Recently a consortium of regulators (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Comptroller of the Currency, the Office of Thrift Supervision, and the Federal Financial Institutions Examination Council) published a policy statement, ostensibly directed to bank examiners reviewing regulatory matters, that offered important guidance for both lenders and borrowers who are dealing with commercial real estate issues. It presents an opportunity for lenders and borrowers to work together in these times of financial stress.
The policy statement emphasizes that bank examiners are to take a balanced approach in assessing a financial institution’s approach to borrowers that are experiencing financial problems. Having obvious reference to the current state of the commercial real estate market, the bank examiners are directed not to unfavorably change the classification of a loan simply because the borrower is in a particular industry that it is the throes of a financial collapse.
Addressing loan workout arrangements generally, the regulators state that workouts may include an extension of the loan’s maturity, a restructuring, or even the granting of additional credit. But in each case the rollover or restructuring should be with a view toward improving the lender’s prospects for recovery of the funds previously advanced.
Thus, so long as lender and borrower have constructed a cogent and prudent workout plan that is designed to facilitate collection of a loan in difficulty, the loan will not be adversely classified even if the value of the collateral is substantially diminished. What that means is that if modified terms are granted to a borrower that appears to have the ability to repay under those terms, examiners will not classify the loan as substandard even if the current value of the real estate is less than the outstanding loan balance. This type of approach offers significant opportunities to lenders and borrowers to work together to craft an effective repayment program without regard to whether the collateral has declined in value since the date the credit was initially extended.
Notwithstanding this major concession to the decline in commercial real estate values, the policy statement does not give free reign to lenders for every loan that is “under water”.
In construction loans, the continued recognition of interest income out of an interest reserve established at the time of initial funding when the project is not generating adequate cash flow to repay principal, is deemed to be sufficient reason to classify the loan adversely.
The policy statement fully recognizes that commercial real estate loans that are scheduled to mature shortly are not likely to be refinanced by another lender because of a decline in real estate valuations. The policy statement acknowledges that this mandates a restructuring of the credit by the current lender so long as the borrower can demonstrate its ability to service the debt. If the borrower can demonstrate its ability to pay, examiners are admonished not to classify the loan adversely.
When a commercial real estate loan is dependent on the sale of the property in order for the lender to be repaid, the examiners are directed to classify as a loss that portion of the loan that is not secured (based on current market valuation less the costs of sale), if there is no other source of repayment. That portion of the loan balance represented by the current market value less the costs of sale is to be classified as “substandard”, and that portion of the loan balance in excess of current market value where the amount of the potential shortfall cannot be reasonably determined is to be classified as “doubtful”.
In instances in which the lender has already determined there must be a partial write-off as a component of the restructuring, and the write off has been taken, the remaining balance is supposed to be classified as no worse than “substandard”, unless the borrower is in bankruptcy or the collateral is subject to a risk such as environmental contamination.
The policy statement suggests that where a partial write off is currently appropriate, it may be equally appropriate for the restructuring to involve a “two note” solution. The first note is to be in an amount the lender feels reasonably assured of recovering. It can be restored to accrual status. The remaining balance, evidenced by a second note, is to be adversely classified and written off.
If the “two note” solution is not adopted, the loan is to be placed on non-accrual if the lender internally records a partial write-off. If at a later date, it appears that the full amount due can be recovered, including the charged-off note, and the loan is brought current, the amount of the first note can be restored to accrual status even if the charged-off amount has not been repaid.
What’s the point? Facially, the policy statement is supposed to guide examiners in classifying loans. But to the extent the policy statement suggests greater flexibility be demonstrated by examiners, it reduces the pressure on lenders and allows them to be more amenable to restructuring troubled credits. The fact that a loan is “under water” is no longer an automatic downgrading. The policy statement is a candid recognition of the extent to which commercial real estate is replacing residential real estate as the economy’s problem child.