Joint Policy Statement on Commercial Real Estate Loan Accommodations and Workouts
By Neal Butala
On June 29, 2023, federal financial institution regulatory agencies, including the National Credit Union Administration (“NCUA”); Board of Governors of the Federal Reserve System (“Federal Reserve”); Federal Deposit Insurance Corporation (“FDIC”); and the Office of the Comptroller of the Currency, Treasury (“OCC”)(each an “Agency”, and collectively the “Agencies”) issued a final policy statement for prudent commercial real estate loan accommodations and workouts (“2023 Policy Statement”). The 2023 Policy Statement supersedes the Policy Statement on Prudent Commercial Real Estate Loan Workouts previously adopted on October 30, 2009 (“2009 Policy Statement”) by the Agencies along with the Federal Financial Institutions Examination Council (“FFIEC”) State Liaison Committee and the former Office of Thrift Supervision (“OTS”).
As the 2009 Policy Statement was released at the depths of the Great Recession, the issuance of the 2023 Policy Statement provides insight into the Agencies’ perception of the current state of the commercial real estate market which has been beleaguered by higher interest rates, vacancies, troubled loans, decreasing real estate valuations, and increasing delinquencies. In fact, over the past year, many commercial borrowers have simply chosen to walk away from mortgages and turn the keys over to lenders for distressed properties. Therefore, financial institutions should expect heightened scrutiny from Agency examiners of their commercial real estate loans and loan workouts programs. On the other hand, the Agencies are also concerned with ensuring that supervisory policies and actions do not inadvertently curtail the availability of credit to creditworthy borrowers. Consequently, the Agencies want to ensure that financial institutions have adequate regulatory guidance to navigate the current market and understand “…the approach examiners will use to review CRE loan accommodation and workout arrangements.”
The 2009 Policy Statement advised financial institutions that for those borrowers “…who have the willingness and capacity to repay their debts…”, financial institutions and borrowers may find it mutually beneficial to work constructively together. The 2009 Policy Statement was intended to (1) reassure financial institutions that they would not be criticized for implementing prudent loan workouts even if the restructured loans had weaknesses that resulted in adverse credit classification and (2) modified loans to borrowers who have the ability to repay their debts would not be subject to adverse classification solely because the value of the underlying collateral has declined. The 2023 Policy Statement is generally consistent with and reaffirms the 2009 Policy Statement and reiterates the importance of “…working constructively with CRE borrowers who are experiencing financial difficulty…”.
In addition to reaffirming the key principles of the 2009 Policy Statement, the 2023 Policy Statement addresses the Agencies’ expectations with respect to a financial institution’s handling of loan accommodation and workout matters including (1) risk management, (2) loan classification, (3) regulatory reporting, and (4) accounting considerations. Furthermore, 2023 Policy Statement incorporates the Agencies’ views on short-term loan accommodations, information about changes in accounting principles since 2009, and revisions and additions to the CRE loan workouts examples.
One of key changes from the 2009 Policy Statement to the 2023 Policy Statement is the distinction of short-term accommodations from long-term workouts. For the purposes of the 2023 Policy Statement, the Agencies declined to define short-term accommodation in part because of their case-specific nature and to allow financial institutions to greater flexibility in their approaches to dealing with borrowers. However, generally, short-term accommodations include any agreement to defer one or more payments, make a partial payment, forbear any delinquent amounts, modify a loan or contract, or provide other assistance or relief to a borrower who is experiencing a financial challenge. By contrast, the 2023 Policy Statement identifies renewals or extensions of a loan’s term, granting additional credit to improve prospects for overall repayment, and restructurings involving formal, legally enforceable modifications to a loan’s terms as examples of long-term workout arrangements. When offering short term accommodations, the 2023 Policy Statement encourages financial institutions to adopt prudent risk management practices and appropriate internal controls, including comprehensive policies and practices, necessary management approvals, an ongoing credit risk review function, and timely and accurate reporting obligations.
If short-term accommodations are not successful, the 2023 Policy Statement provides guidance for more complex, long-term, formal workouts arrangements. Formal loan workout programs should be carefully crafted to bolster a financial institution’s risk management practices as they relate to longer-term or more complex loan arrangements. An Agency examiner’s review of the effectiveness of a financial institution’s workout practices will focus on, among other things: whether the financial institution’s workout policy establishes appropriate loan terms that permit reasonable adjustments to the workout plan if the plan proves to be unsustainable; the effectiveness of management infrastructures that monitor the performance, volume and complexity of loan workout activities; and loan documentation standards that promote institution’s ability to verify borrowers’ creditworthiness.
It should be noted, the 2023 Policy Statement emphasizes that all workout arrangements should improve the financial institution’s prospects for repayment of principal and interest, be consistent with sound banking and accounting and comply with applicable laws and regulations. In considering whether to enter a formal workout, a financial institution should analyze a borrower’s repayment ability, evaluate the support provided by guarantors, and assess the value of any collateral pledged. Additionally, the 2023 Policy Statement recommends more detailed, forward-looking analysis of debt service coverage, including realistic projections of the borrower’s cash flow, as well as the availability, continuity and accessibility of repayment sources. The 2023 Policy Statement stresses that the primary focus of an Agency examiner’s review of a commercial real estate loan is an assessment of the borrower’s ability to repay the loan.
Another change from the 2009 Policy Statement to the 2023 Policy Statement is the evaluation of sponsors, in addition to guarantors, when assessing the quality of a loan. Where the 2009 Policy Statement was focused on the evaluation of guarantors, the 2023 Policy Statement provides that Agency examiners will review the finances and incentives of sponsors that support a loan, even if those sponsors are not legally obligated to repay the loan and acknowledges that such sponsors may be similar to a guarantor in terms of their capacity, willingness and incentives to pay debt service, to make principal curtailments, or to otherwise support a loan.
The 2023 Policy Statement goes on to address accounting changes and updates to GAAP since 2009, including changes relevant to estimating loan losses. Those changes include adding new accounting and regulatory guidance related to Current Expected Credit Losses (“CECL”) methodology (in light of the addition of the CECL methodology to GAAP, in accounting standards issued by the Financial Accounting Standards Board (“FASB”) in 2016), while removing all discussion of troubled debt restructuring (“TDR”) accounting as a result of the FASB’s decision to eliminate the reporting of TDRs completely, as of year-end 2023.
The 2023 Policy Statement also updates and adds to the 2009 Policy Statement’s appendix of illustrative examples of workout scenarios for commercial real estate loans, and the classification and accounting considerations applicable to those examples. Included in the appendix to the 2023 Policy Statement are (i) workout scenarios in the context of a loan secured by an income-producing hotel property; (ii) workout scenarios in the context of a loan for acquisition, development and construction of residential properties; and (iii) workout scenarios in the context of a loan secured by multifamily residential real estate.
While the 2023 Policy Statement does expand upon and update the 2009 Policy Statement, it leaves other aspects of the 2009 Policy Statement largely intact such as the assessments of collateral values, the evaluation of appraisals for loans involved in a workout, and the classification of renewals and restructurings of maturing loans and of loans dependent on the sale of collateral for repayment. Though the 2023 Policy Statement is mostly evolutionary in nature, it does provide valuable information into the Agencies’ priorities in evaluating a financial institution’s approach to troubled commercial real estate loans. If nothing else, the 2023 Policy Statement emphasizes the importance for financial institutions to work prudently with commercial real estate borrowers through all economic cycles.