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Signs of credit quality weakness are beginning to appear in certain CRE sectors. Delinquencies, charge-offs, and ORE levels are rising after a period of relatively benign credit conditions. Banking organizations are tightening lending standards on CRE loans, and many are anticipating CRE loan portfolio deterioration in 2008. 1
In the Third District, residential construction and land development loans comprise a significant portion of some institutions' loan portfolios. Recently, this loan type has seen significant stress, as single family residential home and condominium sales have slowed and inventory levels have swelled. Market prices in some areas are now declining, creating greater leverage and builder/developer cash flow constraints.
Outside of residential construction, most CRE sectors continue to show stable vacancy rates, good net absorption levels, and supportive rental rates. However, some other CRE sectors may not be immune over the long run, and a gradual weakening in overall CRE conditions could be on the horizon.
As lenders look for economical solutions to minimize credit losses in an unstable environment, loan restructurings may become more prolific, and these restructurings may qualify as troubled debt restructurings (TDRs). This article is the first in a two-part series on TDRs and will focus on defining TDRs and managing the associated risk. Part II will appear in the second quarter issue of SRC Insights and will focus on the accounting and regulatory aspect of TDRs.
The term troubled debt restructuring was first introduced with Statement of Financial Accounting Standard 15 (FAS 15) in 1977. FAS 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, as amended by FAS 114, Accounting by Creditors for Impairment of a Loan, defines the activities which constitute a TDR and the prescribed accounting and disclosure requirements. If consistent with prudent lending principles and supervisory guidance, TDRs can improve a bank's collection prospects and assist financially-challenged borrowers.
FAS 15 defines a TDR as a restructuring of a debt when a "creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that would not otherwise be considered." According to FAS 15, "whatever the form of concession granted by the creditor to the debtor in a troubled debt restructuring, the creditor's objective is to make the best of a difficult situation. The creditor expects to obtain more cash or other value from the debtor, or to increase the probability of receipt, by granting the concession than by not granting it." 2
In short, TDRs are compromises ("concessions") that lenders make to improve collectibility or reduce losses on problem loans. These concessions emanate from a borrower's deteriorating financial condition, which in turn prompts the lender to focus on achieving the maximum recovery. Typically, TDRs result from a borrower's inability to repay or meet the contractual obligations under the loan. This predominantly occurs because of cash flow difficulties arising from events such as: the loss of a key contract; unanticipated slow-downs in absorption rates; unanticipated or excessive costs like legal fees or R&D; and, in some cases, poor management.
TDRs are required to be supported by a formal written agreement and can be used to either fully or partially satisfy a loan. FAS 15 identifies the following restructuring activities, which qualify as TDRs:
The most common type of TDR is the "modification of terms." Granting of equity interests in a TDR is less common due to restrictions within Regulations H and Y, which limit state member banks and bank holding companies from retaining equity positions in nonaffiliated companies.
It is important to recognize that not all debt restructuring is considered "troubled." Loan renewals or extensions at interest rates that are equal to the current interest rate or a market rate of interest are not considered renegotiated debt. The factor that ultimately defines a "troubled" situation is a deterioration in financial condition or cash flow. Typically, a borrower that qualifies for a TDR is unable to refinance the debt with another institution at a rate of interest that it can afford to pay, if at all.
Credit Risk Management
Management should apply prudent lending standards and develop policies and procedures to address TDRs as part of its credit risk management program. Ideally, TDRs should occur infrequently and should serve predominantly to protect the bank's investment. Prudent risk management activities associated with TDRs are: written policies and procedures, management oversight, monitoring and reporting, and loan review and audit.
Policies and procedures. As part of a comprehensive risk management program, management should develop policies and procedures for TDRs to ensure that loans are properly identified, monitored, accounted for, and controlled. Policies and procedures should complement the provisions set forth in FAS 15, as well as Statements 5, 114, and 118. Banks are encouraged to establish policies that provide a framework of limits for concessions and that establish approval authorities for the final granting of concessions. Policies and procedures will depend on the institutional profile and the magnitude of problem loan levels and high-risk activities inherent in the portfolio.
Management oversight. TDRs should be identified and monitored closely by management. When resources are available, an institution may assign a loan categorized as a TDR to someone independent of the relationship management function, such as a designated workout officer. In other instances, where a borrower has a good chance of returning to financial health, the loan may remain with the relationship manager. Regardless of the day-to-day management structure, executive management and the board of directors should routinely review reports highlighting the level and trend of TDRs, performance updates, action plans, and loan review reports. It is also good practice for the board of directors, or committee thereof, to approve all concessions offered as part of a TDR, especially if TDRs become increasingly common or represent a significant level of exposure. 3
Monitoring and reporting. The development of systems to track problem loans and TDR activities provides management with valuable information to make strategic decisions and manage risk. Furthermore, management should clearly assign responsibility for monitoring and maintaining the tracking system for TDRs. Because borrowers whose loans are subject to TDRs are typically adversely rated or considered high risk, bank managers are encouraged to develop individual action plans that set objectives and timeframes and monitor each borrower's progress after the debt is restructured. TDRs also require strict quality controls in loan administration and operations to ensure compliance with the modified terms of the loan. In addition to payment monitoring, ticklers should be implemented to ensure that collateral remains protected. Ticklers that monitor real estate tax payments, insurance coverage, UCC filings, escrows, and other pledged assets like securities are essential components of a strong portfolio management system.
Loan review and audit. Internal control functions, such as loan review and audit, provide strong independent sources of information regarding the quality of the bank's loan portfolio and its conformity with accounting and regulatory requirements. The loan review function can provide an independent assessment of TDRs, including the appropriateness of classifying a loan as a TDR, in addition to evaluating the assigned risk rating. If a loan review unit finds that the level or trend of TDRs is high, or that the same loan(s) are being restructured multiple times, systemic problems may be evident. In that case, the observations made by loan review should be referred to the board of directors for review and, possibly, further action.
The audit function should perform a review to ensure that TDRs have been recorded properly in the financial statements, and that the ALLL has been calculated in accordance with FAS 5 and FAS 114. In addition, audit should verify the accuracy of the Call Report with respect to TDRs.
As concerns over credit quality emerge out of a weakening economy, the volume of restructured loans is expected to increase. Troubled debt restructurings can provide an acceptable and more economic alternative to payment demand or foreclosure. For further information regarding the accounting provisions of FAS 15, FAS 114, FAS 5, FAS 118, and the Call Report requirements for TDRs, contact Eddy Hsiao at (215) 574-3772. For further information regarding Third District market trends, contact Bob Rell at (215) 574-4382.
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.