By Erich Paetsch, Chair, Financial Services Industry Group
At the start of the Great Recession, the Federal Financial Institution Examination Counsel agencies (“FFEIC”) adopted a Policy Statement on Prudent Commercial Real Estate Loan Workouts (“2009 Statement”). The 2009 Statement was a useful tool for financial institutions to understand risk management and accounting practices for commercial real estate (“CRE”) loans. Many CRE lending policies and procedures incorporate the 2009 Statement today.
The volume of commercial real estate loans held by financial institutions is at a historic high. As many lenders also know, the COVID-19 pandemic created stress in multiple CRE property types including hospitality, assisted care, office, retail and entertainment, among others. Combined with a rapidly changing interest rate environment, the FFEIC agencies recognize that some borrowers may have difficulty refinancing and CRE portfolios are at increasing performance risk.
Given the increasing and different risks, the FFEIC updated the 2009 Statement on June 30, 2023 (“2023 Update”). The 2023 Update includes significant changes with a particular emphasis on loan accommodations, accounting treatment changes, and removal of troubled debt restructuring (“TDR”) reporting.
Among other changes, the FFEIC wants financial institutions to implement prudent CRE loan accommodation and workout arrangements after completing a comprehensive review. The 2023 Update states that doing so should not result in regulator criticism, even if such arrangements result in modified loans and an adverse loan classification. In addition, modified loans with borrowers who can repay according to reasonable terms will not be subject to adverse classification simply because collateral values have fallen below the loan balance. While the 2023 Update does not specify what constitutes a comprehensive review or reasonable payment terms, it does include new examples for reference.
In addition to updated examples, a general discussion of what constitutes a comprehensive review is also included. Among other suggestions:
- obtaining updated financial information from borrowers and guarantors
- a current valuation and inspection of CRE and other collateral
- an updated evaluation of the financial viability of the CRE project
- a review of loan structure with an emphasis on covenants, curtailment and re-margining
- appropriate legal review and analysis including use of and legally prepared agreements
- maintaining internal risk rating or loan-grading systems
There is also an extensive discussion in the 2023 Update on how to evaluate CRE collateral values. For example, for CRE loans in a workout, the following factors are highlighted as part of a prudent evaluation of whether there is market deterioration in a comprehensive review:
- Project performance
- Conditions for the geographic market and property type
- Variance between actual and appraisal projections
- Changes in project specifications
- Loss of a significant lease or take-out commitment
A concern with the 2023 discussion about collateral value is the potential cost of obtaining new appraisals. The 2023 Update does state that new appraisals may not be required if an internal evaluation updates original appraisal assumptions to market and includes a reasonable current estimate of fair value. Whether a new appraisal is required will vary depending on whether a loan accomodation or loan workout is involved, among other factors.
The 2023 Update also defines and draws a clear distinction between “loan accomodations” and “loan workouts”. The FFEIC considers a loan accomodation a short term or temporary accomodation before a workout occurs and includes payment deferments, partial payments, forbearance of delinquent amounts and modification of loan terms. When a loan accomodation is insufficient, the FFEIC considers longer term or more significant arrangements for a loan workout. Loan workouts vary widely based upon the circumstances and needs of lenders and their borrowers, but they are typically longer in duration and include renewing or extending credit terms and granting additional credit to improve the prospect for overall repayment or restructuring loans.
The other major change in the 2023 Update concerns accounting practices. Among other changes, the 2023 Update incorporates changes to general acceptable accounting principles including the following:
- Changes to the current expected credit loses methodology
- Removal of references to TDR discussion effective at the start of 2024
- Updates to supplemental call report instructions
The 2023 Update is a useful tool for lenders. It is a timely reminder that the conditions and concerns for lenders in the Great Recession do not exist in today’s softening post COVID economy. The 2023 Update highlights the importance of lending institutions reviewing their existing CRE loan policies and procedures. Lenders updating practices and ensuring a comprehensive review in a prudent manner can limit regulatory scrutiny and limit losses.
Erich Paetsch is a partner in the Creditor’s Rights and Bankruptcy Practice Group and chair of the Financial Services Industry Group. The information in this article is not intended to provide legal advice. For professional consultation, please contact Erich at Saalfeld Griggs PC. 503.399.1070. © 2023 Saalfeld Griggs PC