On June 30, the Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”), Office of the Comptroller of the Currency (“OCC”) and the National Credit Union Administration (“NCUA”) (collectively, the “Agencies”) issued a joint Policy Statement on Commercial Real Estate Loan Accommodations and Workouts (the “Policy Statement”), calling for financial institutions to work prudently with borrowers facing financial distress. The Policy Statement updates and supersedes the previous guidance issued in 2009 (the “2009 Guidance”).
The Policy Statement is substantially similar to the Interim Policy Statement (the “Interim Statement”) the Agencies proposed last year. Despite over a decade between the 2009 Guidance and the Policy Statement, the Agencies are reaffirming the central tenets of the 2009 Guidance—encouraging financial institutions to work with borrowers facing financial distress by implementing loan workouts and accommodations backed by, among other things, adequate disclosures, prudent risk management practices, and comprehensive loan classification and valuation policies. As discussed below, the Policy Statement, however, is more favorable to lenders in many respects than the 2009 Guidance.
The Policy Statement is especially timely in light of the liquidity crunch exacerbated by recent bank failures in March of this year, including Silvergate Bank, Silicon Valley Bank, Signature Bank and others. Perhaps masked by such recent bank failures, lending was falling. Rising interest rates and decreasing collateral values from rising cap rates are pressuring lending and creating latent risk to asset values. This is especially concerning for community and regional banks, with commercial real estate (“CRE”) loans making up nearly 30% of regional banks’ assets, as of May 2023, compared with only approximately 6% at “big banks.”1
Not only are regional banks potentially exposed due to their real estate portfolio composition but they are also more profoundly experiencing the “liquidity crunch.” With customers moving their deposits from regional banks to banks “too big to fail” and to money market mutual funds, regional banks saw a negative deposit growth in the second quarter of 2023.2 The concern around rising interest rates has caused a pullback in lending, especially in commercial real estate portfolios.
The regulators have taken notice of such risks. Regulators have made it clear in recent months that CRE portfolios are a focus, particularly among banks with large concentrations. “We have a long-standing expectation, this is interagency, that CRE-concentrated banks should look at their own performance in a downturn. And so, we're scrutinizing that very vigorously,” Todd Vermilyea, senior associate director of the FRB’s Division of Banking Supervision and Regulation, said June 16, 2023. Martin Gruenberg, chairman of the FDIC, said at the release of the FDIC's most recent Quarterly Banking Profile that CRE would be a significant focus for his agency, calling it “a matter of ongoing attention in our supervision work.”3 Peter Dugas, head of the Center of Regulatory Intelligence at financial consulting firm Capco further stated that “when it comes to CRE, it’s really going to be a regional issue. When you look at banks that are operating in states like Florida and Texas and some areas within the South ... they’re in much better shape than states like California or New York or Illinois.”4 Although CRE loan scrutiny has always been a consistent focus for the agencies, “the pendulum is swinging more towards activism,” said Carleton Goss, partner with Hunton Andrews Kurth LLP.5
Thus, bankers should be proactive in addressing areas of concern. The Policy Statement is the handbook for underwriting, ongoing monitoring and workouts. This is particularly relevant because the increase in interest rates reduces prospects for loans to meet the minimum 1:1 debt service coverage ratio required to avoid classification. Further, the Policy Statement presents valuable guidance in an era of rising cap rates and declining occupancy of certain property types as a loan will not be classified simply because property values decline if lenders follow the Agencies’ guidance.
The Agencies recognize that prudent commercial real estate accommodations and workouts are often in the best interest of both the lender and the borrower. Therefore, the Policy Statement reaffirms key principles from the 2009 Guidance:
- banks that implement prudent CRE loan accommodation and workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts, even if these arrangements result in modified loans that have weaknesses that result in adverse classification;
- modified loans to borrowers who have the ability to repay their debts according to reasonable terms will not be subject to adverse classification solely because the value of the underlying collateral has declined to an amount that is less than the outstanding loan balance; and
- examiners will not create their own property valuations unless the assumptions underlying are clearly flawed.
In addition to reaffirming these key principles, the Policy Statement has five main benefits over 2009 Guidance:
- the inclusion of favorable guidance on short-term modifications;
- elimination of Troubled Debt Restructurings (“TDRs”);
- explicit consideration allowed for sponsors;
- the examples in the Policy Statement are more lenient; and
- examiners should consider local and state markets rather than “general market conditions” when analyzing CRE loans and determining borrowers’ ability to repay.6
The Policy Statement now, really for the first time, includes favorable guidance on short-term accommodations, informed in large part by the banking industry’s experiences with borrowers during the COVID-19 pandemic and the subprime crisis before it. The Policy Statement further updates discussions of accounting treatment of commercial real estate loans in light of the implementation of the Current Expected Credit Loss (“CECL”) for estimating allowances for credit losses. The CECL methodology eliminates the use of TDRs, a loan classification previously used for loan modifications. The Policy Statement reflects the elimination of the TDR classification. Because examiners’ practice seemed to be to classify TDRs, the changes pursuant to CECL are most welcome.
The Policy Statement addresses supervisory expectations related to loan accommodations and workouts on matters including: (i) risk management, (ii) loan classification, (iii) regulatory reporting and (iv) accounting considerations. The Policy Statement is prescriptive, describing in detail what the Agencies expect with respect to, among other things, a workout policy, individual loan workout plans, documentation, ongoing monitoring, loan classification and collateral valuation, and accounting analysis, etc.
Regarding risk management, the Policy Statement reflects the Agencies’ view that the adequacy of management information systems (“MIS”) and internal controls are critical to escape regulatory criticism while entering into loan modifications and workouts with distressed borrowers. Informed by the Policy Statement, best practices for information gathering and MIS include, among others:
- formal policies and procedures for more frequently communicating with higher risk borrowers to obtain updated business information;
- updated and comprehensive financial information on the borrower, real estate project and any guarantor/sponsor;
- maintaining current valuations of the collateral and a market analysis of pandemic-effected businesses;
- monitoring of loans that are not classified;
- documentation of conditions, ongoing reporting and other terms of the modification;
- documenting mitigating factors, all communications with borrowers, exceptions to policy limits and analysis of loan performance and repayment capacity as well as sustainability of financial performance;
- setting parameters, including limits and policies for exceptions, for loan workout and accommodation policies; and
- setting sublimits for critical information such as debt service coverage ratios, loan-to-value and amortization period.
In addition to the valuable guidance provided on, among other things, MIS and documentation gathering, the Policy Statement is more accommodating of lenders than the 2009 Guidance by: (i) allowing lenders to rely on sponsors whereas the 2009 Guidance spoke only to reliance on guarantors and (ii) including greater reliance on the use of the other assets especially mentioned (“OAEM”) classification introduced by the OCC and the FDIC in 2013. These concepts, along with the other favorable treatment within the Policy Statement, is reflected in the included hypotheticals.
A hypothetical to the Policy Statement details the following situation:
A lender originated a $4.8 million acquisition and development loan and a $2.4 million construction revolving line of credit, both with a three-year maturity, for a residential real estate project. Development was delayed due to various issues but the demand for housing remained unchanged. Due to such delays, the lender waived the curtailment requirements for both loans. At maturity, the loans were renewed at market rate. Due to the delays, the interest reserve for the A&D (acquisition and development) loan is depleted and the borrower has made payments out-of-pocket. Once development [was] completed, borrower and guarantor liquidity was able to cover any shortfall and the lender estimated that the property’s current “as complete” value resulted in an 80% loan-to-value ratio.7
Despite the modification to the loan, both the lender and the examiner graded the loan as a “pass” due to the borrower’s and guarantor’s ability to continue making payments on reasonable terms. However, during the subprime crisis, this loan would have been a classified loan.
Another hypothetical to the Policy Statement details the following situation:
A lender originated a 36-month, $10 million loan for the construction of a shopping mall. The construction period was 24 months with a 12-month lease-up period to allow the borrower time to achieve stabilized occupancy before obtaining permanent financing. The loan had an interest reserve to cover interest payments over the three-year term. At the end of the third year, there is $10 million outstanding on the loan, as the shopping mall has been built and the interest reserve, which has been covering interest payments, has been fully drawn. The lender renewed the loan for an additional 12 months to provide the borrower time for higher lease-up and to obtain permanent financing. Leases continued to increase but takeout financing was tight.8
The Policy Statement notes that the examiner would list the loan as an OAEM, not a pass credit, because: (i) cash flow only covered interest payments and (ii) there was considerable uncertainty surrounding takeout financing. Again, in the subprime era, our experience is that this would have been a classified loan. Many bankers will gladly reach for OAEM over the possibility, as has been the case, of a “substandard” classification.
Added to the Policy Statement based on industry commentary to the Interim Statement, was the following succinct summary:
“Proactive engagement by the financial institution with the borrower often plays a key role in the success of the workout."
In short, the Policy Statement offers a “carrot and a stick.” Banks that seek to defer judgments by refraining from obtaining information will see management ratings fall and classification levels actually increase. On the other hand, banks that have a robust credit function that obtains the requisite information will be able to take advantage of the Policy Statement. They will, at a minimum, have a better basis for arguing commercial real estate loan grades. Ideally, the Policy Statement will provide such banks more deferential treatment by examiners. At least that is how it is supposed to work.
1 Engler, H., For US regional banks, commercial real estate is seen as next big worry, Thomson Reuters (May 1, 2023) https://www.thomsonreuters.com... Reserve H.8 Data & research by Keefe, Bruyette & Woods. All data as of latest H.8 publication on May 24, 2023.
3 Bennet, A. & Mangulabnan, X., Banks face growing regulatory pressure to address risky CRE portfolios, S&P Capital IQ (July 17, 2023).
6 This benefit was a result of commentary by industry participants, noting that the consideration of local market conditions is consistent with the existing real estate lending standards or requirements issued by the Agencies.
7 FIL-36-2022, Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts, pgs. 56–62.
8 Id. at pgs. 44-46.