Office of the Comptroller of the Currency, Fed, FDIC, NCUA: Policy Statement on Prudent Commercial Real Estate Loan Accommodations, Workouts (Part 1 of 2)
The notice was issued by
Here are excerpts:
* * *
SUMMARY:
DATES:
The final policy statement is available on
FOR FURTHER INFORMATION CONTACT:
OCC:
Board:
NCUA:
SUPPLEMENTARY INFORMATION:
I. Background
On
To incorporate recent policy and accounting changes, the agencies recently proposed updates and expanded the 2009 Statement and sought comment on the resulting proposed Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts (proposed Statement).[2] The agencies considered all comments received and are issuing this final Statement largely as proposed, with certain clarifying changes based on comments received. The final Statement is described in Section II of the Supplementary Information.
The agencies received 22 unique comments from banking organizations and credit unions, state and national trade associations, and individuals. A summary and discussion of comments and changes incorporated in the final Statement are described in Section III of the Supplementary Information.
The Paperwork Reduction Act is addressed in Section IV of the Supplementary Information. Section V of the Supplementary Information presents the final Statement which is available as of
II. Overview of the Final Statement
The risk management principles outlined in the final Statement remain generally consistent with the 2009 Statement. As in the proposed Statement, the final Statement discusses the importance of financial institutions[3] working constructively with CRE borrowers who are experiencing financial difficulty and is consistent with
Consistent with safety and soundness standards, the final Statement reaffirms two key principles from the 2009 Statement: (1) financial institutions 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 with weaknesses that result in adverse classification and (2) 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.
The agencies' risk management expectations as outlined in the final Statement remain generally consistent with the 2009 Statement, and incorporate views on short-term loan accommodations,[6] information about changes in accounting principles since 2009, and revisions and additions to the CRE loan workouts examples.
A. Short-Term Loan Accommodations
The agencies recognize that it may be appropriate for financial institutions to use short-term and less-complex loan accommodations before a loan warrants a longer-term or more-complex workout arrangement. Accordingly, the final Statement identifies short-term loan accommodations as a tool that could be used to mitigate adverse effects on borrowers and encourages financial institutions to work prudently with borrowers who are, or may be, unable to meet their contractual payment obligations during periods of financial stress. The final Statement incorporates principles consistent with existing interagency supervisory guidance on accommodations.[7]
B. Accounting Changes
The final Statement also reflects changes in GAAP since 2009, including those in relation to the current expected credit losses (CECL) methodology.[8] In particular, the Regulatory Reporting and Accounting Considerations section of the Statement was modified to include CECL references, and Appendix 5 of the final Statement addresses the relevant accounting and supervisory guidance on estimating loan losses for financial institutions that use the CECL methodology.
C. CRE Loan Workouts Examples
The final Statement includes updated information about industry loan workout practices. In addition to revising the CRE loan workouts examples from the 2009 Statement, the proposed Statement included three new examples that were carried forward to the final Statement (Income Producing Property--Hotel, Acquisition, Development and Construction--Residential, and Multi-Family Property). All examples in the final Statement are intended to illustrate the application of existing rules, regulatory reporting instructions, and supervisory guidance on credit classifications and the determination of nonaccrual status.
D. Other Items
The final Statement includes updates to the 2009 Statement's Appendix 2, which contains a summary of selected references to relevant supervisory guidance and accounting standards for real estate lending, appraisals, restructured loans, fair value measurement, and regulatory reporting matters.
The final Statement retains information in Appendix 3 about valuation concepts for income-producing real property from the 2009 Statement. Further, Appendix 4 provides the agencies' long-standing special mention and classification definitions that are applied to the examples in Appendix 1.
The final Statement is consistent with the Interagency Guidelines Establishing Standards for Safety and Soundness issued by the Board,
III. Summary and Discussion of Comments
A. Summary of Comments
The agencies received 22 unique comments from banking organizations and credit unions, state and national trade associations, and individuals.[11]
Many commenters supported the agencies' work to provide updated supervisory guidance to the industry. Some commenters stated that the proposed Statement was reasonable and reflected safe and sound business practices. Further, several commenters stated that the short-term loan accommodation section, accounting changes, and additional examples of CRE loan workouts would be a good reference source as lenders evaluate and determine a loan accommodation and workout plan for CRE loans.
Comments also contained numerous observations, suggestions, and recommendations on the proposed Statement, including asking for more detail on certain aspects of the proposed Statement. A number of the comments addressed similar topics including: requesting examiners base any collateral value adjustments on empirical evidence; considering local market conditions when evaluating the appropriateness of loan workouts; clarifying the "doubtful" classification; addressing the importance of global cash flow and considering a financial institution's ability to support the calculation;[12] clarifying the frequency of obtaining updated financial and collateral information; clarifying and defining terminology; and emphasizing the importance of proactive engagement with borrowers. The following sections discuss in more detail the comments received, the agencies' response, and the changes reflected in the final Statement.
B. Valuation Adjustments
Some commenters suggested that examiners should be required to provide empirical data to support collateral valuation adjustments made by examiners during loan reviews. The proposed Statement suggested such adjustments be made when a financial institution was unable or unwilling to address weaknesses in supporting loan documentation or appraisal or evaluation processes. For further clarification, the agencies affirmed that the role of examiners is to review and evaluate the information provided by financial institution management to support the financial institution's valuation and not to perform a separate, independent valuation. Accordingly, the final Statement explains that the examiner may adjust the estimated value of the collateral for credit analysis and classification purposes when the examiner can establish that underlying facts or assumptions presented by the financial institution are irrelevant or inappropriate for the valuation or can support alternative assumptions based on available information.
C. Market Conditions
The proposed Statement referenced the review of general market conditions when evaluating the appropriateness of loan workouts. Several commenters stated that examiners should focus primarily on local and state market conditions, with less emphasis on regional and national trends, when analyzing CRE loans and determining borrowers' ability to repay. Considering local market conditions is consistent with the existing real estate lending standards or requirements[13] issued by the agencies, which state that a financial institution should monitor real estate market conditions in its lending area. In response to these comments, the final Statement clarifies that market conditions include conditions at the state and local levels. Further, to better align the final Statement with regulatory requirements, the agencies included a footnote referencing real estate lending standards or requirements related to monitoring market conditions.
D. Classification
A commenter suggested wording changes in the discussion of a "doubtful" classification to clarify use of that term. The final Statement clarifies that "doubtful" is a temporary designation and subject to a financial institution's timely reassessment of the loan once the outcomes of pending events have occurred or the amount of loss can be reasonably determined.
E. Global Cash Flow
Some commenters agreed with the importance of a global cash flow analysis as discussed in the proposed Statement. One commenter stated that the global cash flow analysis discussion should be enhanced. Another commenter noted that small institutions may not have information necessary to determine the global cash flow.
The proposed Statement emphasized the importance of financial institutions understanding CRE borrowers experiencing financial difficulty. Furthermore, the proposed Statement recognized that financial institutions that have sufficient information on a guarantor's global financial condition, income, liquidity, cash flow, contingent liabilities, and other relevant factors (including credit ratings, when available) are better able to determine the guarantor's financial ability to fulfill its obligation. Consistent with safety and soundness regulations, the agencies emphasize the need for financial institutions to understand the overall financial condition and resources, including global cash flow, of CRE borrowers experiencing financial difficulty.
The final Statement lists actions that a financial institution should perform to not be criticized for engaging in loan workout arrangements. One such action is analyzing the borrower's global debt service coverage. The final Statement clarifies that the debt service coverage analysis should include realistic projections of a borrower's available cash flow and understanding of the continuity and accessibility of repayment sources.
F. Frequency of Obtaining Updated Financial and Collateral Information
Commenters suggested clarifying supervisory expectations for the frequency with which financial institutions should update financial and collateral information for financially distressed borrowers. Consistent with the agencies' approach to supervisory guidance, the final Statement does not set bright lines; the appropriate frequency for updating such information will vary on a case-by-case basis, depending on the type of collateral and other considerations. Given that each loan accommodation and workout is case-specific, financial institutions are encouraged to use their best judgment when considering the guidance principles in the final Statement and consider each loan's specific circumstances when assessing the need for updated collateral information and financial reporting from distressed borrowers.
G. Terminology
Some commenters requested that the agencies define certain terms used in the supervisory guidance to illustrate the level of analysis for reviewing CRE loans. Examples include when the term "comprehensive" described the extent of loan review activity and when "reasonable" described terms and conditions offered to borrowers in restructurings or accommodations. Given that each loan accommodation and workout is case-specific, the agencies are of the view that providing more specific definitions of these terms could result in overly prescriptive supervisory guidance. Accordingly, the final Statement does not define these terms. Financial institutions are encouraged to use their best judgment when considering the principles contained in the final Statement and adapt to the circumstances when dealing with problem loans or loan portfolios.
A few commenters requested changes or more specific supervisory guidance on the definition of a short-term loan accommodation. The agencies are of the view that the scope of coverage on accommodations, as proposed, maintains flexibility for financial institutions. The proposed Statement discussed characteristics that can constitute a short-term accommodation and remained consistent with earlier supervisory guidance issued on the topic. Further, the agencies agree that the proposed Statement's discussion of short-term loan accommodations and long-term loan workout arrangements in sections II and IV, respectively, sufficiently differentiated short-term accommodations and longer-term workouts as separate and distinct options when working with financially distressed borrowers. Accordingly, the agencies have not included revisions related to guidance on short-term loan accommodations[14] in the final Statement.
H. Proactive Engagement With Borrowers
One commenter stated that the agencies should incentivize proactive engagement with borrowers. The agencies agree that proactive engagement is useful and have clarified in the final Statement that proactive engagement with the borrower often plays a key role in the success of a workout.
I. Responses to Questions
In addition to a request for comment on all aspects of the proposed Statement, the agencies asked for responses to five questions.
The first question asked, " To what extent does the proposed Statement reflect safe and sound practices currently incorporated in a financial institution's CRE loan accommodation and workout activities? Should the agencies add, modify, or remove any elements, and, if so, which and why?" Commenters noted that the Statement does reflect safe and sound practices and did not request significant changes to those elements of the Statement. Commenters generally agreed with the supervisory guidance and the revisions proposed and stated that the supervisory guidance is reasonable, clear, and useful in analyzing and managing CRE borrowers.
The second question asked, " What additional information, if any, should be included to optimize the guidance for managing CRE loan portfolios during all business cycles and why?" One commenter responded that the supervisory guidance was sufficient as written and that no additional changes were needed. Another commenter suggested the agencies add an appendix containing the components of adequate policies and procedures. The final Statement contains several updated appendices with references to pertinent regulations and supervisory guidance. The final Statement also includes footnotes to highlight the supervisory guidance contained in the existing real estate lending regulation.
The third question asked, " Some of the principles discussed in the proposed Statement are appropriate for Commercial & Industrial (C&I) lending secured by personal property or other business assets. Should the agencies further address C&I lending more explicitly, and if so, how?" A few commenters suggested including more detail regarding C&I lending in the final Statement, while one commenter stated that no expansion was needed. The agencies recognize the unique risks associated with CRE lending and acknowledge the several commenters who cited the usefulness of having supervisory guidance that specifically addresses CRE risks. Accordingly, the final Statement remains directed to CRE lending. The final Statement acknowledges that financial institutions may find the supervisory guidance more broadly useful for commercial loan workout situations, stating "[c]ertain principles in this statement are also generally applicable to commercial loans that are secured by either real property or other business assets of a commercial borrower." In the future, the agencies may consider separate supervisory guidance to address non-CRE loan accommodations and workouts.
The fourth question asked, " What additional loan workout examples or scenarios should the agencies include or discuss? Are there examples in Appendix 1 of the proposed Statement that are not needed, and if so, why not? Should any of the examples in the proposed Statement be revised to better reflect current practices, and if so, how?" Two commenters had specific recommendations for certain examples in Appendix 1. One commenter said the examples should contain more detail; another suggested the agencies either change or delete a scenario in one of the examples. The final Statement retains all of the examples and scenarios largely as proposed and includes additional detail clarifying the discussion of a multiple note restructuring.
The fifth question asked, " To what extent do the TDR examples continue to be relevant in 2023 given that ASU 2022-02 eliminates the need for a financial institution to identify and account for a new loan modification as a TDR?" The agencies received six comment letters on the accounting for workout loans in the examples in Appendix 1. The commenters asked the agencies to remove references to troubled debt restructurings (TDRs) from the examples, as the relevant accounting standards for TDRs will no longer be applicable after 2023. The agencies agree with the commenters and are removing discussion of TDRs from the examples. The agencies have also removed references to ASC Subtopic 310-10, "Receivables--Overall," and ASC Subtopic 450-20, "Contingencies--Loss Contingencies," and eliminated Appendix 6, "Accounting--Incurred Loss Methodology." Financial institutions that have not adopted ASC Topic 326, "Financial Instruments--Credit Losses," or ASU 2022-02 should continue to identify, measure, and report TDRs in accordance with regulatory reporting instructions.
Based on a commenter request, the agencies made clarifications to the accounting discussion in Example B, Scenario 3, and in Section V.D, Classification and Accrual Treatment of Restructured Loans with a Partial Charge-Off, as reflected in the final Statement. For the regulatory reporting of loan modifications, financial institution management should refer to the appropriate regulatory reporting instructions for supervisory guidance.
IV. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3521) states that no agency may conduct or sponsor, nor is the respondent required to respond to, an information collection unless it displays a currently valid
V. Final Guidance
The text of the final Statement is as follows:
Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts
The agencies[1] recognize that financial institutions[2] face significant challenges when working with commercial real estate (CRE)[3] borrowers who are experiencing diminished operating cash flows, depreciated collateral values, prolonged sales and rental absorption periods, or other issues that may hinder repayment. While such borrowers may experience deterioration in their financial condition, many borrowers will continue to be creditworthy and have the willingness and ability to repay their debts. In such cases, financial institutions may find it beneficial to work constructively with borrowers. Such constructive efforts may involve loan accommodations[4] or more extensive loan workout arrangements.[5]
This statement provides a broad set of risk management principles relevant to CRE loan accommodations and workouts in all business cycles, particularly in challenging economic environments. A wide variety of factors can negatively affect CRE portfolios, including economic downturns, natural disasters, and local, national, and international events. This statement also describes the approach examiners will use to review CRE loan accommodation and workout arrangements and provides examples of CRE loan workout arrangements as well as useful references in the appendices.
The agencies have found that prudent CRE loan accommodations and workouts are often in the best interest of the financial institution and the borrower. The agencies expect their examiners to take a balanced approach in assessing the adequacy of a financial institution's risk management practices for loan accommodation and workout activities. Consistent with the Interagency Guidelines Establishing Standards for Safety and Soundness,[6] financial institutions 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. In addition, 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.
I. Purpose
Consistent with the safety and soundness standards, this statement updates and supersedes previous supervisory guidance to assist financial institutions' efforts to modify CRE loans to borrowers who are, or may be, unable to meet a loan's current contractual payment obligations or fully repay the debt.[7] This statement is intended to promote supervisory consistency among examiners, enhance the transparency of CRE loan accommodation and workout arrangements, and support supervisory policies and actions that do not inadvertently curtail the availability of credit to sound borrowers.
This statement addresses prudent risk management practices regarding short-term loan accommodations, risk management for loan workout programs, long-term loan workout arrangements, classification of loans, and regulatory reporting and accounting requirements and considerations. The statement also includes selected references and materials related to regulatory reporting.[8] The statement does not, however, affect existing regulatory reporting requirements or supervisory guidance provided in relevant interagency statements issued by the agencies or accounting requirements under
Five appendices are incorporated into this statement:
- Appendix 1 contains examples of CRE loan workout arrangements illustrating the application of this statement to classification of loans and determination of nonaccrual treatment.
* Appendix 2 lists selected relevant rules as well as supervisory and accounting guidance for real estate lending, appraisals, allowance methodologies,[9] restructured loans, fair value measurement, and regulatory reporting matters such as nonaccrual status. The agencies intend this statement to be used in conjunction with materials identified in Appendix 2 to reach appropriate conclusions regarding loan classification and regulatory reporting.
* Appendix 3 discusses valuation concepts for income-producing real property.[10]
* Appendix 4 provides the special mention and adverse classification definitions used by the Board,
* Appendix 5 addresses the relevant accounting and supervisory guidance on estimating loan losses for financial institutions that use the current expected credit losses (CECL) methodology.
II. Short-Term Loan Accommodations
The agencies encourage financial institutions to work proactively and prudently with borrowers who are, or may be, unable to meet their contractual payment obligations during periods of financial stress. Such actions may entail loan accommodations that are generally short-term or temporary in nature and occur before a loan reaches a workout scenario. These actions can mitigate long-term adverse effects on borrowers by allowing them to address the issues affecting repayment ability and are often in the best interest of financial institutions and their borrowers.
When entering into an accommodation with a borrower, it is prudent for a financial institution to provide clear, accurate, and timely information about the arrangement to the borrower and any guarantor. Any such accommodation must be consistent with applicable laws and regulations. Further, a financial institution should employ prudent risk management practices and appropriate internal controls over such accommodations. Weak or imprudent risk management practices and internal controls can adversely affect borrowers and expose a financial institution to increases in credit, compliance, operational, or other risks. Imprudent practices that are widespread at a financial institution may also pose a risk to its capital adequacy.
Prudent risk management practices and internal controls will enable financial institutions to identify, measure, monitor, and manage the credit risk of accommodated loans. Prudent risk management practices include developing and maintaining appropriate policies and procedures, updating and assessing financial and collateral information, maintaining an appropriate risk rating (or grading) framework, and ensuring proper tracking and accounting for loan accommodations. Prudent internal controls related to loan accommodations include comprehensive policies[12] and practices, proper management approvals, an ongoing credit risk review function, and timely and accurate reporting and communication.
III. Loan Workout Programs
When short-term accommodation measures are not sufficient or have not been successful in addressing credit problems, financial institutions could proceed into longer-term or more complex loan arrangements with borrowers under a formal workout program. Loan workout arrangements can take many forms, including, but not limited to:
- Renewing or extending loan terms;
- Granting additional credit to improve prospects for overall repayment; or
* Restructuring[13] the loan with or without concessions.
A financial institution's risk management practices for implementing workout arrangements should be appropriate for the scope, complexity, and nature of the financial institution's lending activity. Further, these practices should be consistent with safe and sound lending policies and supervisory guidance, real estate lending standards and requirements,[14] and relevant regulatory reporting requirements. Examiners will evaluate the effectiveness of a financial institution's practices, which typically include:
* A prudent loan workout policy that establishes appropriate loan terms and amortization schedules and that permits the financial institution to reasonably adjust the loan workout plan if sustained repayment performance is not demonstrated or if collateral values do not stabilize;[15]
- Management infrastructure to identify, measure, and monitor the volume and complexity of the loan workout activity;
- Documentation standards to verify a borrower's creditworthiness, including financial condition, repayment ability, and collateral values;
- Management information systems and internal controls to identify and track loan performance and risk, including impact on concentration risk and the allowance;
- Processes designed to ensure that the financial institution's regulatory reports are consistent with regulatory reporting requirements;
- Loan collection procedures;
- Adherence to statutory, regulatory, and internal lending limits;
- Collateral administration to ensure proper lien perfection of the financial institution's collateral interests for both real and personal property; and
* An ongoing credit risk review function.[16]
IV. Long-Term Loan Workout Arrangements
An effective loan workout arrangement should improve the lender's prospects for repayment of principal and interest, be consistent with sound banking and accounting practices, and comply with applicable laws and regulations. Typically, financial institutions consider loan workout arrangements after analyzing a borrower's repayment ability, evaluating the support provided by guarantors, and assessing the value of any collateral pledged. Proactive engagement by the financial institution with the borrower often plays a key role in the success of the workout.
Consistent with safety and soundness standards, examiners will not criticize a financial institution for engaging in loan workout arrangements, even though such loans may be adversely classified, so long as management has:
For each loan, developed a well-conceived and prudent workout plan that supports the ultimate collection of principal and interest and that is based on key elements such as:
- Updated and comprehensive financial information on the borrower, real estate project, and all guarantors and sponsors;
- Current valuations of the collateral supporting the loan and the workout plan;
- Appropriate loan structure (e.g., term and amortization schedule), covenants, and requirements for curtailment or re-margining; and
- Appropriate legal analyses and agreements, including those for changes to original or subsequent loan terms;
* Analyzed the borrower's global debt[17] service coverage, including realistic projections of the borrower's cash flow, as well as the availability, continuity, and accessibility of repayment sources;
* Analyzed the available cash flow of guarantors;
- Demonstrated the willingness and ability to monitor the ongoing performance of the borrower and guarantor under the terms of the workout arrangement;
- Maintained an internal risk rating or loan grading system that accurately and consistently reflects the risk in the workout arrangement; and
* Maintained an allowance methodology that calculates (or measures) an allowance, in accordance with GAAP, for loans that have undergone a workout arrangement and recognizes loan losses in a timely manner through provision expense and recording appropriate charge-offs.[18]
A. Supervisory Assessment of Repayment Ability of Commercial Borrowers
The primary focus of an examiner's review of a CRE loan, including binding commitments, is an assessment of the borrower's ability to repay the loan. The major factors that influence this analysis are the borrower's willingness and ability to repay the loan under reasonable terms and the cash flow potential of the underlying collateral or business. When analyzing a commercial borrower's repayment ability, examiners should consider the following factors:
- The borrower's character, overall financial condition, resources, and payment history;
- The nature and degree of protection provided by the cash flow from business operations or the underlying collateral on a global basis that considers the borrower's and guarantor's total debt obligations;
* Relevant market conditions,[19] particularly those on a state and local level, that may influence repayment prospects and the cash flow potential of the business operations or the underlying collateral; and
- The prospects for repayment support from guarantors.
B. Supervisory Assessment of Guarantees and Sponsorships
Examiners should review the financial attributes of guarantees and sponsorships in considering the loan classification. The presence of a legally enforceable guarantee from a financially responsible guarantor may improve the prospects for repayment of the debt obligation and may be sufficient to preclude adverse loan classification or reduce the severity of the loan classification. A financially responsible guarantor possesses the financial ability, the demonstrated willingness, and the incentive to provide support for the loan through ongoing payments, curtailments, or re-margining.
Examiners also review the financial attributes and economic incentives of sponsors that support a loan. Even if not legally obligated, financially responsible sponsors are similar to guarantors in that they may also possess the financial ability, the demonstrated willingness, and may have an incentive to provide support for the loan through ongoing payments, curtailments, or re-margining.
Financial institutions that have sufficient information on the guarantor's global financial condition, income, liquidity, cash flow, contingent liabilities, and other relevant factors (including credit ratings, when available) are better able to determine the guarantor's financial ability to fulfill its obligation. An effective assessment includes consideration of whether the guarantor has the financial ability to fulfill the total number and amount of guarantees currently extended by the guarantor. A similar analysis should be made for any material sponsors that support the loan.
Examiners should consider whether a guarantor has demonstrated the willingness to fulfill all current and previous obligations, has sufficient economic incentive, and has a significant investment in the project. An important consideration is whether any previous performance under its guarantee(s) was voluntary or the result of legal or other actions by the lender to enforce the guarantee(s).
C. Supervisory Assessment of Collateral Values
As the primary sources of loan repayment decline, information on the underlying collateral's estimated value becomes more important in analyzing the source of repayment, assessing credit risk, and developing an appropriate loan workout plan. Examiners will analyze real estate collateral values based on the financial institution's original appraisal or evaluation, any subsequent updates, additional pertinent information ( e.g., recent inspection results), and relevant market conditions. Examiners will assess the major facts, assumptions, and valuation approaches in the collateral valuation and their influence in the financial institution's credit and allowance analyses.
The agencies' appraisal regulations require financial institutions to review appraisals for compliance with the Uniform Standards of Professional Appraisal Practice.[20] As part of that process, and when reviewing collateral valuations, financial institutions should ensure that assumptions and conclusions used are reasonable. Further, financial institutions typically have policies[21] and procedures that dictate when collateral valuations should be updated as part of financial institutions' ongoing credit risk reviews and monitoring processes, as relevant market conditions change, or as a borrower's financial condition deteriorates.[22]
For a CRE loan in a workout arrangement, a financial institution should consider the current project plans and market conditions in a new or updated appraisal or evaluation, as appropriate. In determining whether to obtain a new appraisal or evaluation, a prudent financial institution considers whether there has been material deterioration in the following factors:
- The performance of the project;
- Conditions for the geographic market and property type;
- Variances between actual conditions and original appraisal assumptions;
* Changes in project specifications (e.g., changing a planned condominium project to an apartment building);
- Loss of a significant lease or a take-out commitment; or
- Increases in pre-sale fallout.
A new appraisal may not be necessary when an evaluation prepared by the financial institution appropriately updates the original appraisal assumptions to reflect current market conditions and provides a reasonable estimate of the underlying collateral's fair value.[23] If new money is being advanced, financial institutions should refer to the agencies' appraisal regulations to determine whether a new appraisal is required.[24]
The market value provided by an appraisal and the fair value for accounting purposes are based on similar valuation concepts.[25] The analysis of the underlying collateral's market value reflects the financial institution's understanding of the property's current "as is" condition (considering the property's highest and best use) and other relevant risk factors affecting the property's value. Valuations of commercial properties may contain more than one value conclusion and could include an "as is" market value, a prospective "as complete" market value, and a prospective "as stabilized" market value.
Financial institutions typically use the market value conclusion (and not the fair value) that corresponds to the workout plan objective and the loan commitment. For example, if the financial institution intends to work with the borrower so that a project will achieve stabilized occupancy, then the financial institution can consider the "as stabilized" market value in its collateral assessment for credit risk grading after confirming that the appraisal's assumptions and conclusions are reasonable. Conversely, if the financial institution intends to foreclose, then it is required for financial reporting purposes that the financial institution use the fair value (less costs to sell)[26] of the property in its current "as is" condition in its collateral assessment.
If weaknesses exist in the financial institution's supporting loan documentation or appraisal or evaluation review process, examiners should direct the financial institution to address the weaknesses, which may require the financial institution to obtain additional information or a new collateral valuation.[27] However, in the rare instance when a financial institution is unable or unwilling to address weaknesses in a timely manner, examiners will assess the property's operating cash flow and the degree of protection provided by a sale of the underlying collateral as part of determining the loan's classification. In performing their credit analysis, examiners will consider expected cash flow from the property, current or implied value, relevant market conditions, and the relevance of the facts and the reasonableness of assumptions used by the financial institution. For an income-producing property, examiners evaluate:
- Net operating income of the property as compared with budget projections, reflecting reasonable operating and maintenance costs;
- Current and projected vacancy and absorption rates;
- Lease renewal trends and anticipated rents;
- Effective rental rates or sale prices, considering sales and financing concessions;
- Time frame for achieving stabilized occupancy or sellout;
- Volume and trends in past due leases; and
- Discount rates and direct capitalization rates (refer to Appendix 3 for more information).
Assumptions, when recently made by qualified appraisers (and, as appropriate, by qualified, independent parties within the financial institution) and when consistent with the discussion above, should be given reasonable deference by examiners. Examiners should also use the appropriate market value conclusion in their collateral assessments. For example, when the financial institution plans to provide the resources to complete a project, examiners can consider the project's prospective market value and the committed loan amount in their analyses.
Examiners generally are not expected to challenge the underlying assumptions, including discount rates and capitalization rates, used in appraisals or evaluations when these assumptions differ only marginally from norms generally associated with the collateral under review. The examiner may adjust the estimated value of the collateral for credit analysis and classification purposes when the examiner can establish that underlying facts or assumptions presented by the financial institution are irrelevant or inappropriate or can support alternative assumptions based on available information.
CRE borrowers may have commercial loans secured by owner occupied real estate or other business assets, such as inventory and accounts receivable, or may have CRE loans also secured by furniture, fixtures, and equipment. For these loans, examiners should assess the adequacy of the financial institution's policies and practices for quantifying the value of such collateral, determining the acceptability of the assets as collateral, and perfecting its security interests. Examiners should also determine whether the financial institution has appropriate procedures for ongoing monitoring of this type of collateral.
* * *
(Continues with Part 2 of 2)
The document was published in the
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