I’m From The Government And I’m Here To Help
“The check is in the mail!” Like many similar sayings, it takes time to know if it’s really true. Just like, “I’m From The Government And I’m Here To Help”.
It’s the same case with the recent policy statement published by the FDIC in July. This was in concert with the Office of Comptroller of the Currency. Also along with the Board of Governors of the Federal Reserve, and the National Credit Union Association. The policy is entitled, “Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts.” Given the length of the title and the use of the term “prudent”, it might take longer than normal to make the call on accuracy.
Discipline in Commercial Loan Portfolios
Over the last several months our blog topics have focused on the need to be especially vigilant in managing the commercial loan portfolio. In particular, some of the more vulnerable segments of the commercial real estate portfolio. We have emphasized the need for disciplined credit underwriting. Also, consistent credit monitoring, stress testing of financial performance, and staying in tune with changes in collateral values. Apparently, the regulators at the FDIC agree!
In a July 24, 2023, Wall Street Journal article by Peter Grant, “Bank Regulators Urge Flexibility in Commercial Real Estate Loan Workouts as Defaults Grow,” the new interagency guidance was developed over concern for “the tidal wave of troubled commercial real estate loans.” The data firm Trepp estimated that over $1 trillion worth of commercial real estate loans are expected to come due during 2023 and 2024. At issue is that many of these loans were made when interest rates were at historic lows. Whereas now rates have increased 5.25% since March of 2020. They continue to expect to trend higher as the Fed attempts to curb persistent inflation concerns.
New Policy Items
At the core of the new policy, the examiners will not criticize a financial institution for efforts to implement reasonable and appropriate loan workout arrangements. Even if the restructured loan has weaknesses that result in an adverse credit classification. Further, examiners would not adversely classify renewed or restructured loans to borrowers solely because the value of the collateral securing the loan had declined below the loan balance when the borrower has the capacity to repay the debt in accordance with reasonable modified terms. The 90-page guidance document includes appendices with numerous examples of loan modifications in various industries to illustrate the guidance.
There are two key changes from previous guidance documents. First is the addition of a definition of short-term or temporary loan accommodation. This is compared to a long-term and complex workout and/or restructuring. The policy statement identifies loan modifications to defer payments, make partial payments, forebear on delinquent loan amounts, temporarily modify a loan, or to provide other short-term assistance to a borrower experiencing a financial challenge as an example of a short-term accommodation. By contrast, renewals or extensions of a loan’s term, granting additional credit to improve prospects for overall repayment, and restructuring (with or without concessions) are considered a long-term workout arrangement.
Another area of focus was to provide additional clarity (if possible) on support provided by guaranties from financially sound guarantors in determining credit classifications for workouts. The new policy also goes a bit further than previous guidance. It will extend this analysis to “sponsorship” of commercial real estate borrowers. The focus in both cases is on the capacity, willingness, and incentives to pay debt service and principal payments or otherwise support the loan. Part of this analysis would be for the financial institution to analyze the borrowers. By extension, the guarantor’s global debt service coverage, also.
Prudent Loan Accommodations
It is worth noting that although the policy statement allows institutions a degree of flexibility for short-term loan accommodations. The guidance also makes abundantly clear that up-to-date risk ratings are part of the definition of “prudent” loan accommodations. Page 20 of the guidance document states “prudent risk management practices and internal controls include …. updating and assessing financial and collateral information”. Along with “maintaining an appropriate risk rating framework.” Later, the policy states that while “loans to sound borrowers that are modified in accordance with prudent underwriting standards should not be adversely classified by examiners unless a well-defined weakness exists,” such loans could be “flagged for management’s attention or for inclusion on designated watch lists” to assure that these loan receive closer monitoring (page 31).
Thoughts on New Policy
As one can imagine, there are varied opinions on the new policy guidance. Proponents praise the changes “as a bridge to the other side”. And it is just what commercial real estate borrowers have been looking for. On the other hand, critics claim that financial institutions are simply postponing the inevitable problems. This is with an “extend and pretend” mentality. In all likelihood, we will probably find examples of both. As borrowers and lenders navigate some rough waters over the coming renewals, we will see. As we noted in the beginning of this post, it may take a bit longer than usual to separate the “truth and the lies.” That said, the team at Enlighten Financial is ready, willing, and able to assist you. We will review and assess your commercial real estate portfolio. We will look for vulnerabilities and assist with recommendations of “prudent loan accommodations and workouts.”
Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.
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