purchase of a 25-unit apartment building. The loan maturity is five 
years, and principal and interest payments are based on a 30-year 
amortization at a market interest rate. The LTV was 75 percent 
(based on an $8.5 million value), and the DSC ratio was 1.50x at 
origination (based on a 30-year principal and interest 
amortization).
    Leases are typically 12-month terms with an additional 12-month 
renewal option. The property is 88 percent leased (22 of 25 units 
rented). Due to poor economic conditions, delinquencies have risen 
from two units to eight units, as tenants have struggled to make 
ends meet. Six of the eight units are 90 days past due, and these 
tenants are facing eviction.
    Scenario 1: At maturity, the lender renewed the $5.9 million 
loan balance on principal and interest payments for 12 months at a 
market interest rate that provides for the incremental risk. The 
borrower had not been delinquent on prior payments. Current 
financial information indicates that the DSC ratio dropped to 0.80x 
because of the rent payment delinquencies. Combining borrower and 
guarantor liquidity shows they can cover cash flow shortfall until 
maturity (including reasonable capital expenditures since the 
building was recently renovated). Borrower projections show a return 
to break-even within six months since the borrower plans to decrease 
rents to be more competitive and attract new tenants. The lender 
estimates that the property's current ``as stabilized'' market value 
is $7 million, resulting in an 84 percent LTV. A new appraisal has 
not been ordered; however, the lender noted in the file that, if the 
borrower does not meet current projections within six months of 
booking the renewed loan, the lender will obtain a new appraisal.
    Classification: The lender internally graded the renewed loan as 
pass and is monitoring the credit. The examiner disagreed with the 
lender's analysis and classified the loan as substandard. While the 
borrower and guarantor can cover the debt service shortfall in the 
near-term using additional guarantor liquidity, the duration of the 
support may be less than the lender anticipates if the leasing fails 
to materialize as projected. Economic conditions are poor, and the 
rent reduction may not be enough to improve the property's 
performance. Lastly, the lender failed to obtain an updated 
collateral valuation, which represents an administrative weakness.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
status. The borrower has demonstrated the ability to make the 
regularly scheduled payments and, even with the decline in the 
borrower's creditworthiness, the borrower and guarantor appear to 
have sufficient cash resources to make these payments if projections 
are met, and full repayment of principal and interest is expected. 
The examiner concurred with the lender's accrual treatment.
    TDR Treatment: While the borrower is experiencing some financial 
deterioration, the borrower is not experiencing financial 
difficulties as the borrower and guarantor have sufficient means to 
service the debt, and there was no history of default. The lender 
expects full collection of principal and interest from the 
borrower's operating income if they meet projections. The examiner 
concurred with the lender's rationale and TDR treatment.
    Scenario 2: At maturity, the lender renewed the $5.9 million 
loan balance on a 12-month interest-only basis at a below market 
interest rate. In response to an event that caused severe economic 
conditions, the federal and state governments enacted moratoriums on 
all rent payments. The borrower has been paying as agreed; however, 
cash flow has been severely impacted by the rent moratoriums. While 
the moratoriums do not forgive the rent (or unpaid fees), they do 
prevent evictions for unpaid rent and have been in effect for the 
past six months. As a result, the borrower's cash flow is severely 
stressed, and the borrower has asked for temporary relief of the 
interest payments. In addition, a review of the current rent roll 
indicates that five of the 25 units are now vacant. A recent 
appraisal values the property at $6 million (98 percent LTV). 
Updated borrower and guarantor financial statements indicate the 
continued ability to cover interest-only payments for the next 12 to 
18 months at the reduced rate of interest. Updated projections that 
indicate below break-even performance over the next 12 months remain 
uncertain given that the end of the moratorium (previously extended) 
is a ``soft'' date and that tenant behaviors may not follow 
historical norms.
    Classification: The lender internally classified the loan as 
substandard and is monitoring the credit. The examiner agreed with 
the lender's treatment due to the borrower's diminished ability to 
make interest payments (even at the reduced rate) and lack of 
principal reduction, the uncertainty surrounding the rent 
moratoriums, and the reduced and tight collateral position.
    Nonaccrual Treatment: The lender maintained the loan on an 
accrual basis because the borrower demonstrated an ability to make 
principal and interest payments and has some capacity to make 
payments on the interest-only terms at a below market interest rate. 
The examiner did not concur with this treatment as the loan was not 
restructured on reasonable repayment terms, the borrower has 
insufficient cash flow to amortize the debt, and the slim collateral 
margin indicates that full repayment of principal and interest may 
be in doubt. After a discussion with the examiner on regulatory 
reporting requirements, the lender placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the borrower is experiencing financial difficulties as 
evidenced by the reported reduced, stressed cash flow that prompted 
the borrower's request for payment relief in the restructure. The 
lender granted a concession (interest-only at a below market 
interest rate) in response. The examiner concurred with the lender's 
TDR treatment.
    Scenario 3: At maturity, the lender renewed the $5.9 million 
loan balance on a 12-month interest-only basis at a below market 
interest rate. The borrower has been sporadically delinquent on 
prior principal and interest payments. A review of the current rent 
roll indicates that 10 of the 25 units are vacant after tenant 
evictions. The vacated units were previously in an advanced state of 
disrepair, and the borrower and guarantors have exhausted their 
liquidity after repairing the units. The repaired units are expected 
to be rented at a lower rental rate. A post-renovation appraisal 
values the property at $5.5 million (107 percent LTV). Updated 
projections indicate the borrower will be below break-even 
performance for the next 12 months.
    Classification: The lender internally classified the loan as 
substandard and is monitoring the credit. The examiner agreed with 
the lender's concerns due to the borrower's diminished ability to 
make principal or interest payments, the guarantor's limited ability 
to support the loan, and insufficient collateral protection. 
However, the examiner classified $900,000 loss ($5.9 million loan 
balance less $5 million (based on the current appraisal of $5.5 
million less estimated cost to sell of 10 percent, or $500,000)). 
The examiner classified the remaining $5 million balance 
substandard. This classification treatment recognizes the collateral 
dependency.
    Nonaccrual Treatment: The lender maintained the loan on accrual 
basis because the borrower demonstrated a previous ability to make 
principal and interest payments. The examiner did not concur with 
the lender's treatment as the loan was not restructured on 
reasonable repayment terms, the borrower has insufficient cash flow 
to service the debt at a below market interest rate on an interest-
only basis, and the impairment of value indicates that full 
repayment of principal and interest is in doubt. After a discussion 
with the examiner on regulatory reporting requirements, the lender 
placed the loan on nonaccrual.
    TDR Treatment: The lender reported the restructured loan as a 
TDR because the

[[Page 56675]]

borrower is experiencing financial difficulties as evidenced by 
sporadic delinquencies, fully dissipated liquidity, and reduced 
collateral protection. The lender granted a concession with the 
interest-only terms at a below market interest rate. The examiner 
concurred with the lender's TDR treatment.

Appendix 2

Selected Rules, Supervisory Guidance, and Authoritative Accounting 
Guidance

Rules

 Board regulations on real estate lending standards and the 
Interagency Guidelines for Real Estate Lending Policies: 12 CFR part 
208, subpart E and appendix C.
 Board regulations on the Interagency Guidelines 
Establishing Standards for Safety and Soundness: 12 CFR part 208 
appendix D-1.
 Board appraisal regulations: 12 CFR part 208, subpart E and 
12 CFR part 225.

Supervisory Guidance

 FFIEC Instructions for Preparation of Consolidated Reports 
of Condition and Income (FFIEC 031, FFIEC 041, and FFIEC 051 
Instructions).
 Interagency Policy Statement on Allowances for Credit 
Losses, issued May 2020, as applicable.
 Interagency Guidance on Credit Risk Review Systems, issued 
May 2020.
 Interagency Supervisory Examiner Guidance for Institutions 
Affected by a Major Disaster, issued December 2017.
 Board, FDIC, and OCC joint guidance entitled Statement on 
Prudent Risk Management for Commercial Real Estate Lending, issued 
December 2015.
 Interagency Supervisory Guidance Addressing Certain Issues 
Related to Troubled Debt Restructurings, issued October 2013.
 Interagency Appraisal and Evaluation Guidelines, issued 
October 2010.
 Board, FDIC, and OCC joint guidance on Concentrations in 
Commercial Real Estate Lending, Sound Risk Management Practices, 
issued December 2006.
 Interagency Policy Statement on the Allowance for Loan and 
Lease Losses, issued December 2006, as applicable.
 Interagency FAQs on Residential Tract Development Lending, 
issued September 2005.
 Interagency Policy Statement on Allowance for Loan and 
Lease Losses Methodologies and Documentation for Banks and Savings 
Institutions, issued July 2001, as applicable.

Authoritative Accounting Standards 29
---------------------------------------------------------------------------

    \29\ ASC Topic 326, Financial Instruments--Credit Losses, when 
adopted by a financial institution, replaces the incurred loss 
methodology included in ASC Subtopic 310-10, Receivables--Overall 
and ASC Subtopic 450-20, Contingencies--Loss Contingencies, for 
financial assets measured at amortized cost, net investments in 
leases, and certain off balance-sheet credit exposures.'' ASC Topic 
326 also, when adopted by a financial institution, supersedes ASC 
Subtopic 310-40 Troubled Debt Restructurings by Creditors.
---------------------------------------------------------------------------

 ASC Topic 310, Receivables
 ASC Subtopic 310-40, Receivables--Troubled Debt 
Restructurings by Creditors
 ASC Topic 326, Financial Instruments--Credit losses
 ASC Subtopic 450-20, Contingencies--Loss Contingencies
 ASC Topic 820, Fair Value Measurement
 ASC Subtopic 825-10, Financial Instruments--Overall

Appendix 3

Valuation Concepts for Income Producing Real Estate

    Several conceptual issues arise during the process of reviewing 
a real estate loan and in using the net present value approach of 
collateral valuation. The following discussion sets forth the 
meaning and use of those key concepts.
    The Discount Rate and the Net Present Value Approach: The 
discount rate used in the net present value approach to convert 
future net cash flows of income-producing real estate into present 
market value terms is the rate of return that market participants 
require for the specific type of real estate investment. The 
discount rate will vary over time with changes in overall interest 
rates and in the risk associated with the physical and financial 
characteristics of the property. The riskiness of the property 
depends both on the type of real estate in question and on local 
market conditions.
    The Direct Capitalization (``Cap'' Rate) Technique: Many market 
participants and analysts use the ``cap'' rate technique to relate 
the value of a property to the net operating income it generates. In 
many applications, a ``cap'' rate is used as a short cut for 
computing the discounted value of a property's income streams.
    The direct income capitalization method calculates the value of 
a property by dividing an estimate of its ``stabilized'' annual 
income by a factor called a ``cap'' rate. Stabilized annual income 
generally is defined as the yearly net operating income produced by 
the property at normal occupancy and rental rates; it may be 
adjusted upward or downward from today's actual market conditions. 
The ``cap'' rate, usually defined for each property type in a market 
area, is viewed by some analysts as the required rate of return 
stated in terms of current income. The ``cap'' rate can be 
considered a direct observation of the required earnings-to-price 
ratio in current income terms. The ``cap'' rate also can be viewed 
as the number of cents per dollar of today's purchase price 
investors would require annually over the life of the property to 
achieve their required rate of return.
    The ``cap'' rate method is an appropriate valuation technique if 
the net operating income to which it is applied is representative of 
all future income streams or if net operating income and the 
property's selling price are expected to increase at a fixed rate. 
The use of this technique assumes that either the stabilized annual 
income or the ``cap'' rate used accurately captures all relevant 
characteristics of the property relating to its risk and income 
potential. If the same risk factors, required rate of return, 
financing arrangements, and income projections are used, the net 
present value approach and the direct capitalization technique will 
yield the same results.
    The direct capitalization technique is not an appropriate 
valuation technique for troubled real estate since income generated 
by the property is not at normal or stabilized levels. In evaluating 
troubled real estate, ordinary discounting typically is used for the 
period before the project reaches its full income potential. A 
``terminal cap rate'' is then utilized to estimate the value of the 
property (its reversion or sales price) at the end of that period.
    Differences Between Discount and Cap Rates: When used for 
estimating real estate market values, discount and ``cap'' rates 
should reflect the current market requirements for rates of return 
on properties of a given type. The discount rate is the required 
rate of return including the expected increases in future prices and 
is applied to income streams reflecting inflation. In contrast, the 
``cap'' rate is used in conjunction with a stabilized net operating 
income figure. The fact that discount rates for real estate are 
typically higher than ``cap'' rates reflects the principal 
difference in the treatment of expected increases in net operating 
income and/or property values.
    Other factors affecting the ``cap'' rate (but not the discount 
rate) include the useful life of the property and financing 
arrangements. The useful life of the property being evaluated 
affects the magnitude of the ``cap'' rate because the income 
generated by a property, in addition to providing the required 
return on investment, has to be sufficient to compensate the 
investor for the depreciation of the property over its useful life. 
The longer the useful life, the smaller is the depreciation in any 
one year, hence, the smaller is the annual income required by the 
investor, and the lower is the ``cap'' rate. Differences in terms 
and the extent of debt financing and the related costs are also 
taken into account.
    Selecting Discount and Cap Rates: The choice of the appropriate 
values for discount and ``cap'' rates is a key aspect of income 
analysis. In markets marked by both a lack of transactions and 
highly speculative or unusually pessimistic attitudes, analysts 
consider historical required returns on the type of property in 
question. Where market information is available to determine current 
required yields, analysts carefully analyze sales prices for 
differences in financing, special rental arrangements, tenant 
improvements, property location, and building characteristics. In 
most local markets, the estimates of discount and ``cap'' rates used 
in an income analysis generally should fall within a fairly narrow 
range for comparable properties.
    Holding Period Versus Marketing Period: When the net present 
value approach is applied to troubled properties, the chosen time 
frame should reflect the period over which a property is expected to 
achieve stabilized occupancy and rental rates (stabilized income). 
That time period is sometimes referred to as the ``holding period.'' 
The longer the period is before stabilization, the smaller the 
reversion value will be within the total value estimate. The 
marketing period is the length of time that

[[Page 56676]]

may be required to sell the property in an open market.

Appendix 4

Special Mention and Adverse Classification Definitions 30
---------------------------------------------------------------------------

    \30\ The Board's loan classification definitions of Substandard, 
Doubtful, and Loss may be found in the Uniform Agreement on the 
Classification and Appraisal of Securities Held by Depository 
Institutions Attachment 1--Classification Definitions (SR Letter 13-
18). The Board's definition of Special Mention may be found in the 
Interagency Statement on the Supervisory Definition of Special 
Mention Assets (June 10, 1993).
---------------------------------------------------------------------------

    The Board uses the following definitions for assets adversely 
classified for supervisory purposes as well as those assets listed 
as special mention:

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.

Adverse Classifications

    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 effected in the future.

Appendix 5

Accounting--Current Expected Credit Losses Methodology (CECL)

    This appendix addresses the relevant accounting and regulatory 
guidance for financial institutions that have adopted Accounting 
Standards Update (ASU) 2016-13, Financial Instruments--Credit Losses 
(Topic 326): Measurement of Credit Losses on Financial Instruments 
and its subsequent amendments (collectively, ASC Topic 326) in 
determining the allowance for credit losses (ACL). Additional 
guidance for the financial institution's estimate of the ACL and for 
examiners' responsibilities to evaluate these estimates is presented 
in the Interagency Policy Statement on Allowances for Credit Losses 
(June 2020). Additional information related to identifying and 
disclosing modifications for regulatory reporting under ASC Topic 
326 is located in the FFIEC Call Report.
    Expected credit losses on loans under ASC Topic 326 are 
estimated under the same CECL methodology as all other loans in the 
portfolio. Loans, including loans modified in a restructuring, 
should be evaluated on a collective basis unless they do not share 
similar risk characteristics with other loans. Changes in credit 
risk, borrower circumstances, recognition of charge-offs, or cash 
collections that have been fully applied to principal, often require 
reevaluation to determine if the modified loan should be included in 
a different pool of assets with similar risks for measuring expected 
credit losses.
    Although ASC Topic 326 allows a financial institution to use any 
appropriate loss estimation method to estimate the ACL, there are 
some circumstances when specific measurement methods are required. 
If a financial asset is collateral dependent,\31\ the ACL is 
estimated using the fair value of the collateral. For a collateral-
dependent loan, regulatory reporting requires that if the amortized 
cost of the loan exceeds the fair value \32\ of the collateral (less 
costs to sell if the costs are expected to reduce the cash flows 
available to repay or otherwise satisfy the loan, as applicable), 
this excess is included in the amount of expected credit losses when 
estimating the ACL. However, some or all of this difference may 
represent a Loss for classification purposes that should be charged 
off against the ACL in a timely manner.
---------------------------------------------------------------------------

    \31\ The repayment of a collateral-dependent loan is expected to 
be provided substantially through the operation or sale of the 
collateral when the borrower is experiencing financial difficulty 
based on the entity's assessment as of the reporting date. Refer to 
the glossary entry in the Call Report instructions for ``Allowance 
for Credit Losses--Collateral-Dependent Financial Assets.''
    \32\ The fair value of collateral should be measured in 
accordance with FASB ASC Topic 820, Fair Value Measurement. For 
impairment analysis purposes, the fair value of collateral should 
reflect the current condition of the property, not the potential 
value of the collateral at some future date.
---------------------------------------------------------------------------

    Financial institutions also should consider the need to 
recognize an allowance for expected credit losses on off-balance 
sheet credit exposures, such as loan commitments, in other 
liabilities consistent with ASC Topic 326.

Appendix 6

Accounting--Incurred Loss Methodology

    This Appendix addresses the relevant accounting and regulatory 
guidance for financial institutions using the incurred loss 
methodology to estimate the allowance for loan and lease losses 
under ASC Subtopics 310-10, Receivables--Overall and 450-20, 
Contingencies--Loss Contingencies and have not adopted Accounting 
Standards Update (ASU) 2016-13, Financial Instruments--Credit Losses 
(Topic 326).

Restructured Loans

    The restructuring of a loan or other debt instrument should be 
undertaken in ways that improve the likelihood that the maximum 
credit repayment will be achieved under the modified terms in 
accordance with a reasonable repayment schedule. A financial 
institution should evaluate each restructured loan to determine 
whether the loan should be reported as a TDR. For reporting 
purposes, a restructured loan is considered a TDR when the financial 
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 financial institution would 
not otherwise consider. To make this determination, the financial 
institution assesses whether (a) the borrower is experiencing 
financial difficulties and (b) the financial institution has granted 
a concession.\33\
---------------------------------------------------------------------------

    \33\ Refer to ASC Subtopic 310-40, Receivables--Troubled Debt 
Restructurings by Creditors. Refer also to the FFIEC Call Report.
---------------------------------------------------------------------------

    The determination of whether a restructured loan is a TDR 
requires consideration of all relevant 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, financial 
institutions and examiners should use judgment in evaluating whether 
a modification is a TDR.

Allowance for Loan and Lease Losses (ALLL)

    Guidance for the financial 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).
    Financial 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 considered 
impaired and are typically evaluated on an individual loan basis in 
accordance with ASC Subtopics 310-40, and 310-10. Generally, if an 
individually assessed loan \34\ is impaired, but is not collateral 
dependent, management allocates in the ALLL for the amount of the 
recorded investment in the loan that exceeds the present value of 
expected future cash flows, discounted at the original loan's 
effective interest rate.
---------------------------------------------------------------------------

    \34\ The recorded investment in the loan for accounting purposes 
may differ from the loan balance as described elsewhere in this 
statement. The recorded investment in the loan for accounting 
purposes is the loan balance adjusted for any unamortized premium or 
discount and unamortized loan fees or costs, less any amount 
previously charged off, plus recorded accrued interest.

---------------------------------------------------------------------------

[[Page 56677]]

    For an individually evaluated impaired collateral dependent 
loan,\35\ regulatory reporting requires the amount of the recorded 
investment in the loan that exceeds the fair value of the collateral 
\36\ (less costs to sell) \37\ if the costs are expected to reduce 
the cash flows available to repay or otherwise satisfy the loan, as 
applicable), to be charged off to the ALLL in a timely manner.
---------------------------------------------------------------------------

    \35\ Under ASC Subtopic 310-10, a loan is collateral dependent 
when the loan for which repayment is expected to be provided solely 
by the underlying collateral. Refer to the glossary entry in the 
Call Report instructions for ``Allowance for Credit Losses--
Collateral-Dependent Financial Assets.''
    \36\ The fair value of collateral should be measured in 
accordance with FASB ASC Topic 820, Fair Value Measurement. For 
impairment analysis purposes, the fair value of collateral should 
reflect the current condition of the property, not the potential 
value of the collateral at some future date.
    \37\ See footnote 24.
---------------------------------------------------------------------------

    Financial 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 ASC Subtopic 825-10, Financial 
Instruments--Overall. For additional information, refer to the FFIEC 
Call Report instructions pertaining to regulatory reporting.
    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 recorded 
investment in the loan. However, declines in collateral values 
should be considered when applying qualitative factors to calculate 
loss rates for affected groups of loans when estimating loan losses 
under ASC Subtopic 450-20.

    By order of the Board of Governors of the Federal Reserve 
System.
Ann E. Misback,
Secretary of the Board.
[FR Doc. 2022-19940 Filed 9-14-22; 8:45 am]
BILLING CODE 6210-01-P