On October 30, 2009, the Federal Financial Institutions Examination Council (FFIEC) adopted a policy statement regarding “Prudent Commercial Real Estate Loan Workouts.” This policy statement recognizes that loan workout strategies related to commercial real estate (CRE) loans are of particular interest to financial institutions in light of current economic conditions. The statement is intended to provide financial institutions and regulatory authorities with specific guidance with respect to a prudent approach to CRE loan workouts. It is further intended to provide guidance to examination staff so that examinations of financial institutions are conducted in a consistent and balanced manner, taking into consideration the importance of prudent CRE loan workouts.

Overview of CRE Loan Workout Policy Statement
The CRE Prudent Commercial Real Estate Workout Policy Statement (Policy Statement) sets forth the appropriate standards to be utilized by regulatory authorities in the evaluation of loan workout procedures. The loan workout procedures identified for evaluation in accordance with the Policy Statement principals include:

• CRE loan workout risk management procedures;
• General CRE loan workout arrangements;
• Analysis of CRE borrower repayment capacity;
• Evaluation of loan guarantees;
• Assessment of collateral value assessments;
• Classification of CRE loans and assessment of loan performance;
• Classification of CRE loan renewals or restructuring;
• Classification of troubled CRE loans dependent on the sale of collateral for repayment;
• Accrual treatment for restructured loans with partial charge-offs;
• Regulatory reporting and accounting considerations;
• Implications for interest accrual; and
• Allowance for loan and lease losses (ALLL).

Each of these procedures, the applicable evaluation standards, and principles identified under the Policy Statement are discussed below.

It is important to note that the Policy Statement is not necessarily limited to CRE loans. Rather, the same principals and evaluation standards may be applied to commercial loans that are secured by other business assets of a commercial borrower.

The Policy Statement and its accompanying attachments provide examples of typical CRE loan workouts. The attachments also include references and background materials related to regulatory reporting and accounting, appraisals and valuation concepts, and classification definitions.

The Policy Statement also makes clear that its application is not intended to change existing regulatory reporting or accounting guidance or standards.

CRE Loan Workout Risk Managment CRE
An institution’s CRE loan workout risk management procedures should be consistent with general safe and sound lending practices and applicable regulatory reporting requirements. A financial institution’s risk management practices should, at a minimum, address:

• Management infrastructure in place used to identify, control and manage the volume and complexity of the overall loan workout activity;
• Documentation standards necessary to verify a borrower’s financial condition and valuation of collateral;
• Adequacy of internal management information systems and controls necessary to identify and track loan performance and risk, including the risk associated with loan concentrations;
• Management’s ability to ensure that the regulatory reports of the institution are consistent with regulatory reporting requirements (including GAAP) and supervisory guidance;
• Effectiveness of the financial institution’s loan collection procedures;
• Compliance with statutory, regulatory and internal lending limits;
• Collateral administration to ensure proper lien perfection for both real and personal property; and
• Procedures to insure that an ongoing credit review function is performed.

General CRE Loan Workout Arrangement
The Policy Statement recognizes that CRE loan workouts may take many forms, including a renewal or extension of loan terms, the extension of additional credit, or a restructuring of the loan with or without concessions.

Significantly, the Policy Statement indicates that renewed or restructured loans to borrowers who have the ability to repay their debts under reasonable modified terms will not be subject to an adverse classification by regulatory authorities solely due to the fact that the value of underlying collateral may have declined to an amount that is less than the loan balance.

While institutions may enter into restructurings with borrowers that ultimately result in an adverse classification, an institution will not be criticized for engaging in loan workout arrangements so long as management has employed and utilized:

• A prudent workout policy that establishes appropriate loan terms and amortization schedules that also permit the institution to modify the workout plan if sustained repayment performance is not demonstrated or if collateral values do not stabilize;
• A well-conceived and prudent workout plan that analyzes the current financial information of the borrower or guarantor. This should include: (i) updated and comprehensive financial information on the borrower, real estate project and any guarantor; (ii) current valuations of the collateral supporting the loan and the workout plan; (iii) analysis and identification of appropriate loan structure (e.g., term and amortization schedule), curtailment, covenants or re-margining requirements; and (iv) appropriate legal documentation for any changes to loan terms;
• An analysis of a realistic projection of the borrower’s global debt service;
• A procedure designed to monitor the ongoing performance of the borrower and any guarantor;
• An internal loan grading system that accurately and consistently reflects the risk in the workout arrangement; and
• An ALLL methodology that covers estimated credit losses in accordance with GAAP and in a timely manner, as appropriate.

Repayment Capacity AnalysisThe Policy Statement provides that a primary focus of an examiner’s review of a financial institution’s commercial loan portfolio is to include an assessment of the individual borrower’s ability to repay under reasonable terms. When conducting this assessment, examiners are instructed to consider the following factors:
 

• The borrower’s character, overall financial condition, resources and payment record;
• The nature and degree of protection provided by the cash flow from business operations or the collateral on a global basis that considers the borrower’s total debt obligations;
• Market conditions that may influence repayment prospects and the cash flow potential of the business operations or underlying collateral; and
• The prospects for repayment support from any other financially responsible guarantor(s).

Guarantee Analysis
The support provided by guarantors is a consideration in determining the credit classification for a workout loan. The presence of a guarantee from a financially responsible party may improve the prospects for repayment of the debt obligation and may be sufficient to either preclude a loan classification entirely or reduce the severity of such classification.

The attributes of a financially responsible guarantor include:

• The guarantor has both the financial capacity and willingness to provide support for the credit through ongoing payments, curtailments or re-margining;
• The guarantee is adequate to provide support for repayment of the indebtedness, in whole or in part, during the remaining loan term; and
• The guarantee is written and legally enforceable.

Moreover, the financial institution should have sufficient information regarding the guarantor’s global financial condition to demonstrate the guarantor’s financial capacity to honor its obligations. This assessment should also include consideration of:

• The total number and amount of guarantees for which the guarantor is obligated;
• The guarantor’s willingness to fulfill all current and previous obligations;
• Whether the guarantor has sufficient economic incentive and investment in the project to warrant repayment under the guarantee obligation; and
• Whether previously required performance under guarantee obligations was voluntary or the result of legal or other actions by a lender.

Collateral Value Assessments
As the primary sources of loan repayment decline, the importance of collateral value as a secondary repayment source increases. The financial institution is responsible for obtaining and reviewing current collateral valuations to ensure that their valuation assumptions and conclusions are reasonable. Further, the institution should have policies and procedures implemented that dictate or identify when collateral valuations should be updated.

For CRE loans involved in a workout process, a new or updated appraisal or evaluation, as appropriate, should address the current project plans and market conditions that were considered in the development of the workout plan, including whether there has been a material change or deterioration in any of the following factors:

• Project performance;
• Geographic market and property type conditions;
• Variances between actual conditions and the original appraisal assumptions;
• Changes in project specifications;
• Loss of a significant lease or a takeout commitment; and
• Changes or increases in pre-sales fallout.

However, it is important to note that the Policy Statement advises that in some cases a new appraisal may not be necessary, provided that an internal evaluation by the financial institution appropriately updates the original appraisal assumptions to reflect current market conditions and provides an estimate of the collateral’s fair value for impairment analysis.

A financial institution that engages in CRE loan workouts should have sufficient and complete documentation demonstrating a full understanding of the property’s current “as is” appraised value. However, the institution should use the market value conclusion (and not the fair value) that corresponds to the workout plan and the loan commitment. For example, if the financial institution proposes to work with the borrower in order to stabilize project occupancy, then the financial institution may consider the “as stabilized” market value in its collateral assessment for credit risk grading after reviewing the reasonableness of the appraisal’s assumptions and conclusions. Conversely, if the financial institution intends to foreclose on the project, it should then use the fair value (less costs to sell) of the property in its current “as is” condition in connection with the collateral assessment.

The Policy Statement directs regulatory examiners to review the appropriateness of the major facts, assumptions and valuation approaches utilized by the institution in its collateral valuation and in the institution’s internal credit review and impairment analysis. If weaknesses are noted, then regulatory examiners may make adjustments. For example, when reviewing the reasonableness of the facts and assumptions associated with the value of an income-producing property, regulatory examiners will likely evaluate:

• Current and projected vacancy and absorption rates;
• Lease renewal trends and anticipated rents;
• Estimated or anticipated time frames for achieving stabilized occupancy or sellout;
• Volume and trends in past due leases;
• Net operating income of the property as compared with budget projections, reflecting reasonable operating and maintenance costs; and
• Discount rates and direct capitalization rates

The Policy Statement advises that examiners should give a reasonable amount of deference to collateral assumptions, when recently made by qualified appraisers (and, as appropriate, by the financial institution) and when consistent with the discussion above. Further, examiners also should use the appropriate market value conclusion in their collateral assessments. For example, when the 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 analysis.

Examiners generally are not expected to challenge the underlying valuation assumptions, including discount rates and capitalization rates, used in appraisals or evaluations when these assumptions differ only in a limited way from norms that would generally be associated with the collateral under review. When the examiner can establish that any underlying facts or assumptions are inappropriate or can support alternative assumptions, the estimated value of the underlying collateral may be adjusted for credit analysis purposes.

Many CRE borrowers may have other indebtedness secured by other business assets such as furniture, fixtures, equipment, inventory and accounts receivable. An institution should have appropriate policies and practices for quantifying the value of such assets, determining the acceptability of the collateral, and perfecting its security interest. The institution also should have appropriate procedures for ongoing monitoring of the value of its collateral interests and security protection.

Loan Performance Assessment for Classification Purposes
Loans that are adequately protected by the current sound worth and debt service capacity of the borrower, guarantor or underlying collateral are generally not adversely classified. Unless well-defined weaknesses exist that jeopardize repayment, loans to sound borrowers that are renewed or restructured in accordance with prudent underwriting standards should not be adversely classified or criticized. In addition, a loan should not be adversely classified solely because the borrower is associated with a particular industry that is experiencing financial difficulties.

However, when an institution’s restructurings are not supported by adequate analysis and documentation, examiners are expected to exercise reasonable judgment in reviewing and determining loan classifications.

When determining whether a loan should be classified, its record of performance to date should be considered. 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, when well-defined weaknesses exist that will jeopardize repayment, an examiner may classify a performing loan.

Typically, loan performance is based on whether the borrower is current on all principal and interest payments. However, in cases involving interest reserves, for example, the loan may be contractually current but the repayment of principal may be in jeopardy due to any number of factors, including slow sales, a decline in property values or the failure of leasing efforts. In these cases, adverse classification of the loan may still be appropriate.

Classification of Renewals and Restructed Mature Loans
Loans made to commercial borrowers often have short maturities. Borrowers whose loans mature in the midst of an economic crisis may have difficulty obtaining financing due to deterioration in collateral values despite their current ability to service the debt. In such cases, a financial institution may determine that the most appropriate and prudent course of action is to restructure or renew loans to existing borrowers who have demonstrated an ability to pay their debts, but who may not be in a position, at the time of the loan’s maturity, to obtain long-term financing.

However, since restructured loans tend to increase credit risk, each credit should be assessed based on its collectibility. Renewals or restructurings of maturing loans to commercial borrowers who have the ability to repay on reasonable terms will not be subject to adverse classification, but should be identified in the institution’s internal credit grading system, and will likely warrant close monitoring.

Classification of Troubled Collateral-Dependant CRE Loans
For a troubled 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 market value of the real estate collateral less the costs to sell should usually be classified as a “loss.”

Classification and Accrual Treatment of Restructured Loans with Partial Charge-Off
In some cases, a partial charge-off may occur as part of a restructuring process. The Policy Statement indicates that when well-defined weaknesses exist and have been identified, and when a partial charge-off has been taken, the remaining recorded balance for the restructured loan generally should be classified no more severely than “substandard.”

Regulatory Reporting and Accounting Considerations
The financial institution’s management is responsible for preparing accurate regulatory reports in accordance with GAAP, as well as all applicable regulatory reporting requirements and supervisory guidance. In conjunction with the review of the financial institution’s accounting and regulatory reporting, examiners will conduct an evaluation as to the accuracy of the institution’s internal credit scoring or grading processes. In this regard, the Policy Statement emphasizes that examiners must differentiate between credit risk management and accounting and regulatory reporting.

Implications for Interest Accrual
For a restructured loan that is not already in non-accrual status before restructuring, the Policy Statement indicates that the financial institution needs to consider whether the loan should be placed in non-accrual status.

Restructures Loans
The Policy Statement recognizes that in general, the restructuring of a loan should improve the likelihood that the credit will be repaid in full under the modified terms. However, all restructured loans should be evaluated by financial institution management to determine whether the proposed restructured loan should be reported as a Troubled Debt Restructuring (TDR). In accordance with the Policy Statement, a restructured loan is considered a TDR when the institution, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the institution would not otherwise consider. An overall general decline in the economy or a decline or deterioration in a borrower’s financial condition does not automatically mean that the borrower is experiencing financial difficulties. 

Allowance for Loan and Leases Losses (ALLL)
Financial institutions are required to estimate credit losses based on a loan-by-loan assessment for certain types of loans and on a group basis for the remaining loans in their portfolio. All loans that are reported as TDRs are deemed impaired and should be evaluated on an individual basis.

Generally, according to the Policy Statement, if the recorded amount of an individually assessed loan that is impaired, but not collateral dependent, exceeds the present value of expected future cash flows (discounted at the original loan’s effective interest rate), such excess is reported as a valuation allowance. With respect to an individually assessed impaired collateral dependent loan, if the recorded amount of the loan exceeds the fair value of the collateral, the excess is to be included in the financial institution’s ALLL.

For performing CRE loans, neither the Policy Statement nor other applicable supervisory policies require an automatic increase in the ALLL solely because the value of the collateral has declined to an amount that is less than the loan balance. However, the financial institution should consider declines in collateral values when calculating loss rates for affected groups of loans and when estimating loan losses and reserves.

For further information, please contact Timothy M. Sullivan, Michael D. Morehead or your regular Hinshaw attorney.

Tax Advice Disclosure: To ensure compliance with the Internal Revenue Service regulations governing the issuance of advice on Federal tax issues, we advise you that any tax advice in this communication (and any attachments) is not written with the intent that it be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code.

This alert has been prepared by Hinshaw & Culbertson LLP to prguaovide information on recent legal developments of interest to our readers. It is not intended to provide legal advice for a specific situation or to create an attorney-client relationship.