SRC Insights: First Quarter 2010

Prudent Measures for Commercial Real Estate Workouts

by Sharon D. Wells, Examiner

It's no surprise that nonperforming assets (NPAs) and other real estate owned (OREO) levels in the Third District and the nation continue to rise as of the third quarter of 2009. Actual classification levels at many institutions may be higher, and workout activities and their associated costs are also on the rise. In response to the need for more robust workout programs and to provide institutions with insight into regulatory concerns, interagency regulatory guidance was issued in October 2009—SR Letter 09-7, Prudent Commercial Real Estate Loan Workouts (the guidance).¹ This article discusses the highlights of the guidance, and an article will appear in the second quarter issue of SRC Insights to provide a more detailed discussion of strategic loan workouts.

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Essential Elements of a Strong Workout Program

The guidance supports prudent workout activities that are designed to minimize losses and improve opportunities for recovery, identifies key risk management practices essential to a meaningful loan workout program, and provides expectations for loan restructuring activities. In addition, specific examples of workout situations, classification assignment, and regulatory reporting requirements are included as an aid to both bankers and examiners.

The guidance stresses that financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers' financial conditions will not be subject to criticism for engaging in these efforts, even if restructured loans have weaknesses that result in an adverse classification. In addition, examiners should evaluate a loan workout based on the fundamentals of the particular loan, taking into consideration the project's current and stabilized cash flows, debt service capacity, guarantor support, and other factors relevant to the borrower's ability and willingness to repay the debt.

Essentially, the guidance reinforces the need for institutions to maintain an overall problem loan management program that is reflective of the nature of an organization's lending activities and identifies several essential risk management elements, including the following:

An adequate management infrastructure to identify, control, and manage the volume and complexity of workout activities
Documentation standards to verify the borrower's financial condition and collateral values
Adequate management information systems (MIS) and internal controls to identify and track loan performance risk, including concentration risk and statutory, regulatory, and internal lending limits
Sufficient management oversight to ensure that regulatory reports are compliant
Effective loan collection procedures
Adherence to statutory, regulatory, and internal lending limits
Adequate collateral administration procedures to ensure proper lien perfection of collateral
An ongoing credit review function

Management infrastructure. The management infrastructure of a workout department may vary. Most commonly, a special assets committee is appointed to periodically monitor and review the success of workout strategies and the level of problem assets and routinely reports the results to the board of directors. Generally, a specific team of individuals separate from the relationship management/business development activities is responsible for handling collection activities and problem loans. The benefits of this approach are as follows:

It ensures objectivity in the loan disposition process.
It eliminates any conflicts of interest.
It provides a dedicated resource concerned only with loan collection.

Organizations that maintain a separate "watch" credit committee and staff experienced with workouts can anticipate future problems and implement loss mitigation strategies early in the process, potentially thwarting or reducing the velocity with which problem loans result in loss.

Financial and collateral documentation verification standards. A strong workout program will require a meaningful review of the financial condition of the borrower from a holistic perspective. This includes evaluating all affiliated relationships and exposures within the organization to determine the impact of these activities on the collectability of the loan as well as, when possible, the borrower's global exposure at other institutions. Comprehensive, current borrower financial information should be obtained.

Management information systems, internal controls, and regulatory reporting oversight. Management information systems should promote early detection of potential issues and ongoing tracking of delinquencies, problem loans, nonaccruals, ORE, property valuations, property taxes, insurances, occupancy changes, absorption rate changes, covenant compliance, LTV exceptions (Regulation H compliance), loan concentrations, etc., in order to monitor factors that affect the collectability of the loan (DCRs and LTVs), comply with regulatory guidance and statutory provisions (concentrations, LTVs, ORE), open up opportunities for negotiation of terms or acceleration of collections (covenant compliance), and ensure that collateral is perfected adequately.

Loan collection procedures. An institution that philosophically invests in collection procedures during the early stages of delinquency will have a better chance of reducing losses either through outright collection or early development of loss mitigation strategies. Emphasis should be placed clearly on those loans that represent the largest percentage of the institution's capital, with priorities highlighted within a written policy that reflects the economic benefits of the initiative levels. For smaller loans, an organization may determine that it is not economically advantageous to engage in collection procedures; in this instance, a charge-off strategy would prevail.

Collateral administration. Strong collateral administration practices are essential for institutions facing a high level of CRE loan delinquencies. Routine lien searches should be conducted, and mortgage recordings, UCC filings, and tax and insurance payment status for all problem loans should be evaluated and, if necessary, remedied as soon as possible. Institutions with high CRE concentrations should aggressively clear up any documentation deficiencies that may impact the institution's collateral position.

Ongoing loan review. An organization's first line of defense is a strong portfolio risk rating system and independent loan review function aimed at those lending sectors or markets where there are weaknesses or where the outlook is questionable. A system for downgrading or upgrading credits should be documented as part of any comprehensive policy and should include a control system that ensures that risk ratings are objective and accurately reflect the obvious or inherent weaknesses in the loan portfolio.

Restructuring Activities

Restructuring, modification, renewal, and/or extension activities are recognized as essential activities in the loan workout process, provided that they are designed to improve the prospect of repayment of principal and interest, and that they are "consistent with sound banking, supervisory and accounting practices." The guidance provides that these activities will not be criticized by regulators if the following supporting elements are in place and practiced effectively:

A written workout policy
A workout plan for each individual credit
A global borrower and guarantor debt service analysis
Loan terms that promote monitoring the borrower's performance against the restructured loan terms and expectations
An accurate internal loan grading and classification system
An ALLL methodology that estimates credit losses in restructured loans
Timely allocation of loan loss provisioning and recognition of loan loss

Workout policies. Institutions should have policies and procedures for problem loan workout and loss mitigation. Policies and procedures should include, at a minimum, circumstances and requirements for:

Terms for various workout programs, including extensions, re-aging, modifications, and re-writes
Requirements for analysis of financial capacity and debt service ability under new loan terms (see individual workout plans below)
Suggested and allowable loss mitigating strategies, including foreclosure
Appropriate MIS to track and monitor the effectiveness of workout programs and the performance of all categories of workout loans, including delinquency and loss tracking

Individual workout plans. Individual workout plans, or "action plans," provide a mechanism to encourage, memorialize, and report strategies to minimize loss. Workout plans should outline future activities aimed at reducing loss. Workout plans should be reviewed by management periodically and guided by the limits established by the central workout policy.

Individual workout plans should be based on an evaluation of the most currently known financial condition and repayment capacity of the borrower, the project, and the guarantors, as well as current collateral information. The guidance places emphasis on the use of global cash flow analysis to determine the debt repayment capacity of the borrower and guarantor, primarily to ensure that all cash flow requirements are considered. If restructuring activities are part of the plan, justification for the most appropriate loan structure, including terms, covenants, curtailments, etc., should be included.

Collateral documentation within the workout plan is necessary and should reflect the current "as-is" value of collateral based on its highest and best use and other factors that affect the value. Valuations utilized should be well supported and documented. Additionally, institutions should verify that discounts, or "haircuts," on appraised values should also be well supported and documented through market information and trends. Valuations that have been discounted and carried over for impairment analysis for provisioning or charge-off purposes must also be well supported.

Loan grading and classifications. In addition to these workout program considerations, the guidance also highlights classification parameters under general and restructured loan scenarios, but most importantly, the guidance serves as a reminder that "collateral deficiency alone does not warrant classification of a loan." Classification, first and foremost, should be predicated on well-defined weaknesses that jeopardize repayment of the loan. Most importantly, the guidance addresses the treatment of land acquisition and development (LAD) loans, where interest reserves have supported debt service on an otherwise stalled project. For these types of loans, fundamental weaknesses in the underlying source of repayment (i.e., lot sales) would warrant classification in the event that interest reserves prove insufficient, and there are no alternative sources of repayment to be gathered under formal restructuring arrangements. Severity of the classification also depends on a guarantor's ability to carry debt service on a project over an extended period of time, including principal reduction if the perceived time horizon for sellout is materially protracted or uncertain.

Loans where maturities have been extended based on a borrower's inability to refinance at the time of original maturity should be evaluated on a case-by-case basis, considering whether defined weaknesses jeopardize the loan repayment. An absence of available credit in the market alone would not warrant classification if the borrower is financially sound and demonstrates the ability to repay under reasonable terms.

Loans that are dependent upon the sale of the underlying collateral for repayment require collateral shortfalls to be classified as loss, premised upon the market value of the real estate less costs to sell with the covered portion of the loan generally classified as no worse than substandard. In some instances where pending events may exist, a doubtful category can be assigned (e.g., as additional financial information, an appraisal, or environmental site assessment are being evaluated).

For loans with partial charge-offs or bifurcated into "A" and "B" facilities, with the "A" facility having adequate repayment sources to fulfill the obligation and the "B" facility representing the equivalent of a deficiency note, the classification for the "A" note is based upon the presence of well-defined weaknesses that jeopardize the repayment source. Typically, the entire loan would have been classified prior to the restructure into two notes. Generally, a sustained period of performance is required to declassify any loan, even if it is bifurcated. In any case, any upgrade from classified status should be well documented, supported, and implemented in a controlled environment (i.e., subject to review by a designated authority or authorities, such as senior management, the board, problem loan management committees, etc., and confirmed by an independent function, such as loan review).

ALLL methodology. Regulatory emphasis on the ALLL continues to remain high, with particular emphasis placed not only on the level of the ALLL, but also on the methodology's compliance with GAAP under FAS 5 and FAS 114 and related regulatory guidance. SR 09-7 confirms the regulatory guidance detailed in SR 06-17, Interagency Policy Statement on the Allowance for Loan and Lease Losses, and SR 01-17, Interagency Policy Statement on Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions.² Lenders can also refer to sections 2070.1 and 2072.1 in the Commercial Bank Examinations Manual (CBEM) for further information.³

The guidance further reminds lenders that a decline in collateral value below the loan balance for a loan that is not primarily collateral-dependent (i.e., reliant upon the sale of collateral for repayment) does not require an automatic increase in the ALLL.

Regulatory Reporting and Accounting

The guidance also emphasizes that institutions must comply with regulatory reporting requirements, GAAP, and supervisory guidance, and that an adequate governance and internal control structure must be in place. This structure should include written policies and procedures that provide clear guidelines on accounting matters. The guidance emphasizes the need for accurate reporting of nonaccruals, restructured loans, and charge-offs.

The accrual status of a restructured loan should be based on the borrower's sustained ability to demonstrate satisfactory repayment status. Loans on nonaccrual that have been restructured and are demonstrating adequate repayment histories and ability should maintain a sustained period of repayment performance (typically six months minimum).

All restructured loans should be evaluated to determine whether they should be classified as a troubled debt restructuring (TDR). Mechanisms to identify, monitor, and report TDRs should be incorporated into workout processes and procedures, and TDRs should be identified as part of any restructuring requests and should be accounted for and reported properly. An easy way to monitor TDRs is to add a simple checklist to all loan approval memorandums highlighting the four primary conditions identified in FAS 15 and the CEBM under Section 2040.1. A loan identified as a TDR on the loan approval document can be added to a centralized reporting system, preferably the loan accounting system, to ensure that it is accurately monitored and incorporated within the call report.

Finally, confirmed loan losses should be charged to the ALLL as soon as they are identified, recalling that the guidance emphasizes that a reduction in collateral value alone is not a reason for classifying it, determining impairment, or rendering a charge-off.

Summary

As problem loans and workout activities continue to increase, regulatory scrutiny over the adequacy and effectiveness of workout programs is on the rise. Lenders are encouraged to review the newly developed guidance to enhance current workout practices at their institutions and to gain insight into the supervisory and regulatory emphasis and expectations for examinations. A number of helpful examples and scenarios are provided to help illustrate the principles of the guidance under practical application.

Lenders who wish to review the subject guidance and other SR Letters can go to the Board of Governors' website. If you have any questions on this guidance, please contact Sharon D. Wells at (215) 574-2548 or your assigned Third District portfolio manager.

¹ SR Letter 09-7, Prudent Commercial Real Estate Loan Workouts, is available on the Board of Governors' website.
² Supervision and Regulation letters are available on the Board of Governors' website.
³ The current Commercial Bank Examination Manual is available online.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.