[Federal Register Volume 88, Number 128 (Thursday, July 6, 2023)]
[Notices]
[Pages 43115-43134]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2023-14247]
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DEPARTMENT OF TREASURY
Office of the Comptroller of the Currency
[Docket ID OCC-2022-0017]
FEDERAL RESERVE SYSTEM
[Docket ID OP-1779]
FEDERAL DEPOSIT INSURANCE CORPORATION
RIN 3064-ZA33
NATIONAL CREDIT UNION ADMINISTRATION
[Docket No. 2022-0123]
Policy Statement on Prudent Commercial Real Estate Loan
Accommodations and Workouts
AGENCY: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation; and National Credit Union Administration.
ACTION: Final policy statement.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of
Governors of the Federal Reserve System (Board), Federal Deposit
Insurance Corporation (FDIC), and National Credit Union Administration
(NCUA) (the agencies), in consultation with state bank and credit union
regulators, are issuing a final policy statement for prudent commercial
real estate loan accommodations and workouts. The statement is relevant
to all financial institutions supervised by the agencies. This updated
policy statement builds on existing supervisory guidance calling for
financial institutions to work prudently and constructively with
creditworthy borrowers during times of financial stress, updates
existing interagency supervisory guidance on commercial real estate
loan workouts, and adds a section on short-term loan accommodations.
The updated statement also addresses relevant accounting standard
changes on estimating loan losses and provides updated examples of
classifying and accounting for loans modified or affected by loan
accommodations or loan workout activity.
DATES: The final policy statement is available on July 6, 2023.
FOR FURTHER INFORMATION CONTACT:
OCC: Beth Nalyvayko, Credit Risk Specialist, Bank Supervision
Policy, (202) 649-6670; or Kevin Korzeniewski, Counsel, Chief Counsel's
Office, (202) 649-5490. If you are deaf, hard of hearing, or have a
speech disability, please dial 7-1-1 to access telecommunications relay
services.
Board: Juan Climent, Assistant Director, (202) 872-7526; Carmen
Holly, Lead Financial Institution Policy Analyst, (202) 973-6122; Ryan
Engler, Senior Financial Institution Policy Analyst, (202) 452-2050;
Kevin Chiu, Senior Accounting Policy Analyst, (202) 912-4608, Division
of Supervision and Regulation; Jay Schwarz, Assistant General Counsel,
(202) 452-2970; or 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.
FDIC: Thomas F. Lyons, Associate Director, Risk Management Policy,
[email protected], (202) 898-6850; Peter A. Martino, Senior Examination
Specialist, Risk Management Policy, [email protected], (813) 973-7046
x8113, Division of Risk Management Supervision; Gregory Feder, Counsel,
[email protected], (202) 898-8724; or Kate Marks, Counsel,
[email protected], (202) 898-3896, Supervision and Legislation Branch,
Legal Division, Federal Deposit Insurance Corporation, 550 17th Street
NW, Washington, DC 20429.
NCUA: Naghi H. Khaled, Director of Credit Markets, and Simon
Hermann, Senior Credit Specialist, Office of Examination and Insurance,
(703) 518-6360; Ian Marenna, Associate General Counsel, Marvin Shaw and
Ariel Pereira, Senior Staff Attorneys, Office of General Counsel, (703)
518-6540; or by mail at National Credit Union Administration, 1775 Duke
Street, Alexandria, VA 22314.
SUPPLEMENTARY INFORMATION:
I. Background
On October 30, 2009, the agencies, along with the 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 (2009 Statement).\1\
The agencies view the 2009 Statement as being useful for the agencies'
staff and financial institutions in understanding risk management and
accounting practices for commercial real estate (CRE) loan workouts.
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\1\ See FFIEC Press Release, October 30, 2009, available at:
https://www.ffiec.gov/press/pr103009.htm.
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To incorporate recent policy and accounting changes, the agencies
recently proposed updates and expanded the 2009 Statement and sought
comment on the resulting proposed Policy Statement on Prudent
Commercial Real Estate Loan Accommodations and Workouts (proposed
Statement).\2\ The agencies considered all comments received and are
issuing this final Statement largely as proposed, with certain
clarifying changes based on comments received. The final Statement is
described in Section II of the Supplementary Information.
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\2\ See OCC, FDIC, NCUA, Policy Statement on Prudent Commercial
Real Estate Loan Accommodations and Workouts, 87 FR 47273 (Aug. 2,
2022); Board Policy Statement on Prudent Commercial Real Estate Loan
Accommodations and Workouts, 87 FR 56658 (Sept. 15, 2022). While
published at different times, the proposed policy statements are
substantively the same and are referenced as a single statement in
this notice.
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The agencies received 22 unique comments from banking organizations
and credit unions, state and national trade associations, and
individuals. A summary and discussion of comments and changes
incorporated in the final Statement are described in Section III of the
Supplementary Information.
The Paperwork Reduction Act is addressed in Section IV of the
Supplementary Information. Section V of the Supplementary Information
presents the final Statement which is available as of July 6, 2023.
This final Statement supersedes the 2009 Statement for all supervised
financial institutions.
[[Page 43116]]
II. Overview of the Final Statement
The risk management principles outlined in the final Statement
remain generally consistent with the 2009 Statement. As in the proposed
Statement, the final Statement discusses the importance of financial
institutions \3\ working constructively with CRE borrowers who are
experiencing financial difficulty and is consistent with U.S. generally
accepted accounting principles (GAAP).\4\ The final Statement addresses
supervisory expectations with respect to a financial institution's
handling of loan accommodation and workout matters including (1) risk
management, (2) loan classification, (3) regulatory reporting, and (4)
accounting considerations. Additionally, the final Statement includes
updated references to supervisory guidance \5\ and revised language to
incorporate current industry terminology.
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\3\ For purposes of this final Statement, financial institutions
are those supervised by the Board, FDIC, NCUA, or OCC.
\4\ Federally insured credit unions with less than $10 million
in assets are not required to comply with GAAP, unless the credit
union is state-chartered and GAAP compliance is mandated by state
law (86 FR 34924 (July 1, 2021)).
\5\ Supervisory guidance outlines the agencies' supervisory
practices or priorities and articulates the agencies' general views
regarding appropriate practices for a given subject area. The
agencies have each adopted regulations setting forth Statements
Clarifying the Role of Supervisory Guidance. See 12 CFR 4, subpart F
(OCC); 12 CFR 262, appendix A (Board); 12 CFR 302, appendix A
(FDIC); and 12 CFR 791, subpart D (NCUA).
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Consistent with safety and soundness standards, the final 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 with
weaknesses that result in adverse 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 outstanding loan balance.
The agencies' risk management expectations as outlined in the final
Statement remain generally consistent with the 2009 Statement, and
incorporate views on short-term loan accommodations,\6\ information
about changes in accounting principles since 2009, and revisions and
additions to the CRE loan workouts examples.
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\6\ See Joint Statement on Additional Loan Accommodations
Related to COVID-19: SR Letter 20-18 (Board), FIL-74-2020 (FDIC),
Bulletin 2020-72 (OCC), and Press Release August 3, 2020 (NCUA). See
also Interagency Statement on Loan Modifications and Reporting for
Financial Institutions Working with Customers Affected by the
Coronavirus (Revised): FIL-36-2020 (FDIC); Bulletin 2020-35 (OCC);
Letter to Credit Unions 20-CU-13 (NCUA) and Joint Press Release
April 7, 2020 (Board).
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A. Short-Term Loan Accommodations
The agencies recognize that it may be appropriate for financial
institutions to use short-term and less-complex loan accommodations
before a loan warrants a longer-term or more-complex workout
arrangement. Accordingly, the final Statement identifies short-term
loan accommodations as a tool that could be used to mitigate adverse
effects on borrowers and 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. The
final Statement incorporates principles consistent with existing
interagency supervisory guidance on accommodations.\7\
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\7\ Id.
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B. Accounting Changes
The final Statement also reflects changes in GAAP since 2009,
including those in relation to the current expected credit losses
(CECL) methodology.\8\ In particular, the Regulatory Reporting and
Accounting Considerations section of the Statement was modified to
include CECL references, and Appendix 5 of the final Statement
addresses the relevant accounting and supervisory guidance on
estimating loan losses for financial institutions that use the CECL
methodology.
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\8\ 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 allowances for credit losses
(ACLs) and introduces the CECL methodology.
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C. CRE Loan Workouts Examples
The final Statement includes updated information about industry
loan workout practices. In addition to revising the CRE loan workouts
examples from the 2009 Statement, the proposed Statement included three
new examples that were carried forward to the final Statement (Income
Producing Property--Hotel, Acquisition, Development and Construction--
Residential, and Multi-Family Property). All examples in the final
Statement are intended to illustrate the application of existing rules,
regulatory reporting instructions, and supervisory guidance on credit
classifications and the determination of nonaccrual status.
D. Other Items
The final Statement includes updates to the 2009 Statement's
Appendix 2, which contains a 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.
The final Statement retains information in Appendix 3 about
valuation concepts for income-producing real property from the 2009
Statement. Further, Appendix 4 provides the agencies' long-standing
special mention and classification definitions that are applied to the
examples in Appendix 1.
The final Statement is consistent with the Interagency Guidelines
Establishing Standards for Safety and Soundness issued by the Board,
FDIC, and OCC,\9\ which articulate safety and soundness standards for
financial institutions to establish and maintain prudent credit
underwriting practices and to establish and maintain systems to
identify distressed assets and manage deterioration in those
assets.\10\
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\9\ 12 CFR part 30, appendix A (OCC); 12 CFR part 208 Appendix
D-1 (Board); and 12 CFR part 364 appendix A (FDIC).
\10\ The NCUA issued the proposed Statement pursuant to its
regulation in 12 CFR part 723, governing member business loans and
commercial lending, 12 CFR 741.3(b)(2) on written lending policies
that cover loan workout arrangements and nonaccrual standards, and
appendix B to 12 CFR part 741 regarding loan workout arrangements
and nonaccrual policy. Additional supervisory guidance is available
in NCUA letter to credit unions 10-CU-02 ``Current Risks in Business
Lending and Sound Risk Management Practices,'' issued January 2010,
and in the Commercial and Member Business Loans section of the NCUA
Examiner's Guide.
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III. Summary and Discussion of Comments
A. Summary of Comments
The agencies received 22 unique comments from banking organizations
and credit unions, state and national trade associations, and
individuals.\11\
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\11\ The agencies also received comments on topics outside the
scope of the proposed Statement. Those comments are not addressed
herein.
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Many commenters supported the agencies' work to provide updated
supervisory guidance to the industry. Some commenters stated that the
proposed Statement was reasonable and reflected safe and sound business
practices. Further, several commenters stated that the short-term loan
accommodation section, accounting
[[Page 43117]]
changes, and additional examples of CRE loan workouts would be a good
reference source as lenders evaluate and determine a loan accommodation
and workout plan for CRE loans.
Comments also contained numerous observations, suggestions, and
recommendations on the proposed Statement, including asking for more
detail on certain aspects of the proposed Statement. A number of the
comments addressed similar topics including: requesting examiners base
any collateral value adjustments on empirical evidence; considering
local market conditions when evaluating the appropriateness of loan
workouts; clarifying the ``doubtful'' classification; addressing the
importance of global cash flow and considering a financial
institution's ability to support the calculation; \12\ clarifying the
frequency of obtaining updated financial and collateral information;
clarifying and defining terminology; and emphasizing the importance of
proactive engagement with borrowers. The following sections discuss in
more detail the comments received, the agencies' response, and the
changes reflected in the final Statement.
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\12\ Financial institutions use global cash flow to assess the
combined cash flow of a group of people and/or entities to get a
global picture of their ability to service their debt.
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B. Valuation Adjustments
Some commenters suggested that examiners should be required to
provide empirical data to support collateral valuation adjustments made
by examiners during loan reviews. The proposed Statement suggested such
adjustments be made when a financial institution was unable or
unwilling to address weaknesses in supporting loan documentation or
appraisal or evaluation processes. For further clarification, the
agencies affirmed that the role of examiners is to review and evaluate
the information provided by financial institution management to support
the financial institution's valuation and not to perform a separate,
independent valuation. Accordingly, the final Statement explains that
the examiner may adjust the estimated value of the collateral for
credit analysis and classification purposes when the examiner can
establish that underlying facts or assumptions presented by the
financial institution are irrelevant or inappropriate for the valuation
or can support alternative assumptions based on available information.
C. Market Conditions
The proposed Statement referenced the review of general market
conditions when evaluating the appropriateness of loan workouts.
Several commenters stated that examiners should focus primarily on
local and state market conditions, with less emphasis on regional and
national trends, when analyzing CRE loans and determining borrowers'
ability to repay. Considering local market conditions is consistent
with the existing real estate lending standards or requirements \13\
issued by the agencies, which state that a financial institution should
monitor real estate market conditions in its lending area. In response
to these comments, the final Statement clarifies that market conditions
include conditions at the state and local levels. Further, to better
align the final Statement with regulatory requirements, the agencies
included a footnote referencing real estate lending standards or
requirements related to monitoring market conditions.
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\13\ See 12 CFR 34.62(a) (OCC); 12 CFR 208.51(a) (Board); and 12
CFR 365.2(a) (FDIC) regarding real estate lending standards at
financial institutions. For NCUA requirements, refer to 12 CFR part
723 for commercial real estate lending and 12 CFR part 741, appendix
B, which addresses loan workouts, nonaccrual policy, and regulatory
reporting of workout loans.
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D. Classification
A commenter suggested wording changes in the discussion of a
``doubtful'' classification to clarify use of that term. The final
Statement clarifies that ``doubtful'' is a temporary designation and
subject to a financial institution's timely reassessment of the loan
once the outcomes of pending events have occurred or the amount of loss
can be reasonably determined.
E. Global Cash Flow
Some commenters agreed with the importance of a global cash flow
analysis as discussed in the proposed Statement. One commenter stated
that the global cash flow analysis discussion should be enhanced.
Another commenter noted that small institutions may not have
information necessary to determine the global cash flow.
The proposed Statement emphasized the importance of financial
institutions understanding CRE borrowers experiencing financial
difficulty. Furthermore, the proposed Statement recognized that
financial institutions that have sufficient information on a
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 ability to fulfill its obligation. Consistent with safety and
soundness regulations, the agencies emphasize the need for financial
institutions to understand the overall financial condition and
resources, including global cash flow, of CRE borrowers experiencing
financial difficulty.
The final Statement lists actions that a financial institution
should perform to not be criticized for engaging in loan workout
arrangements. One such action is analyzing the borrower's global debt
service coverage. The final Statement clarifies that the debt service
coverage analysis should include realistic projections of a borrower's
available cash flow and understanding of the continuity and
accessibility of repayment sources.
F. Frequency of Obtaining Updated Financial and Collateral Information
Commenters suggested clarifying supervisory expectations for the
frequency with which financial institutions should update financial and
collateral information for financially distressed borrowers. Consistent
with the agencies' approach to supervisory guidance, the final
Statement does not set bright lines; the appropriate frequency for
updating such information will vary on a case-by-case basis, depending
on the type of collateral and other considerations. Given that each
loan accommodation and workout is case-specific, financial institutions
are encouraged to use their best judgment when considering the guidance
principles in the final Statement and consider each loan's specific
circumstances when assessing the need for updated collateral
information and financial reporting from distressed borrowers.
G. Terminology
Some commenters requested that the agencies define certain terms
used in the supervisory guidance to illustrate the level of analysis
for reviewing CRE loans. Examples include when the term
``comprehensive'' described the extent of loan review activity and when
``reasonable'' described terms and conditions offered to borrowers in
restructurings or accommodations. Given that each loan accommodation
and workout is case-specific, the agencies are of the view that
providing more specific definitions of these terms could result in
overly prescriptive supervisory guidance. Accordingly, the final
Statement does not define these terms. Financial institutions are
encouraged to use their best judgment when considering the principles
contained in the final Statement and adapt to the circumstances when
dealing with problem loans or loan portfolios.
[[Page 43118]]
A few commenters requested changes or more specific supervisory
guidance on the definition of a short-term loan accommodation. The
agencies are of the view that the scope of coverage on accommodations,
as proposed, maintains flexibility for financial institutions. The
proposed Statement discussed characteristics that can constitute a
short-term accommodation and remained consistent with earlier
supervisory guidance issued on the topic. Further, the agencies agree
that the proposed Statement's discussion of short-term loan
accommodations and long-term loan workout arrangements in sections II
and IV, respectively, sufficiently differentiated short-term
accommodations and longer-term workouts as separate and distinct
options when working with financially distressed borrowers.
Accordingly, the agencies have not included revisions related to
guidance on short-term loan accommodations \14\ in the final Statement.
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\14\ For the purposes of the final 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.
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H. Proactive Engagement With Borrowers
One commenter stated that the agencies should incentivize proactive
engagement with borrowers. The agencies agree that proactive engagement
is useful and have clarified in the final Statement that proactive
engagement with the borrower often plays a key role in the success of a
workout.
I. Responses to Questions
In addition to a request for comment on all aspects of the proposed
Statement, the agencies asked for responses to five questions.
The first question asked, ``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 agencies add, modify, or remove any elements, and, if so,
which and why?'' Commenters noted that the Statement does reflect safe
and sound practices and did not request significant changes to those
elements of the Statement. Commenters generally agreed with the
supervisory guidance and the revisions proposed and stated that the
supervisory guidance is reasonable, clear, and useful in analyzing and
managing CRE borrowers.
The second question asked, ``What additional information, if any,
should be included to optimize the guidance for managing CRE loan
portfolios during all business cycles and why?'' One commenter
responded that the supervisory guidance was sufficient as written and
that no additional changes were needed. Another commenter suggested the
agencies add an appendix containing the components of adequate policies
and procedures. The final Statement contains several updated appendices
with references to pertinent regulations and supervisory guidance. The
final Statement also includes footnotes to highlight the supervisory
guidance contained in the existing real estate lending regulation.
The third question asked, ``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 agencies further address C&I lending more explicitly, and if so,
how?'' A few commenters suggested including more detail regarding C&I
lending in the final Statement, while one commenter stated that no
expansion was needed. The agencies recognize the unique risks
associated with CRE lending and acknowledge the several commenters who
cited the usefulness of having supervisory guidance that specifically
addresses CRE risks. Accordingly, the final Statement remains directed
to CRE lending. The final Statement acknowledges that financial
institutions may find the supervisory guidance more broadly useful for
commercial loan workout situations, stating ``[c]ertain 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.'' In the future, the agencies may consider
separate supervisory guidance to address non-CRE loan accommodations
and workouts.
The fourth question asked, ``What additional loan workout examples
or scenarios should the agencies 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?'' Two
commenters had specific recommendations for certain examples in
Appendix 1. One commenter said the examples should contain more detail;
another suggested the agencies either change or delete a scenario in
one of the examples. The final Statement retains all of the examples
and scenarios largely as proposed and includes additional detail
clarifying the discussion of a multiple note restructuring.
The fifth question asked, ``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?'' The agencies received six comment letters on
the accounting for workout loans in the examples in Appendix 1. The
commenters asked the agencies to remove references to troubled debt
restructurings (TDRs) from the examples, as the relevant accounting
standards for TDRs will no longer be applicable after 2023. The
agencies agree with the commenters and are removing discussion of TDRs
from the examples. The agencies have also removed references to ASC
Subtopic 310-10, ``Receivables--Overall,'' and ASC Subtopic 450-20,
``Contingencies--Loss Contingencies,'' and eliminated Appendix 6,
``Accounting--Incurred Loss Methodology.'' Financial institutions that
have not adopted ASC Topic 326, ``Financial Instruments--Credit
Losses,'' or ASU 2022-02 should continue to identify, measure, and
report TDRs in accordance with regulatory reporting instructions.
Based on a commenter request, the agencies made clarifications to
the accounting discussion in Example B, Scenario 3, and in Section V.D,
Classification and Accrual Treatment of Restructured Loans with a
Partial Charge-Off, as reflected in the final Statement. For the
regulatory reporting of loan modifications, financial institution
management should refer to the appropriate regulatory reporting
instructions for supervisory guidance.
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
Agencies have determined that this 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. Final Guidance
The text of the final Statement is as follows:
[[Page 43119]]
Policy Statement on Prudent Commercial Real Estate Loan Accommodations
and Workouts
The agencies \1\ recognize that financial institutions \2\ face
significant challenges when working with commercial real estate (CRE)
\3\ 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 such
borrowers may experience deterioration in their financial condition,
many borrowers will continue to be creditworthy and have the
willingness and ability 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
\4\ or more extensive loan workout arrangements.\5\
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\1\ The Board of Governors of the Federal Reserve System
(Board), the Federal Deposit Insurance Corporation (FDIC), the
National Credit Union Administration (NCUA), and the Office of the
Comptroller of the Currency (OCC) (collectively, the agencies). This
Policy Statement was developed in consultation with state bank and
credit union regulators.
\2\ For the purposes of this statement, financial institutions
are those supervised by the Board, FDIC, NCUA, or OCC.
\3\ 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 1-4
family residential and commercial construction loans), other land
loans, loans to real estate investment trusts (REITs), and unsecured
loans to developers. For credit unions, ``commercial real estate
loans'' refers to ``commercial loans,'' as defined in Section 723.2
of the NCUA Rules and Regulations, secured by real estate.
\4\ 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.
\5\ Workouts can take many forms, including a renewal or
extension of loan terms, extension of additional credit, or a
restructuring with or without concessions.
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This statement provides a broad set of risk management principles
relevant to CRE loan accommodations and workouts in all business
cycles, particularly in challenging economic environments. A wide
variety of factors can negatively affect CRE portfolios, including
economic downturns, natural disasters, and local, national, and
international events. This statement also describes the approach
examiners will use to review CRE loan accommodation and workout
arrangements and provides examples of CRE loan workout arrangements as
well as useful references in the appendices.
The agencies have found that prudent CRE loan accommodations and
workouts are often in the best interest of the financial institution
and the borrower. The agencies expect their examiners 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,\6\ 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.
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\6\ 12 CFR part 30, appendix A (OCC); 12 CFR part 208 Appendix
D-1 (Board); and 12 CFR part 364 appendix A (FDIC). For the NCUA,
refer to 12 CFR part 741.3(b)(2), 12 CFR part 741 appendix B, 12 CFR
part 723, and letter to credit unions 10-CU-02 ``Current Risks in
Business Lending and Sound Risk Management Practices'' issued
January 2010. Credit unions should also refer to the Commercial and
Member Business Loans section of the NCUA Examiner's Guide.
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I. Purpose
Consistent with the safety and soundness standards, this statement
updates and supersedes previous 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.\7\ This statement is intended to
promote supervisory consistency among examiners, enhance the
transparency of CRE loan accommodation and workout arrangements, and
support supervisory policies and actions that do not inadvertently
curtail the availability of credit to sound borrowers.
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\7\ This statement replaces the interagency Policy Statement on
Prudent Commercial Real Estate Loan Workouts (October 2009). See
FFIEC Press Release, October 30, 2009, available at: https://www.ffiec.gov/press/pr103009.htm.
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This statement addresses prudent risk management practices
regarding short-term loan accommodations, risk management 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.\8\ The statement does not,
however, affect existing regulatory reporting requirements or
supervisory guidance provided in relevant interagency statements issued
by the agencies 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.
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\8\ For banks, the FFIEC Consolidated Reports of Condition and
Income (FFIEC Call Report), and for credit unions, the NCUA 5300
Call Report (NCUA Call Report).
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Five 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 nonaccrual treatment.
Appendix 2 lists selected relevant rules as well as
supervisory and accounting guidance for real estate lending,
appraisals, allowance methodologies,\9\ restructured loans, fair value
measurement, and regulatory reporting matters such as nonaccrual
status. The agencies intend this statement to be used in conjunction
with materials identified in Appendix 2 to reach appropriate
conclusions regarding loan classification and regulatory reporting.
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\9\ 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.
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Appendix 3 discusses valuation concepts for income-
producing real property.\10\
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\10\ Valuation concepts applied to regulatory reporting
processes also should be consistent with ASC Topic 820, Fair Value
Measurement.
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Appendix 4 provides the special mention and adverse
classification definitions used by the Board, FDIC, and OCC.\11\
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\11\ Credit unions must apply a relative credit risk score
(i.e., credit risk rating) to each commercial loan as required by 12
CFR part 723 Member Business Loans; Commercial Lending (see Section
723.4(g)(3)) or the equivalent state regulation as applicable.
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Appendix 5 addresses the relevant accounting and
supervisory guidance on estimating loan losses for financial
institutions that use the current expected credit losses (CECL)
methodology.
[[Page 43120]]
II. Short-Term Loan Accommodations
The agencies encourage financial institutions to work proactively
and 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 and 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
ability 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 a 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. Weak 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 a 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 and maintaining appropriate policies and procedures,
updating and assessing financial and collateral information,
maintaining an appropriate risk rating (or grading) framework, and
ensuring proper tracking and accounting for loan accommodations.
Prudent internal controls related to loan accommodations include
comprehensive policies \12\ and practices, proper management approvals,
an ongoing credit risk review function, and timely and accurate
reporting and communication.
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\12\ See 12 CFR 34.62(a) and 160.101(a) (OCC); 12 CFR 208.51(a)
(Board); and 12 CFR 365.2(a) (FDIC) regarding real estate lending
policies at financial institutions. For NCUA, refer to 12 CFR part
723 for commercial real estate lending and 12 CFR part 741, appendix
B, which addresses loan workouts, nonaccrual policy, and regulatory
reporting of workout loans.
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III. Loan Workout Programs
When short-term accommodation measures are not sufficient or have
not been successful in addressing credit problems, 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 \13\ the loan with or without concessions.
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\13\ A restructuring involves a formal, legally enforceable
modification in the loan's terms.
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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 supervisory guidance, real estate lending
standards and requirements,\14\ and relevant regulatory reporting
requirements. Examiners will evaluate the effectiveness of a financial
institution's practices, which typically include:
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\14\ 12 CFR part 34, subpart D, and Appendix to 160.101 (OCC);
12 CFR 208.51 (Board); and 12 CFR part 365 (FDIC). For NCUA
requirements, refer to 12 CFR part 723 for member business loan and
commercial loan regulations, which addresses CRE lending, and 12 CFR
part 741, Appendix B, which addresses loan workouts, nonaccrual
policy, and regulatory reporting of workout loans.
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A prudent loan workout policy that establishes appropriate
loan terms and amortization schedules and that permits the financial
institution to reasonably adjust the loan workout plan if sustained
repayment performance is not demonstrated or if collateral values do
not stabilize; \15\
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\15\ Federal credit unions are reminded that in making decisions
related to loan workout arrangements, they must take into
consideration any applicable maturity limits (12 CFR 701.21(c)(4)).
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Management infrastructure to identify, measure, and
monitor the volume and complexity of the loan workout activity;
Documentation standards to verify a borrower's
creditworthiness, including financial condition, repayment ability, 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.\16\
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\16\ See Interagency Guidance on Credit Risk Review Systems. OCC
Bulletin 2020-50 (May 8, 2020); FDIC Financial Institution Letter
FIL-55-2020 (May 8, 2020); Federal Reserve Supervision and
Regulation (SR) letter 20-13 (May 8, 2020); and NCUA press release
(May 8, 2020).
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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 ability,
evaluating the support provided by guarantors, and assessing the value
of any collateral pledged. Proactive engagement by the financial
institution with the borrower often plays a key role in the success of
the workout.
Consistent with safety and soundness standards, examiners will not
criticize a financial institution for engaging in loan workout
arrangements, even though such loans may be adversely classified, 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 original or subsequent loan terms;
Analyzed the borrower's global debt \17\ service coverage,
including realistic projections of the borrower's cash flow, as well as
the availability, continuity, and accessibility of repayment sources;
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\17\ Global debt service coverage is inclusive of the cash flows
generated by both the borrower(s) and guarantor(s), as well as the
combined financial obligations (including contingent obligations) of
the borrower(s) and guarantor(s).
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Analyzed the available cash flow of guarantors;
[[Page 43121]]
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
manner through provision expense and recording appropriate charge-
offs.\18\
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\18\ Additionally, if applicable, financial institutions should
recognize in a separate liability account an allowance for expected
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.
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A. Supervisory Assessment of Repayment Ability 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 ability 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 underlying collateral on a global
basis that considers the borrower's and guarantor's total debt
obligations;
Relevant market conditions,\19\ particularly those on a
state and local level, that may influence repayment prospects and the
cash flow potential of the business operations or the underlying
collateral; and
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\19\ See 12 CFR 34.62(c) and 160.101(c)(OCC); 12 CFR 208.51(a)
(Board); and 12 CFR 365.2(c) (FDIC) regarding the need for financial
institutions to monitor conditions in the real estate market in its
lending area to ensure that its real estate lending policies
continue to be appropriate for current market conditions. For the
NCUA, refer to 12 CFR 723.4(f)(6) requiring that a federally insured
credit union's commercial loan policy have underwriting standards
that include an analysis of the impact of current market conditions
on the borrower and associated borrowers.
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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 adverse loan classification or reduce the
severity of the loan classification. A financially responsible
guarantor possesses the financial ability, 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 ability, 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 ability to fulfill its obligation. An effective assessment
includes consideration of whether the guarantor has the financial
ability 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, information on
the underlying collateral's estimated value becomes more important in
analyzing the source of repayment, assessing credit risk, and
developing an appropriate loan 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. Examiners 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 agencies' appraisal regulations require financial institutions
to review appraisals for compliance with the Uniform Standards of
Professional Appraisal Practice.\20\ As part of that process, and when
reviewing collateral valuations, financial institutions should ensure
that assumptions and conclusions used are reasonable. Further,
financial institutions typically have policies \21\ and procedures that
dictate when collateral valuations should be updated as part of
financial institutions' ongoing credit risk reviews and monitoring
processes, as relevant market conditions change, or as a borrower's
financial condition deteriorates.\22\
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\20\ See 12 CFR part 34, subpart C (OCC); 12 CFR part 208,
subpart E, and 12 CFR part 225, subpart G (Board); 12 CFR part 323
(FDIC); and 12 CFR part 722 (NCUA).
\21\ See Footnote 12.
\22\ For further reference, see Interagency Appraisal and
Evaluation Guidelines, 75 FR 77450 (December 10, 2010).
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For a CRE loan in a workout arrangement, a financial institution
should consider the 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 underlying collateral's fair value.\23\ If
new money is being
[[Page 43122]]
advanced, financial institutions should refer to the agencies'
appraisal regulations to determine whether a new appraisal is
required.\24\
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\23\ 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.''
\24\ See footnote 20.
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The market value provided by an appraisal and the fair value for
accounting purposes are based on similar valuation concepts.\25\ The
analysis of the underlying 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 the property's value. Valuations
of commercial properties may contain more than one value conclusion and
could include an ``as is'' market value, a prospective ``as complete''
market value, and a prospective ``as stabilized'' market value.
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\25\ 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.
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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 required for financial reporting
purposes that the financial institution use the fair value (less costs
to sell) \26\ of the property in its current ``as is'' condition in its
collateral assessment.
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\26\ Costs to sell may be used in determining any allowance for
collateral-dependent loans. Under ASC Topic 326, 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. 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.
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If weaknesses exist in the financial institution's supporting loan
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 additional
information or a new collateral valuation.\27\ However, in the rare
instance when a financial institution is unable or unwilling to address
weaknesses in a timely manner, examiners will assess the property's
operating cash flow and the degree of protection provided by a sale of
the underlying collateral as part of determining the loan's
classification. In performing their credit analysis, examiners will
consider expected cash flow from the property, current or implied
value, relevant market conditions, and the relevance of the facts and
the reasonableness of assumptions used by the financial institution.
For an income-producing property, examiners evaluate:
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\27\ See 12 CFR 34.43(c) (OCC); 12 CFR 225.63(c) (Board); 12 CFR
323.3(c) (FDIC); and 12 CFR 722.3(e) (NCUA).
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Net operating income of the property as compared with
budget projections, reflecting reasonable operating and maintenance
costs;
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; 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 qualified, independent parties within 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
analyses.
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
examiner may adjust the estimated value of the collateral for credit
analysis and classification purposes when the examiner can establish
that underlying facts or assumptions presented by the financial
institution are irrelevant or inappropriate or can support alternative
assumptions based on available information.
CRE borrowers may have 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, examiners should assess the adequacy of
the financial institution's policies and practices for quantifying the
value of such collateral, determining the acceptability of the assets
as collateral, and perfecting its security interests. Examiners should
also determine whether the financial institution has appropriate
procedures for ongoing monitoring of this type of collateral.
V. Classification of Loans
Loans that are adequately protected by the current sound worth and
debt service ability 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 by examiners
unless well-defined weaknesses exist that jeopardize repayment.
However, such loans could be flagged for management's attention or for
inclusion in 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.
[[Page 43123]]
Refer to Appendix 4 for the classification definitions.\28\
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\28\ The NCUA does not require credit unions to adopt a uniform
regulatory classification schematic of loss, doubtful, or
substandard. A credit union must apply a relative credit risk score
(i.e., credit risk rating) to each commercial loan as required by 12
CFR part 723, Member Business Loans; Commercial Lending, or the
equivalent state regulation as applicable (see Section 723.4(g)(3)).
Adversely classified refers to loans more severely graded under the
credit union's credit risk rating system. Adversely classified loans
generally require enhanced monitoring and present a higher risk of
loss. Refer to the NCUA's Examiner's Guide for further information
on credit risk rating systems.
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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 on loan performance is based upon an assessment as
to whether the borrower is contractually current on principal or
interest payments. For many loans, the assessment of payment status is
sufficient to arrive at a loan's classification. 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.
However, if the development project stalls and management fails to
evaluate the collectability of the loan, interest income could 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 this case, 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. This repayment
uncertainty is especially true 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 this situation,
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 remaining
life of the loan. 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 the CRE property considering 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 bridge loans to finance recently completed
CRE projects for a period to achieve stabilized occupancy before
obtaining permanent financing or selling the property. 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 the
borrower's 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 loan. 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 should be 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 Problem CRE Loans Dependent on the Sale of
Collateral for Repayment
As a general classification principle for a problem 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 for which there are no other available reliable sources
of repayment such as a financially capable guarantor.\29\
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\29\ See footnote 26.
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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, as such a designation
is temporary and subject to a financial
[[Page 43124]]
institution's timely reassessment of the loan once the outcomes of
pending events have occurred or the amount of loss can be reasonably
determined.
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 when 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 loan is restructured into two notes (referred to as Note A
and Note B). Lenders may separate a portion of the current outstanding
debt into a new, legally enforceable note (Note A) that is reasonably
assured of repayment and performance according to prudently modified
terms. When restructuring a collateral-dependent loan using a multiple
note structure, the amount of Note A should be determined using the
fair value of the collateral. This note may be placed back in 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 unlikely to be
repaid or collected and therefore is deemed uncollectible (Note B)
would be adversely classified ``loss'' and must be charged off.
In contrast, the loan should remain on, or be placed in, nonaccrual
status if the financial institution 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 amount.\30\ 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.
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\30\ 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 cost, 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 supervisory guidance on
returning a loan to accrual status.
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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 agencies have observed
this governance and control structure commonly includes policies and
procedures that provide clear guidance on accounting matters. Accurate
regulatory reports are critical to the transparency of a financial
institution's financial position and risk profile and are 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 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 and the allowance) when assessing the
adequacy of the financial institution's reporting practices for on- and
off-balance sheet credit exposures. Refer to Appendix 5 for a summary
of the allowance standard under ASC Topic 326, Financial Instruments--
Credit Losses. Examiners should also refer to regulatory reporting
instructions in the FFIEC Call Report and the NCUA 5300 Call Report
guidance as well as applicable accounting standards 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 FFIEC and NCUA 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 in accrual status, the restructuring and any charge-off taken on
the loan must be supported by a current, well-documented credit
assessment of the borrower's financial condition and prospects for
repayment under the revised terms. Otherwise, the restructured loan
must be placed in nonaccrual status.
A restructured loan placed in nonaccrual status should not be
returned to accrual status until the borrower demonstrates 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
[[Page 43125]]
to the instructions for the FFIEC Call Report and the NCUA 5300 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.\31\ Although not
discussed in the examples below, examiners consider the adequacy of
a financial institution'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. Financial institutions should refer to the appropriate
regulatory reporting instructions for supervisory guidance on the
recognition, measurement, and regulatory reporting of loan
modifications.
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\31\ The agencies view that the accrual treatments in these
examples as falling within the range of acceptable practices under
regulatory reporting instructions.
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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 classification and nonaccrual
treatment.\32\
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\32\ In addition, estimates of the fair value of collateral use
assumptions based on judgment and should be consistent with
measurement of fair value in ASC Topic 820, Fair Value Measurement;
see Appendix 2.
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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 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 in 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.
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,\33\ representing administrative
weaknesses.
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\33\ In relation to comments on valuations within these
examples, refer to the appraisal regulations applicable to the
financial institution to determine whether there is a regulatory
requirement for either an evaluation or appraisal. See footnote 20.
---------------------------------------------------------------------------
Nonaccrual Treatment: The lender maintained the loan in 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.
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 in 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
ability 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.
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
[[Page 43126]]
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 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 loan.
Nonaccrual Treatment: The lender maintained the loan in 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.
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 ability 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.
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 which
reasonably estimates the fair value on the shopping mall reported an
``as is'' market value of $7 million, resulting in an LTV of 143
percent.
At the original loan's maturity, the lender restructured the $10
million debt, which is a collateral-dependent loan, into two notes.
The lender placed the first note of $7 million (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. For the second note (Note B), the
lender placed the remaining $3 million, which represents the excess
of the $10 million debt over the $7 million market value of the
shopping mall, into a 2 percent interest-only loan that resets in
five years into an amortizing payment. The lender then charged-off
the $3 million note due to the project's lack of repayment ability
and to provide reasonable collateral protection for the remaining
on-book loan of $7 million. The lender also reversed accrued but
unpaid interest. 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.
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.
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
[[Page 43127]]
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 \34\ 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 would not be reversed.
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\34\ Refer to the supervisory guidance on ``nonaccrual status''
in the FFIEC Call Report and NCUA 5300 Call Report instructions.
---------------------------------------------------------------------------
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) \35\ 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.
---------------------------------------------------------------------------
\35\ 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 in 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.
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 ability 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 limited unencumbered
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 with
the lender's treatment due to the borrower's diminished ongoing
ability to make payments, the 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 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.
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
[[Page 43128]]
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.
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 in accrual
status. The borrower and 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.
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
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 in 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.
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.
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
[[Page 43129]]
($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.
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-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 ability 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.
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.
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 ability 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.
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.
[[Page 43130]]
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 ability 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 in accrual
status. The examiner did not concur with this treatment. The loan
was not restructured on reasonable repayment terms, the borrower has
limited ability 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 regulatory reporting
instructions. The lender also agreed to not recognize any further
interest income from the interest reserve.
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 agreed 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 in 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.
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 agreed 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.
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
satisfactory, and an updated appraisal is not considered necessary.
[[Page 43131]]
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 in
accrual status as the borrower has demonstrated an ongoing ability
to perform, has the financial ability 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.
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 ability 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 ability 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 as a going concern. The examiner
concurred with the lender's nonaccrual treatment.
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 in 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.
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. The examiner concluded that
the loan was not restructured on reasonable repayment terms because
the borrower does not have the ability 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
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 in 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 ability to service the debt, value of
the collateral is permanently impaired, and full repayment of
principal and interest is not assured.
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
[[Page 43132]]
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 in 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.
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 evictions. 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 ability 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.
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.
Appendix 2
Selected Rules, Supervisory Guidance, and Authoritative Accounting
Guidance
Rules
Federal regulations on real estate lending standards
and the Interagency Guidelines for Real Estate Lending Policies: 12
CFR part 34, subpart D, and appendix A to subpart D (OCC), 160.100,
160.101, and Appendix to 160.101 (OCC); 12 CFR part 208, subpart E
and appendix C (Board); and 12 CFR part 365 and appendix A (FDIC).
For NCUA, refer to 12 CFR part 723 for member business loan and
commercial loan regulation which addresses commercial real estate
lending and 12 CFR part 741, appendix B, which addresses loan
workouts, nonaccrual policy, and regulatory reporting of workout
loans.
Federal regulations on the Interagency Guidelines
Establishing Standards for Safety and Soundness: 12 CFR part 30,
appendix A (OCC); 12 CFR part 208 Appendix D-1 (Board); and 12 CFR
part 364 appendix A (FDIC). For NCUA safety and soundness
regulations and supervisory guidance, see 12 CFR 741.3(b)(2); 12 CFR
part 741, appendix B; 12 CFR part 723; and NCUA letters to credit
unions 10-CU-02 ``Current Risks in Business Lending and Sound Risk
Management Practices'' issued January 2010 (NCUA). Credit unions
should also refer to the Commercial and Member Business Loans
section of the NCUA Examiner's Guide.
Federal appraisal regulations: 12 CFR part 34, subpart
C (OCC); 12 CFR part 208, subpart E and 12 CFR part 225, subpart G
(Board); 12 CFR part 323 (FDIC); and 12 CFR part 722 (NCUA).
Supervisory Guidance
FFIEC Instructions for Preparation of Consolidated
Reports of Condition and Income (FFIEC 031, FFIEC 041, and FFIEC 051
Instructions) and NCUA 5300 Call Report Instructions.
Interagency Policy Statement on Allowances for Credit
Losses (Revised April 2023), issued April 2023.
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 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 FAQs on Residential Tract Development
Lending, issued September 2005.
Authoritative Accounting Standards
ASC Topic 310, Receivables
ASC Topic 326, Financial Instruments--Credit losses
ASC Topic 820, Fair Value Measurement
ASC Subtopic 825-10, Financial Instruments--Overall
[[Page 43133]]
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 present value calculation to
determine the value of collateral. The following discussion sets
forth the meaning and use of those key concepts.
The Discount Rate and the Present Value: The discount rate used
to calculate the present value 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 present value is the value of a future
payment or series of payments discounted to the date of the
valuation. If the income producing real estate is a property that
requires cash outlays, a net present value calculation may be used
in the valuation of collateral. Net present value considers the
present value of capital outlays and subtracts that from the present
value of payments received for the income producing property.
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 accomplished through periodic income, the reversion,
or a combination of both. 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
periodic income streams over a number of years in the future
(discount rate) compared to a static one-year analysis (``cap''
rate).
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 the depreciation in any one
year, hence, the smaller the annual income required by the investor,
and the lower 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 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 time that may be required to sell the property in an open
market.
Appendix 4
Special Mention and Adverse Classification Definitions 36
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\36\ Federal banking agencies 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
(OCC: OCC Bulletin 2013-28; Board: SR Letter 13-18; and FDIC: FIL-
51-2013). The Federal banking agencies definition of Special Mention
may be found in the Interagency Statement on the Supervisory
Definition of Special Mention Assets (June 10, 1993). The NCUA does
not require credit unions to adopt the definition of special mention
or a uniform regulatory classification schematic of loss, doubtful,
substandard. A credit union must apply a relative credit risk score
(i.e., credit risk rating) to each commercial loan as required by 12
CFR part 723 Member Business Loans; Commercial Lending (see Section
723.4(g)(3)) or the equivalent state regulation as applicable.
Adversely classified refers to loans more severely graded under the
credit union's credit risk rating system. Adversely classified loans
generally require enhanced monitoring and present a higher risk of
loss.
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The Board, FDIC, and OCC use the following definitions for
assets adversely classified for supervisory purposes as well as
those assets listed as special mention:
Special Mention
Special Mention Assets: 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 supervisory
guidance for
[[Page 43134]]
financial institutions in accordance with 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 supervisory
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
(Revised April 2023). Additional information related to identifying
and disclosing modifications for regulatory reporting under ASC
Topic 326 is located in the FFIEC Call Report and NCUA 5300 Call
Report instructions.
In accordance with ASC Topic 326, expected credit losses on
restructured or modified loans 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,\37\ 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 \38\ 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.
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\37\ 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 FFIEC Call Report instructions for
``Allowance for Credit Losses--Collateral-Dependent Financial
Assets.''
\38\ The fair value of collateral should be measured in
accordance with FASB ASC Topic 820, Fair Value Measurement. For
allowance measurement 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.
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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.
Michael J. Hsu,
Acting Comptroller of the Currency.
By order of the Board of Governors of the Federal Reserve
System.
Ann E. Misback,
Secretary of the Board Federal Deposit Insurance Corporation.
By order of the Board of Directors.
Dated at Washington, DC, on May 31, 2023.
James P. Sheesley,
Assistant Executive Secretary.
By order of the Board of the National Credit Union
Administration.
Dated at Alexandria, VA, this 26th of June 2023.
Melane Conyers-Ausbrooks,
Secretary of the Board, National Credit Union Administration.
[FR Doc. 2023-14247 Filed 7-5-23; 8:45 am]
BILLING CODE 4810-33-P; 6714-01-P; 7535-01-P