With interest rates rising over 128%1 in the last 24 months causing commercial property values to decline, commercial real estate lenders are under pressure as borrowers increasingly fail to comply with their loan agreements. On June 29, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Board of Governors of the Federal Reserve System (collectively, the "Agencies") jointly issued a final policy statement (Final Policy Statement) on commercial real estate (CRE) loan accommodations and workouts. The Final Policy Statement, which applies to all financial institutions supervised by the Agencies, summarizes the 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. The Final Policy Statement also includes updated references to supervisory guidance and current industry terminology.
The Final Policy Statement provides detailed examples of how examiners of the Agencies (Examiners) should approach the review of CRE loans and accommodations. The Agencies also reaffirm two key principles from the 2009 Statement (defined below). First, the Final Policy Statement provides that as long as lenders work "prudently and constructively" with borrowers to modify CRE loans, such loans will not be subject to adverse classification. Second, with respect to modified loans that continue to be paid, a lender will not be subject to adverse classification even if the value of the underlying collateral declines to less than the outstanding loan balance. Further, the Final Policy Statement provides a new section on short-term loan accommodations, expands previous guidance regarding the evaluation and assessment of guarantors to include loan sponsors, addresses recent accounting changes for estimating loan losses, and updates CRE workout examples.
Background of the Final Policy Statement
The subprime mortgage crisis, which led to the Great Recession, acted as a catalyst for the Statement on Prudent Commercial Real Estate Loan Workouts (2009 Statement) adopted by the Agencies, the Federal Financial Institutions Examination Council State Liaison Committee, and the former Office of Thrift Supervision. The 2009 Statement provided guidance on CRE loan workouts and encouraged financial institutions to work constructively with borrowers unable to pay their CRE loan obligations. Updates to the 2009 Statement were first proposed in 2022. While the risk management principles in the Final Policy Statement are generally consistent with those in the 2009 Statement, the Final Policy Statement updates and supersedes the previous guidance issued in the 2009 Statement. The Final Policy Statement emphasizes that each loan's treatment is "case-specific" and the statement does not mandate workouts or accommodations for any specific situation.
Reaffirms that Financial Institutions Can Avoid Criticism by Engaging in a Comprehensive Review and Implementing Prudent Workouts and Accommodations
The Final Policy Statement reaffirms the message from the 2009 Statement that financial institutions should implement prudent CRE workouts and accommodations with creditworthy borrowers facing financial distress while also adding new language that emphasizes the importance of workouts and accommodations during all economic cycles, including periods of economic downturn. If a CRE borrower is found to be creditworthy after a comprehensive review, financial institutions are encouraged to use their best judgment, which may include making accommodations and workouts even when the result is a weaker, modified loan. The guidance specifically instructs Examiners not to adversely classify loans given to creditworthy borrowers that have been modified in accordance with prudent underwriting standards.
While there are exceptions to this general guidance of avoiding adverse classification, such as a modified loan having well-defined weaknesses that strongly signal it will not be repaid, the Final Policy Statement urges financial institutions to avoid adversely classifying all CRE loans that receive workouts or modifications with financially sound borrowers or borrowers that evidence the ability to repay. The Final Policy Statement further provides that Examiners should not adversely classify or require the recognition of a partial charge-off on a CRE loan solely due to the value of the underlying collateral declining to an amount less than the outstanding loan balance. As long as financial institutions engage in a comprehensive review and ensure that their borrowers have evidenced their ability to repay the loan, financial institutions can be comforted by the unlikelihood of adverse classifications. Further, in the event that a modified loan is subject to adverse classification after a comprehensive review of a borrower's financial condition, such financial institution will not be subject to criticism or be punished for the modification because it performed in exactly the manner the Agencies instructed.
Provides New Guidance on Short-Term Accommodations: If Successful, Short-Term Loan Accommodations Can Prevent Workouts and Long-Term Accommodations
A key change from the 2009 Statement to the Final Policy Statement is the addition of discussion of short-term or temporary loan accommodations. In the 2009 Statement, there was no such differentiation between short term accommodations and long-term workouts and restructurings. Further, the Final Policy Statement encourages financial institutions to work proactively and prudently with borrowers in financial distress, which may entail arranging temporary or short-term loan accommodations before a loan requires a workout arrangement. Such short-term arrangements can mitigate long-term adverse effects as it allows the borrower to address the issues affecting repayment ability, which is often in the best interest of both the financial institution and its borrowers.
It also provides a few examples of short-term accommodations, including:
- Temporary modification of a loan;
- Providing short-term assistance to a borrower during financial hardship;
- Making partial payments; and
- Deferring payments.
During short term-loan accommodations, the Final Policy Statement directs financial institutions to exercise prudence in the form of providing transparent and timely information about the arrangement to the borrower and any guarantor. Notably, even with this new guidance, the Final Policy Statement and the examples do not add any specific, detailed illustrative examples of short-term loan accommodations in the same manner that it addresses long-term loan workouts.
After a short-term accommodation fails to address credit problems, the Final Policy Statement instructs financial institutions to consider engaging in a long-term accommodation or workout arrangement. When considering a long-term accommodation or workout, the Final Policy Statement recommends analyzing a borrower's repayment ability, evaluating the potential support by guarantors, and reviewing the value of any collateral pledged. If implemented effectively with proactive engagement of the financial institution with the borrower, the loan workout arrangement should greatly improve the lender's prospects for repayment of principal and interest.
Loan workout programs can take many forms, including, but not limited to:
- Renewing or extending loan terms;
- Granting additional credit to improve prospects for overall repayment; and
- Restructuring the loan with or without concessions.
Expands Guidance on Evaluation and Assessment of Guarantors to Include Loan Sponsors
The Final Policy Statement provides new guidance directing Examiners to more closely examine the sponsors of CRE loans, including the financial condition and economic incentives of the sponsor. The guidance notes that even if not legally obligated, financially responsible sponsors are similar to guarantors in that they may have an incentive to provide support for the loan. The Final Policy Statement provides that the analysis that is applied to guarantors should similarly be applied to sponsors of the loan, because financial institutions with more information on a guarantor's or sponsor's global financial condition are in a better position to determine a guarantor's ability to fulfill its obligation and determine a sponsor's ability to step in and assist.
The Final Policy Statement also provides that Examiners should assess whether: (i) the guarantor has the financial ability to fulfill the total number and amount of guarantees currently extended by the guarantor; (ii) a guarantor has demonstrated a willingness to fulfill all current and previous obligations; (iii) the guarantor has sufficient economic incentive and a significant capital investment in the project; and (iv) any previous performance under a guarantor's guarantee was the result of legal or other actions. While sponsors are not specifically mentioned in all of the guidance for guarantors, the direction from the Final Policy Statement that a similar analysis applies to sponsors makes all such guidance applicable whenever feasible.
Reflects Recent Accounting Changes
The Final Policy Statement reflects the changes in generally accepted accounting principles (GAAP) since the 2009 Statement, which include changes to the expected credit losses (CECL) methodology. Specifically, the Final Policy Statement provides additional guidance on the CECL methodology and how it affects CRE loan workouts. In addition, the Final Policy Statement removes guidance on debt restructuring accounting to reflect the elimination of the reporting requirement for troubled debt restructurings (TDRs).
Prudent Risk Management Practices, Internal Controls and Capital Adequacy Considerations
While the Agencies encourage financial institutions to work proactively with borrowers who are, or may be, unable to meeting contractual obligations during periods of financial stress, financial institutions are expected to be prudent in entering into any accommodation, and all accommodations must be consistent with applicable laws, regulations, and related supervisory guidance. Financial institutions are also expected to have prudent risk management practices and appropriate internal controls over such accommodations. The Final Policy Statement notes that prudent risk management practices include developing and maintaining policies and procedures, updating and assessing financial and collateral information, maintaining an appropriate risk rating framework and ensuring accurate tracking and accounting for loan accommodations. Prudent internal controls may include comprehensive policies and practices, proper management approvals, an ongoing credit risk review function, and timely and accurate reporting and communication.
The Final Policy Statement does not specifically address capital treatment of CRE loan workouts, but notes that imprudent practices by a financial institution may pose a risk to its capital adequacy. As noted above, financial institutions are expected to continue to comply with all applicable laws and regulations when entering into loan accommodations, including those related to capital adequacy. For example, under the U.S. bank capital rules, when calculating risk-weighted assets under the standardized approach, banks are expected to apply a higher risk weight for exposures that are 90 days or more past due or on nonaccrual2. Financial institutions need to continue to monitor capital adequacy in connection with loan accommodations to ensure that the financial institutions are meeting their capital and liquidity requirements.
Adds New CRE Workout Examples
The Final Policy Statement adds to the 2009 Statement a variety of new examples of CRE loan workouts including their applicable classification, regulatory reporting requirements, and accounting considerations. Further, the Final Policy Statement modernizes its examples to reflect emerging technology's influence on loans. For example, the Final Policy Statement references "hybrid work-from-home" arrangements as a factor to be considered when considering whether or not leases will be profitable. While not specifically mentioned in the examples, the Final Policy Statement states that Examiners also consider a financial institution's internal analysis, choice to enter into a loan workout arrangement, and adequacy of supporting documentation when making loan classifications.
The Final Policy Statement includes three new examples: (i) Income Producing Property—Hotel, (ii) Multi-Family Property, and (iii) Acquisition, and Development and Construction—Residential, which have been attached as Exhibit A to this article (reformatted as a table) with nine different scenarios from the Final Policy Statement. The examples in Exhibit A provide clarity to loan credit classifications and the determination of accrual status with respect to the Final Policy Statement. Further, the examples take into account the application of existing rules, regulatory reporting instructions, and other supervisory guidance.
With respect to accrual treatment, the new examples in Exhibit A include scenarios with a variety of factors leading to an ultimate determination, which are listed in the table below. While no one factor is dispositive and each accrual treatment must be examined on a case-by-case basis, (i) expectance of full repayment of the loan and (ii) restructuring the loan on reasonable payment terms are weighed heavily, as evidenced by the Accrual Treatment Scenarios table below. Expectance of full repayment of principal and interest often results in accrual status, and failing to restructure a loan on reasonable repayment terms is a strong indicator of nonaccrual status.
| Accrual Treatment Scenarios | |||
| Fact Pattern from Exhibit A | Negative Factors | Positive Factors | Ultimate Determination |
| Base Case 1, Scenario 1 |
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Accrual Status |
| Base Case 1, Scenario 2 |
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Nonaccrual Status |
| Base Case 1, Scenario 3 |
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Accrual Status |
| Base Case 2, Scenario 1 |
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Accrual Status |
| Base Case 2, Scenario 2 |
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Nonaccrual Status |
| Base Case 2, Scenario 3 |
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Nonaccrual Status |
| Base Case 3, Scenario 1 |
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Accrual Status |
| Base Case 3, Scenario 2 |
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Accrual Status |
| Base Case 3, Scenario 3 |
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Nonaccrual Status |
With respect to loan classifications, the new examples in Exhibit A include a number of scenarios with a variety of factors leading to an ultimate determination, some of which are listed in the table below. Again, it is important to note that no one factor is dispositive and each loan must be examined on a case-by-case basis.
| Loan Classification Scenarios | ||
| Fact Pattern from Exhibit A | Factors | Ultimate Determination |
| Base Case 1, Scenario 1 | The borrower and guarantors have sufficient resources to support the interest payments. Additionally, the borrower's reserve account is sufficient to complete renovations as planned. | Loan graded as a pass |
| Base Case 1, Scenario 2 | The borrower has a diminished ongoing ability to make payments, the guarantors have a limited ability to support the loan, and there is a reduced collateral position. | Loan classified as substandard |
| Base Case 1, Scenario 3 | The lender internally classified the most recent restructured loan substandard, but the borrower is 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. | Loan graded as a pass |
| Base Case 2, Scenario 1 |
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. | Loan classified as substandard |
| Base Case 2, Scenario 2 |
The borrower has a diminished ability to make interest payments (even at the reduced rate) and lack of principal reduction, there is uncertainty surrounding rent moratoriums, and there is a reduced and tight collateral position. | Loan classified as substandard |
| Base Case 2, Scenario 3 |
The borrower has a diminished ability to make principal or interest payments, the guarantor has a limited ability to support the loan, and there is insufficient collateral protection. | Loan classified as substandard |
| Base Case 3, Scenario 1 |
The borrower and guarantor can continue making payments on reasonable terms and the project moving forward is supported by demand. 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. | Loan graded as a pass |
| Base Case 3, Scenario 2 |
There is deterioration and uncertainty surrounding the market (as evidenced by slower than anticipated sales on the project), a lack of principal reduction, and a reduced collateral margin. | Loan classified as substandard |
| Base Case 3, Scenario 3 |
The borrower and guarantor have a diminished ability to make interest payments (even at the reduced rate), the project is stalled, and there is reduced collateral protection. | Loan classified as substandard |
Exhibit A.
| Base Case 1: Income Producing Property—Hotel | ||
| 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) 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. 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 | Scenario 2 | Scenario 3 |
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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. |
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. |
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 of Scenario 1: 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. |
Classification of Scenario 2: 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. |
Classification of Scenario 3: 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 of Scenario 1: 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. |
Nonaccrual Treatment of Scenario 2: 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. |
Nonaccrual Treatment of Scenario 3: 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. |
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Base Case 2: Multi-Family Property |
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| 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 | Scenario 2 | Scenario 3 |
| At maturity, the lender renewed the $5.9 million loan balance on principal and interest payments for 12 months at a market interest rate that provides for the incremental risk. The borrower had not been delinquent on prior payments. Current financial information indicates that the DSC ratio dropped to 0.80x because of the rent payment delinquencies. Combining borrower and guarantor liquidity shows they can cover cash flow shortfall until maturity (including reasonable capital expenditures since the building was recently renovated). Borrower projections show a return to break-even within six months since the borrower plans to decrease rents to be more competitive and attract new tenants. The lender estimates that the property's current "as stabilized" market value is $7 million, resulting in an 84 percent LTV. A new appraisal has not been ordered; however, the lender noted in the file that, if the borrower does not meet current projections within six months of booking the renewed loan, the lender will obtain a new appraisal. | 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. | 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 of Scenario
1: 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. |
Classification of Scenario 2: 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. |
Classification of Scenario 3: 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 of Scenario 1: 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. |
Nonaccrual Treatment of Scenario 2: 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. |
Nonaccrual Treatment of Scenario 3: 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. |
| Base Case 3: Acquisition, and Development and Construction—Residential | ||
| 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 | Scenario 2 | Scenario 3 |
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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. 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. |
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. | Lot development was completed on schedule, and the borrower quickly sold and settled the first 10 units. At maturity, the lender renewed the $3.6 million A&D loan balance ($4.8 million reduced by the sale and settlement of the 10 units ($120,000 release price x 10) to arrive at $3.6 million) and $2.4 million construction revolver on a 12-month interest-only basis at a below market interest rate. The borrower then sold an additional 10 units to an investor; the loan officer (new to the financial institution) mistakenly marked these units as pre-sold and allowed construction to commence on all 10 units. Market conditions then deteriorated quickly, and the investor defaulted under the terms of the bulk contract. The units were completed, but the builder has been unable to re-sell any of the units, recently dropping the sales price by 10 percent and engaging a new marketing firm, which is working with several potential buyers. A recent appraisal estimates that absorption has dropped to three lots per quarter and assigns an "as complete" value of $2.3 million for the remaining 28 lots, resulting in an LTV of 156 percent. A bulk appraisal of the 10 units assigns an "as-is" value of the units of $4.0 million ($400,000/unit). The loans are cross-defaulted and cross-collateralized; the LTV on a combined basis is 95 percent ($6 million outstanding debt (A&D plus revolver) divided by $6.3 million in combined collateral value). Updated borrower and guarantor financial statements indicate a continued ability to cover interest-only payments for the next 12 months at the reduced rate; however, this may be limited in the future given other troubled projects in the borrower's portfolio that have been affected by market conditions. The lender modified the release price for each unit to net proceeds; any additional proceeds as units are sold will go towards repayment of the A&D loan. Assuming the units sell at a 10 percent reduction, the lender calculates the average sales price would be $450,000. The financial institution's prior release price was $320,000 ($120,000 for the A&D loan and $200,000 for the construction revolver). As such (by requiring net proceeds), the financial institution will be receiving an additional $130,000 per lot, or $1.3 million for the completed units, to repay the A&D loan ($450,000 average sales price less $320,000 bank's release price equals $130,000). Assuming the borrower will have to pay $30,000 in related sales/settlement costs leaves approximately $100,000 remaining per unit to apply towards the A&D loan, or $1 million total for the remaining 10 units ($100,000 times 10). |
| Classification of Scenario 1: 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. |
Classification of Scenario 2: 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. |
Classification of Scenario 3: 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 of Scenario 1: 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. |
Nonaccrual Treatment of Scenario 2: 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. |
Nonaccrual Treatment of Scenario 3: 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. |
Footnotes
2. E.g., 12 CFR 217.32(k).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
