[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.
---------------------------------------------------------------------------

     Appendix 3 discusses valuation concepts for income-
producing real property.\10\
---------------------------------------------------------------------------

    \10\ Valuation concepts applied to regulatory reporting 
processes also should be consistent with ASC Topic 820, Fair Value 
Measurement.
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    \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).
---------------------------------------------------------------------------

     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.
---------------------------------------------------------------------------

    \31\ The agencies view that the accrual treatments in these 
examples as falling within the range of acceptable practices under 
regulatory reporting instructions.
---------------------------------------------------------------------------

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

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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