Federal Policy Statement Regarding Commercial Real Estate Loans
Increasing interest rates coupled with post-COVID work-from-home trends and the consequent decreased use of commercial space has resulted in an increase in defaults of commercial real estate (“CRE”) loans. To enhance transparency of CRE loan accommodation and protect the availability of credit for otherwise sound borrowers, on June 30, 2023, the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency issued a joint Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts (the “Policy”), encouraging commercial lenders to work with borrowers to decrease the rates of default on their loans.
The Policy, which serves as an update to a similar statement issued in 2009 in the aftermath of the Great Recession, provides guidance on the agencies’ supervisory expectations with respect to financial institutions’ handling of CRE loan accommodation and workout matters. Of particular note is the Policy’s guidance on risk management, loan classification, regulatory reporting, and accounting considerations. The Policy further reaffirms certain aspects of the agencies’ 2009 policy statement.
I. Risk Management and Loan Accommodations
One of the key updates in the 2023 Policy is the agencies’ encouragement of short-term loan accommodations, with the goal of reducing the overall number of loan workouts and long-term accommodations. Examples of such short-term accommodations may include deferral of one or more payments, allowing partial payment, forbearance of delinquent amounts, temporary modification of the loan, or other assistance or relief to borrowers experiencing a financial challenge.
If short-term accommodations are unsuccessful, the 2023 statement also reaffirms some aspects of the agencies’ 2009 guidance regarding longer-term accommodations or workout programs, including the renewal or extension of loan terms, granting of additional credit to improve prospects for overall repayment, or restructuring the loan with or without concessions. These long-term workout arrangements aim to improve the lender’s prospects for repayment of CRE loans consistent with sound banking and accounting practices and applicable laws and regulations.
Importantly, the Policy also reaffirms that examiners will not criticize a financial institution for engaging in loan workout arrangements, even though such loans may be adversely classified, as long as the financial institution’s management has (i) developed an appropriate workout plan; (ii) undertaken a sufficient analysis of the borrower’s and guarantor’s financial status; (iii) demonstrated that it will continue to monitor the developed an appropriate workout plan; (iv) maintained an internal grading system reflecting the risks in the workout plan; and (v) developed a methodology to calculate an allowance for loans that have undergone a workout and timely and appropriately recognizes loan losses.
II. Loan Classification
Another important aspect of the Policy is that loans that are adequately protected by the borrower’s or guarantor’s current worth and debt service ability are not adversely classified. That includes loans to sound borrowers that are modified within the new policy standards, unless there is a well-defined risk that may affect repayment.
Further, a loan should not be adversely classified solely because the value of any underlying collateral is no longer sufficient to cover the full loan balance (although the Policy acknowledges that problem loans dependent on the sale of collateral for repayment may be adversely classified in certain circumstances). Rather, classification should consider both the loan’s historical performance, including whether the borrower is current on principal or interest payments, and the borrower’s ability to meet its obligations over the life of the loan. This approach more accurately assesses loan risks by considering not just the borrower’s payment history, but also the borrower’s prospective financial strength.
Additionally, shorter-term loans are not automatically subject to adverse classification simply because the lender restructures or renews these loans. While the renewal or restructuring of a maturing loan may indicate a level of credit risk (i.e., the borrower was not able to refinance or otherwise obtain long-term financing as expected), the Policy provides that each loan should be assessed by its individual characteristics. Renewed or restructured loans should be closely monitored internally by the lender, but adverse classification should be reserved for loans with well-defined weaknesses that jeopardize repayment.
III. Regulatory Agency Reporting and Accounting Considerations
The Policy reiterates that the financial institution’s management is responsible for supplying regulatory reports in accordance with GAAP and the regulators’ reporting requirements. Considering that loan accommodations and workouts may affect reporting, including by affecting interest accruals and loan loss estimates, the agencies encourage transparency and communication between the lenders’ workout, accounting, and regulatory staff to ensure CRE loans are appropriately reported.
The Policy also addresses changes in accounting standards since 2009, including by removing all discussion of troubled debt restructuring and by recognizing that expected credit losses for all loans in a portfolio—including modified or restructured loans—are estimated using the same current expected credit losses methodology.
As CRE borrowers face increased financial hardship, the agencies’ updated Policy encourages lending institutions to work with those borrowers and employ less-drastic loan accommodation and workout options to avoid a spike in CRE defaults. To increase the efficacy of the agencies’ recommendations, lenders should adopt policies that (1) promote the clear, accurate, and timely exchange of information about the arrangement both internally and between the borrower and lender, (2) implement internal controls and risk management practices to measure, monitor, and manage the credit risk of loans in accommodation, and (3) put into place comprehensive policies and practices, proper management approvals, ongoing credit risk review functions, and timely and accurate reporting and communication practices.
Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.