Oct. 25, 2013
On Oct. 24, 2013, the federal financial institution regulatory agencies – the Federal Reserve (Fed), Federal Deposit Insurance Corp. (FDIC), National Credit Union Administration (NCUA), and Office of the Comptroller of the Currency (OCC) – jointly issued “Interagency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings.” The agencies aim to clarify certain issues related to the accounting treatment and regulatory classification of commercial and residential real estate loans that have undergone troubled debt restructurings (TDRs).
The guidance reiterates important aspects of previously issued guidance. In addition, it includes information about the definition of collateral-dependent loans and the classification and charge-off treatment for impaired loans, including TDRs. In addition, the guidance states, “The agencies generally will not criticize financial institutions for engaging in prudent workout arrangements.”
Significant points addressed in the guidance include the following.
- A nonaccrual loan modified in a TDR need not remain on nonaccrual status for the life of the loan. The financial institution can return the loan to accrual status if it meets certain criteria, including performing a current, well-documented credit analysis based on the borrower’s financial condition and prospects for repayment. In addition, the analysis must evaluate whether there is a sustained period of repayment performance – generally a minimum of six months.
- An accruing loan modified in a TDR can remain on accrual status provided the institution performs a current, well-documented credit analysis, collection under the revised terms is reasonably assured, and the borrower has demonstrated sustained historical repayment performance. However, the agencies noted that a history of interest-only payments may raise questions about the borrower’s ability to service the debt under a TDR.
Regulatory Credit Risk Grade or Classification
- Credit risk grade and TDR analysis are separate and distinct, but related, decisions. Although TDR designation means the loan is impaired for accounting purposes, it does not automatically result in an adverse classification or credit risk grade.
- The institution should perform a well-documented assessment of the cash flows available to service the modified debt, including any collateral protection and guarantor support, to determine the classification or credit risk grade.
Collateral-Dependent Loan Definition and Impairment Measurement
- Any loan modified in a TDR is, by definition, impaired. However, not all impaired loans are collateral dependent. For regulatory reporting purposes, an institution must measure impairment using the fair value of the collateral if the loan is collateral dependent. A loan is considered collateral dependent if the repayment is expected to be provided solely by the underlying collateral, through liquidation or operation of the collateral. Nominal payment from other sources is not sufficient to change the classification from collateral dependent. An example of a collateral-dependent loan is an impaired loan secured by an apartment building or shopping mall where the cash flows are derived solely from the rental income of the property. An example of a noncollateral-dependent loan would be an impaired loan secured by owner-occupied commercial real estate (for example, a manufacturer or retailer) where the cash flows are derived from ongoing business operations, provided such cash flows are sufficient to service the debt.
- An institution must measure impairment based on the fair value of the collateral, less costs to sell if applicable, regardless of whether foreclosure is probable.
Classification and Charge-Off Treatment: Impaired Loan That Is Collateral Dependent
- For an impaired loan that is collateral dependent, charge-offs should be taken in the period in which the loan, or portion of the loan, is deemed uncollectible, and any portion of the loan not charged off should be adversely credit risk rated no worse than substandard.
- While a doubtful classification or credit risk grade for the full amount of the loan can be used when certain pending circumstances exist, the agencies noted that such risk grading should be used infrequently and for a limited time to permit the pending events to be resolved.
Impairment Measurement: Impaired Loan That Is Not Collateral Dependent
- When measuring impairment on an impaired loan that is not collateral dependent, institutions must use the present value of expected future cash flows method. As a practical expedient, however, the creditor may measure impairment based on the loan’s observable market price.
- It should not be presumed that the contractual payments under a newly modified loan represent the expected cash flows. As such, institutions should consider default and prepayment assumptions and other environmental factors when estimating expected cash flows. For balloon payments, institutions should consider the borrower’s ability to satisfy the payment through refinancing or payment. When no sources of cash flows are reasonably expected to be available to support the assumption that the borrower will be able to repay or refinance, an acceptable approach is to consider the fair value of collateral, less cost to sell, as the terminal payment. The terminal payment should not exceed the total balloon payment.
Classification and Charge-Off Treatment: Impaired Loan That Is Not Collateral Dependent
- For an impaired loan that is not collateral dependent, disbursements by a financial institution to protect its collateral position (for example, real estate taxes and insurance) can be capitalized, provided that it is permissible under the applicable loan agreement. Such disbursements increase the amount of the recorded investment, which is the basis for measuring impairment.