At the end of the day, what really drives lender decisions with regard to addressing problem loan modifications, workouts, and restructuring issues revolves around the impact of those decisions on the financial statements condition of the institution.
Likewise, the regulatory and accounting treatment behind those decisions tends to dictate policy and procedure for the CRE lending and workout areas of the bank.
If a CRE credit is restructured or modified because the debtor is unable or unwilling to pay as agreed, the institution must deal with the specter of having the debt designated a “trouble debt restructuring” (“TDR”), and all loans whose credit terms are modified in the TDR process, including both commercial and retail loans, must be evaluated for “impairment” under FAS 114.
FAS 15 defines a TDR basically as a restructuring in which a bank, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that the bank would not otherwise consider. That includes a modification of the terms of a loan that provides for a reduction of either interest or principal. FAS 114 requires that all TDR’s be “evaluated for impairment”, which includes securing appropriate updated valuations for collateral consisting of real estate. A loan is “impaired” when, based on current information and events, it is probable that an institution will be unable to collect all amounts due according to the contractual terms of the loan agreement. For restructured troubled loans, all amounts due according to the contractual terms means the contractual terms specified by the original loan agreements, not the contractual terms specified by the restructuring agreement. Therefore, if impairment is measured using an estimate of the expected future cash flows, the interest rate used to calculate the present value of those cash flows is based on the original effective interest rate on the loan, not the rate specified in the restructuring agreement.
Documenting the severity of the “impairment” for CRE credits would typically entail updating any relevant appraisals on real property held as collateral and, in the current market, there is a very real possibility (if not likelihood) that CRE collateral value may well have declined from the time the loan was made.
The financial impact of designating a credit as a TDR in a “normal” market brings with it the likelihood of needing to allocate additional reserves for the credit, but in the current “challenging” market (with declining real estate values) the concept of a TDR is especially troublesome. FAS 5 sets forth parameters on how such loans are treated for purposes of the institution’s allowance for loan and lease losses (“ALLL”). And similar loans in a portfolio may qualify for “wholesale” treatment (including ALLL treatment) depending on whether they have sufficiently similar risk characteristics, subject to certain limitations.
In all instances, the institution is required to document its consideration of the matter and be prepared to support its measurement of impairment and resulting financial impact.
Having to write down the asset to the underlying collateral (impaired) value when there is no likelihood of cash repayment can have devastating financial results for the institution, again especially in a market where the collateral value may well be less than the value when the credit was originated.
Each of the federal banking agencies has announced that they will be focusing on TDR’s and “impairment”, and emphasizing updated appraisals for all TDR’s, in coming exams. That focus may well have a profound impact on the earnings of most, if not all, lending institutions with significant CRE portfolios.