New Guidance From Financial Regulators for Commercial Real Estate Loan Workouts
On October 30, 2009, the financial regulators that collectively constitute the Federal Financial Institutions Examination Council (FFIEC) adopted a Policy Statement on Prudent Commercial Real Estate Loan Workouts (the “Policy Statement”). The Policy Statement updates and replaces policy statements previously issued by the FFIEC in November 1991 and June 1993. The Policy Statement is intended to guide federal and state financial institution examiners in evaluating the efforts of institutions to renew or restructure loans to creditworthy commercial real estate (CRE) borrowers. Such guidance is particularly important in light of the current economic downturn, which has resulted in CRE borrowers experiencing diminished operating cash flows, depreciated collateral values, and prolonged sales and rental absorption periods.
The FFIEC intends for the Policy Statement to promote supervisory consistency, enhance the transparency of CRE workout transactions, and ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. Among other things, the Policy Statement sets forth guidelines for evaluating the risk management elements of loan workout programs, specific loan workout arrangements, and the classification of individual loans.
Risk Management Elements for Loan Workout Programs. The Policy Statement advises that an institution’s risk management practices for renewing and restructuring CRE loans should be appropriate for the complexity and nature of its lending activity and should be consistent with safe and sound lending practices and relevant regulatory reporting requirements. The Policy Statement sets forth specific issues that proper risk management practices should address, including:
· Documentation standards to verify a borrower’s financial condition and collateral values;
· Effectiveness of loan collection procedures; and
· Adherence to statutory, regulatory, and internal lending limits.
Loan Workout Arrangements. The thesis of the Policy Statement with respect to particular loan workout arrangements is that a renewal or restructuring should improve the lender’s prospects for repayment of principal and interest and be consistent with sound banking, supervisory, and accounting practices. Loan workout arrangements should be designed to ensure that an institution maximizes its recovery potential. The Policy Statement states that restructured loans to borrowers who have the ability to repay their debts under reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. The Policy Statement further provides that an institution will not be criticized for engaging in loan workout arrangements that result in an adverse classification so long as management has acted reasonably, i.e., in accordance with the workout guidelines set forth in the Policy Statement.
Three aspects of workout arrangements are given particular attention in the Policy Statement: a borrower’s ability to pay, loan guarantees, and collateral values. The FFIEC states that the primary focus of a federal or state financial institution examiner’s review of a commercial loan should be an assessment of the borrower’s ability to repay the loan. According to the Policy
Statement, the major factors that influence the analysis of a borrower’s ability to pay are the borrower’s willingness and capacity to repay the loan under reasonable terms and the cash flow potential of the underlying collateral or business. The Policy Statement lists specific factors examiners should consider when analyzing a commercial borrower’s repayment ability.
The second aspect of workout arrangements discussed in the Policy Statement is the presence of guarantees. According to the Policy Statement, a guarantee from a financially responsible guarantor may improve the prospects for repayment of the debt obligation and may be sufficient to preclude classification or reduce the severity of classification. The Policy Statement describes a sound guarantee as one that is (1) provided by a guarantor with the financial capacity and willingness to provide support for the loan through ongoing payments, curtailments, or re-margining; (2) is adequate to provide support for repayment of the indebtedness, in whole or in part, during the remaining loan term; and (3) is written and legally enforceable. The Policy Statement further advises that an institution should have sufficient information regarding a guarantor’s global financial condition, income, liquidity, cash flow, contingent liability, and other relevant factors (including credit ratings, when available) to demonstrate the guarantor’s financial capacity to fulfill the obligation.
Finally, the Policy Statement addresses the importance of the collateral’s value as a secondary repayment source in analyzing credit risk and developing a proper workout plan. The FFIEC states that an individual institution should be responsible for reviewing current collateral valuations (i.e., appraisals or evaluations) to ensure that the assumptions and conclusions in the valuations are reasonable. In addition, institutions are encouraged to have policies and procedures that dictate when collateral valuations should be updated as part of an institution’s ongoing credit review, as market conditions change, or a borrower’s financial condition deteriorates.
Classification of Loans. The Policy Statement acknowledges that many CRE loans are not adversely classified. For example, loans that are adequately protected by the current sound worth and debt service capacity of the borrower, guarantor, or the underlying collateral are generally not adversely classified. Likewise, loans to sound borrowers that are renewed or restructured in accordance with prudent underwriting standards should not be adversely classified or criticized unless well-defined weaknesses exist that jeopardize repayment. The Policy Statement also directs that loans should not be adversely classified solely because the borrower is associated with a particular industry that is experiencing financial difficulties.
The Policy Statement provides that a loan’s record of performance to date should be considered when determining whether a loan should be classified. The FFIEC set forth the general principle that examiners of financial institutions should not adversely classify a performing commercial loan solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. The Policy Statement reiterates, however, that it is appropriate to classify a performing loan adversely when well-defined weaknesses exist that will jeopardize repayment. The Policy Statement also points out that a borrower’s being contractually current on payments can be misleading as to the credit risk represented by a loan, such as where the loan’s underwriting structure or the liberal use of extensions and renewals mask credit weaknesses and obscure a borrower’s inability to meet reasonable repayment terms.
The Policy Statement recognizes that many borrowers whose loans mature in the midst of an economic crisis have difficulty obtaining short-term financing or adequate sources of long-term credit due to deterioration in collateral values, despite the borrowers’ current ability to service the debt. The Policy Statement acknowledges that in cases like these, an institution may determine that the most appropriate and prudent course is to restructure or renew loans to existing borrowers who have demonstrated an ability to pay their debts, but that may not be in a position, at the time of the loan’s maturity, to obtain long-term financing. The FFIEC recognized that prudent loan workout agreements or restructurings are generally in the best interest of both the lending institution and the borrower.
Examples of CRE Loan Workouts. The FFIEC included in the Policy Statement several hypothetical examples of CRE loan workouts. The examples were designed to demonstrate a potential examiner’s analytical thought process to identify appropriate classification, implications for interest accrual, and whether a loan should be reported as a troubled debt restructuring (TDR) for regulatory reporting purposes. A detailed analysis of the examples included in the Policy Statement is beyond the scope of this document, but suffice it to say the examples may be useful to illustrate how an examiner might evaluate a renewed or restructured CRE loan in light of the principles announced in the Policy Statement.
Effect on Lenders and Borrowers. With the guidance offered by the Policy Statement, lending institutions have a better idea of the principles that federal and state examiners will be considering when evaluating institutions’ efforts to renew or restructure CRE loans. Armed with this knowledge, lenders can implement the types of prudent workout practices discussed in the Policy Statement, which may result in more restructuring of distressed loans on terms that minimize their losses while allowing borrowers to retain possession of their properties. Borrowers, too, can benefit from the principles announced in the Policy Statement, by understanding what a lender can and cannot do to modify or extend a loan in order to minimize loss recognition and avoid regulatory difficulties.
While the Policy Statement cannot account for every unique situation involving CRE loans, it does provide some much-needed updates to policy statements that had been in place since the early 1990s. The Policy Statement will likely prove useful to both lenders and borrowers seeking to restructure distressed CRE loans as they attempt to weather our current financial crisis. For additional information, or if you have questions about how the FFIEC’s recent Policy Statement might affect you or your business, please contact the Karr Tuttle Campbell attorneys below.
James L. Austin, Jr. – (206) 224-8137 / email@example.com
Diana K. Carey – (206) 224-8066 firstname.lastname@example.org
Michael M. Feinberg – (206) 224-8095 email@example.com
James S. Irby – (206) 224-8025 firstname.lastname@example.org
Walter M. Maas III – (206) 224-8076 email@example.com
George S. Treperinas (206) 224-8053 firstname.lastname@example.org
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