# SR 23-5: Prudent Commercial Real Estate Loan Accommodations and Workouts > Federal · Agency guidance · In force URL: https://www.frixlaw.com/law-library/statutes/FRB_SR2305 ## Section - **Citation:** SR 23-5 - **Heading:** Prudent Commercial Real Estate Loan Accommodations and Workouts - **Jurisdiction:** Federal - **Kind:** Agency guidance - **Status:** In force - **Text as of:** August 14, 2026 - **Source:** Compiled text - **Location:** Federal Reserve SR/CA Letters / Prudent Commercial Real Estate Loan Accommodations and Workouts ## Text Page 1 of 2 BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 20551 DIVISION OF SUPERVISION AND REGULATION SR 23-5 June 30, 2023 TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK SUBJECT: Prudent Commercial Real Estate Loan Accommodations and Workouts Applicability: This guidance applies to all institutions supervised by the Federal Reserve, including those with $10 billion or less in consolidated assets. The Federal Reserve, along with the other financial regulators,1 has adopted the attached policy statement on Prudent Commercial Real Estate Loan Accommodations and Workouts. The Federal Reserve and the other financial regulators issued this policy statement to update previous guidance, reinforce the message that financial institutions should work prudently and constructively with creditworthy commercial borrowers experiencing financial difficulties, and clarify that such message applies in all stages of the economic cycle. This policy statement is intended to promote supervisory consistency among examiners and ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. This policy statement provides a broad set of principles relevant to all commercial loan accommodations and workouts. The policy statement also includes guidance applicable to the specific risks and structures of commercial real estate (CRE) loans tency among examiners and ensure that supervisory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. This policy statement provides a broad set of principles relevant to all commercial loan accommodations and workouts. The policy statement also includes guidance applicable to the specific risks and structures of commercial real estate (CRE) loans. Consistent with the safety and soundness standards, this policy statement updates and supersedes existing supervisory guidance to assist financial institutions’ efforts to modify CRE and other commercial loans to borrowers who are, or may be, unable to meet a loan’s current contractual payment obligations.2 The policy statement also includes: a section on short-term loan accommodations; a discussion of recent accounting changes on estimating loan losses; and updated examples that clarify how to classify and account for loans modified or affected by loan accommodations or loan workout activity. 1 The other financial regulators are the Federal Deposit Insurance Corporation, National Credit Union Administration, and Office of the Comptroller of the Currency. 2 This policy statement replaces the interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 2009). Page 2 of 2 Reserve Banks are asked to distribute this letter to the supervised institutions in their districts and to appropriate supervisory staff. Questions may be sent via the Board’s public website.3 Michael S. Gibson Director Division of Supervision and Regulation Attachments: • Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts • Federal Register Notice Supersedes: • SR letter 09-7, “Prudent Commercial Real Estate Loan Workouts” 3 See http://www.federalreserve.gov/apps/contactus/feedback.aspx. e sent via the Board’s public website.3 Michael S. Gibson Director Division of Supervision and Regulation Attachments: • Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts • Federal Register Notice Supersedes: • SR letter 09-7, “Prudent Commercial Real Estate Loan Workouts” 3 See http://www.federalreserve.gov/apps/contactus/feedback.aspx. Page 1 of 39 _________________________________________________________________________________ Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation National Credit Union Administration Office of the Comptroller of the Currency _________________________________________________________________________________ June 30, 2023 Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts The agencies1 recognize that financial institutions2 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 accommodations4 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 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 1 The Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC) (collectively, the agencies). This Policy Statement was developed in consultation with state bank and credit union regulators. 2 For the purposes of this statement, financial institutions are those supervised by the Board, FDIC, NCUA, or OCC. 3 Consistent with the Board, FDIC, and OCC joint guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (December 2006), CRE loans include loans secured by multifamily property, and nonfarm nonresidential property where the primary source of repayment is derived from rental income associated with the property (that is, loans for which 50 percent or more of the source of repayment comes from third party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property CRE loans include loans secured by multifamily property, and nonfarm nonresidential property where the primary source of repayment is derived from rental income associated with the property (that is, loans for which 50 percent or more of the source of repayment comes from third party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. CRE loans also include land development and construction loans (including 1-4 family residential and commercial construction loans), other land loans, loans to real estate investment trusts (REITs), and unsecured loans to developers. For credit unions, “commercial real estate loans” refers to “commercial loans,” as defined in Section 723.2 of the NCUA Rules and Regulations, secured by real estate. 4 For the purposes of this statement, an accommodation includes 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. 5 Workouts can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions. Page 2 of 39 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 s 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 U.S. generally accepted accounting principles (GAAP) nting 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 U.S. generally accepted accounting principles (GAAP). Certain 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. 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 6 12 CFR part 30, appendix A (OCC); 12 CFR part 208 Appendix D-1 (Board); and 12 CFR part 364 appendix A (FDIC). For the NCUA, refer to 12 CFR part 741.3(b)(2), 12 CFR part 741 appendix B, 12 CFR part 723, and letter to credit unions 10-CU-02 “Current Risks in Business Lending and Sound Risk Management Practices” issued January 2010. Credit unions should also refer to the Commercial and Member Business Loans section of the NCUA Examiner’s Guide. 7 This statement replaces the interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 2009). See FFIEC Press Release, October 30, 2009, available at: https://www.ffiec.gov/press/pr103009.htm. 8 For banks, the FFIEC Consolidated Reports of Condition and Income (FFIEC Call Report), and for credit unions, the NCUA 5300 Call Report (NCUA Call Report). ner’s Guide. 7 This statement replaces the interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 2009). See FFIEC Press Release, October 30, 2009, available at: https://www.ffiec.gov/press/pr103009.htm. 8 For banks, the FFIEC Consolidated Reports of Condition and Income (FFIEC Call Report), and for credit unions, the NCUA 5300 Call Report (NCUA Call Report). Page 3 of 39 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, FDIC, and OCC.11 • 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 ate 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 policies12 and practices, proper management approvals, an ongoing credit risk review function, and timely and 9 The allowance methodology refers to the allowance for credit losses (ACL) under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 326, Financial Instruments – Credit Losses. 10 Valuation concepts applied to regulatory reporting processes also should be consistent with ASC Topic 820, Fair Value Measurement g credit risk review function, and timely and 9 The allowance methodology refers to the allowance for credit losses (ACL) under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 326, Financial Instruments – Credit Losses. 10 Valuation concepts applied to regulatory reporting processes also should be consistent with ASC Topic 820, Fair Value Measurement. 11 Credit unions must apply a relative credit risk score (i.e., credit risk rating) to each commercial loan as required by 12 CFR part 723 Member Business Loans; Commercial Lending (see Section 723.4(g)(3)) or the equivalent state regulation as applicable. 12 See 12 CFR 34.62(a) and 160.101(a) (OCC); 12 CFR 208.51(a) (Board); and 12 CFR 365.2(a) (FDIC) regarding real estate lending policies at financial institutions. For NCUA, refer to 12 CFR part 723 for commercial real estate lending and 12 CFR part 741, appendix B, which addresses loan workouts, nonaccrual policy, and regulatory reporting of workout loans. Page 4 of 39 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 • Restructuring13 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 al 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 13 A restructuring involves a formal, legally enforceable modification in the loan’s terms. 14 12 CFR part 34, subpart D, and Appendix to 160.101 (OCC); 12 CFR section 208.51 (Board); and 12 CFR part 365 (FDIC) 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 13 A restructuring involves a formal, legally enforceable modification in the loan’s terms. 14 12 CFR part 34, subpart D, and Appendix to 160.101 (OCC); 12 CFR section 208.51 (Board); and 12 CFR part 365 (FDIC). For NCUA requirements, refer to 12 CFR part 723 for member business loan and commercial loan regulations, which addresses CRE lending, and 12 CFR part 741, Appendix B, which addresses loan workouts, nonaccrual policy, and regulatory reporting of workout loans. 15 Federal credit unions are reminded that in making decisions related to loan workout arrangements, they must take into consideration any applicable maturity limits (12 CFR 701.21(c)(4)). Page 5 of 39 • 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 ractices, 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 debt17 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 expe 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 16 See Interagency Guidance on Credit Risk Review Systems. OCC Bulletin 2020-50 (May 8, 2020); FDIC Financial Institution Letter FIL-55-2020 (May 8, 2020); Federal Reserve Supervision and Regulation (SR) letter 20-13 (May 8, 2020); and NCUA press release (May 8, 2020). 17 Global debt service coverage is inclusive of the cash flows generated by both the borrower(s) and guarantor(s), as well as the combined financial obligations (including contingent obligations) of the borrower(s) and guarantor(s). 18 Additionally, if applicable, financial institutions should recognize in a separate liability account an allowance for expected credit losses on off-balance sheet credit exposures related to restructured loans (e.g., loan commitments) and should reverse interest accruals on loans that are deemed uncollectible. Page 6 of 39 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 are deemed uncollectible. Page 6 of 39 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 lude 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 19 See 12 CFR 34.62(c) and 160.101(c)(OCC); 12 CFR 208.51(a) (Board); and 12 CFR 365.2(c) (FDIC) regarding the need for financial institutions to monitor conditions in the real estate market in its lending area to ensure that its real estate lending policies continue to be appropriate for current market conditions bligations, has sufficient economic incentive, and has a significant investment 19 See 12 CFR 34.62(c) and 160.101(c)(OCC); 12 CFR 208.51(a) (Board); and 12 CFR 365.2(c) (FDIC) regarding the need for financial institutions to monitor conditions in the real estate market in its lending area to ensure that its real estate lending policies continue to be appropriate for current market conditions. For the NCUA, refer to 12 CFR 723.4(f)(6) requiring that a federally insured credit union’s commercial loan policy have underwriting standards that include an analysis of the impact of current market conditions on the borrower and associated borrowers. Page 7 of 39 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 luence 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 policies21 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 20 See 12 CFR part 34, subpart C (OCC); 12 CFR part 208, subpart E, and 12 CFR part 225, subpart G (Board); 12 CFR part 323 (FDIC); and 12 CFR part 722 (NCUA) 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 20 See 12 CFR part 34, subpart C (OCC); 12 CFR part 208, subpart E, and 12 CFR part 225, subpart G (Board); 12 CFR part 323 (FDIC); and 12 CFR part 722 (NCUA). 21 See Footnote 12. 22 For further reference, see Interagency Appraisal and Evaluation Guidelines, 75 FR 77450 (December 10, 2010). 23 According to the FASB ASC Master Glossary, “fair value” is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Page 8 of 39 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 s 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; 24 See footnote 20. 25 The term “market value” as used in an appraisal is based on similar valuation concepts as “fair value” for accounting purposes under GAAP mptions 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; 24 See footnote 20. 25 The term “market value” as used in an appraisal is based on similar valuation concepts as “fair value” for accounting purposes under GAAP. For both terms, these valuation concepts about the real property and the real estate transaction contemplate that the property has been exposed to the market before the valuation date, the buyer and seller are well informed and acting in their own best interest (that is, the transaction is not a forced liquidation or distressed sale), and marketing activities are usual and customary (that is, the value of the property is unaffected by special financing or sales concessions). The market value in an appraisal may differ from the collateral’s fair value if the values are determined as of different dates or the fair value estimate reflects different assumptions from those in the appraisal. This may occur as a result of changes in market conditions and property use since the “as of” date of the appraisal. 26 Costs to sell may be used in determining any allowance for collateral-dependent loans. Under ASC Topic 326, a loan is collateral dependent when the repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the entity’s assessment as of the reporting date. Costs to sell are used when the loan is dependent on the sale of the collateral. Costs to sell are not used when the collateral-dependent loan is dependent on the operation of the collateral. 27 See 12 CFR 34.43(c) (OCC); 12 CFR 225.63(c) (Board); 12 CFR 323.3(c) (FDIC); and 12 CFR 722.3(e) (NCUA). is experiencing financial difficulty based on the entity’s assessment as of the reporting date. Costs to sell are used when the loan is dependent on the sale of the collateral. Costs to sell are not used when the collateral-dependent loan is dependent on the operation of the collateral. 27 See 12 CFR 34.43(c) (OCC); 12 CFR 225.63(c) (Board); 12 CFR 323.3(c) (FDIC); and 12 CFR 722.3(e) (NCUA). Page 9 of 39 • 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 arginally 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. V. Classification of Loans Loans that are adequately protected by the current sound worth and debt service ability of the borrower, guarantor, or the underlying collateral generally are not adversely classified. Similarly, loans to sound borrowers that are modified in accordance with prudent underwriting standards should not be adversely classified by examiners unless well-defined weaknesses exist that jeopardize repayment. However, such loans could be flagged for management’s attention or for inclusion in designated “watch lists” of loans that management is more closely monitoring. Further, examiners should not adversely classify loans solely because the borrower is associated with a particular industry that is experiencing financial difficulties unless well-defined weaknesses exist that jeopardize repayment. However, such loans could be flagged for management’s attention or for inclusion in designated “watch lists” of loans that management is more closely monitoring. Further, examiners should not adversely classify loans solely because the borrower is associated with a particular industry that is experiencing financial difficulties. When a financial institution’s loan modifications are not supported by adequate analysis and documentation, examiners are expected to exercise reasonable judgment in reviewing and determining loan classifications until such time as the financial institution is able to provide information to support management’s conclusions and internal loan grades. Refer to Appendix 4 for the classification Page 10 of 39 definitions.28 A. Loan Performance Assessment for Classification Purposes The loan’s record of performance to date should be one of several considerations when determining whether a loan should be adversely classified. As a general principle, examiners should not adversely classify or require the recognition of a partial charge-off on a performing commercial loan solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. However, it is appropriate to classify a performing loan when well-defined weaknesses exist that jeopardize repayment. One perspective on loan performance is based upon an assessment as to whether the borrower is contractually current on principal or interest payments. For many loans, the assessment of payment status is sufficient to arrive at a loan’s classification. In other cases, being contractually current on payments can be misleading as to the credit risk embedded in the loan. This may occur when the loan’s underwriting structure or the liberal use of extensions and renewals masks credit weaknesses and obscures a borrower’s inability to meet reasonable repayment terms assessment of payment status is sufficient to arrive at a loan’s classification. In other cases, being contractually current on payments can be misleading as to the credit risk embedded in the loan. This may occur when the loan’s underwriting structure or the liberal use of extensions and renewals masks credit weaknesses and obscures a borrower’s inability to meet reasonable repayment terms. For example, for many acquisition, development, and construction projects, the loan is structured with an “interest reserve” for the construction phase of the project. At the time the loan is originated, the lender establishes the interest reserve as a portion of the initial loan commitment. During the construction phase, the lender recognizes interest income from the interest reserve and capitalizes the interest into the loan balance. After completion of the construction, the lender recognizes the proceeds from the sale of lots, homes, or buildings for the repayment of principal, including any of the capitalized interest. For a commercial construction loan where the property has achieved stabilized occupancy, the lender uses the proceeds from permanent financing for repayment of the construction loan or converts the construction loan to an amortizing loan. However, if the development project stalls and management fails to evaluate the collectability of the loan, interest income could continue to be recognized from the interest reserve and capitalized into the loan balance, even though the project is not generating sufficient cash flows to repay the loan. In this case, the loan will be contractually current due to the interest payments being funded from the reserve, but the repayment of principal may be in jeopardy. This repayment uncertainty is especially true when leases or sales have not occurred as projected and property values have dropped below the market value reported in the original collateral valuation. In this situation, adverse classification of the loan may be appropriate y current due to the interest payments being funded from the reserve, but the repayment of principal may be in jeopardy. This repayment uncertainty is especially true when leases or sales have not occurred as projected and property values have dropped below the market value reported in the original collateral valuation. In this situation, adverse classification of the loan may be appropriate. A second perspective for assessing a loan’s classification is to consider the borrower’s expected performance and ability to meet its obligations in accordance with the modified terms over the remaining life of the loan. Therefore, the loan classification is meant to measure risk over the term 28 The NCUA does not require credit unions to adopt a uniform regulatory classification schematic of loss, doubtful, or substandard. A credit union must apply a relative credit risk score (i.e., credit risk rating) to each commercial loan as required by 12 CFR part 723, Member Business Loans; Commercial Lending, or the equivalent state regulation as applicable (see Section 723.4(g)(3)). Adversely classified refers to loans more severely graded under the credit union’s credit risk rating system. Adversely classified loans generally require enhanced monitoring and present a higher risk of loss. Refer to the NCUA’s Examiner’s Guide for further information on credit risk rating systems. Page 11 of 39 of the loan rather than just reflecting the loan’s payment history. As a borrower’s expected performance is dependent upon future events, examiners’ credit analyses should focus on: • The borrower’s financial strength as reflected by its historical and projected balance sheet and income statement outcomes; and • The prospects for the CRE property considering events and market conditions that reasonably may occur during the term of the loan. B t history. As a borrower’s expected performance is dependent upon future events, examiners’ credit analyses should focus on: • The borrower’s financial strength as reflected by its historical and projected balance sheet and income statement outcomes; and • The prospects for the CRE property considering events and market conditions that reasonably may occur during the term of the loan. B. Classification of Renewals or Restructurings of Maturing Loans Loans to commercial borrowers can have short maturities, including short-term working capital loans to businesses, financing for CRE construction projects, or bridge loans to finance recently completed CRE projects for a period to achieve stabilized occupancy before obtaining permanent financing or selling the property. When there has been deterioration in collateral values, a borrower with a maturing loan amid an economic downturn may have difficulty obtaining short- term financing or adequate sources of long-term credit, despite the borrower’s demonstrated and continued ability to service the debt. In such cases, financial institutions may determine that the most appropriate course is to restructure or renew the loan. Such actions, when done prudently, are often in the best interest of both the financial institution and the borrower. A restructured loan typically reflects an elevated level of credit risk, as the borrower may not be, or has not been, able to perform according to the original contractual terms. The assessment of each loan should be based upon the fundamental characteristics affecting the collectability of that loan. In general, renewals or restructurings of maturing loans to commercial borrowers who have the ability to repay on reasonable terms will not automatically be subject to adverse classification by examiners. However, consistent with safety and soundness standards, such loans should be identified in the financial institution’s internal credit grading system and may warrant close monitoring loan. In general, renewals or restructurings of maturing loans to commercial borrowers who have the ability to repay on reasonable terms will not automatically be subject to adverse classification by examiners. However, consistent with safety and soundness standards, such loans should be identified in the financial institution’s internal credit grading system and may warrant close monitoring. Adverse classification of a renewed or restructured loan would be appropriate if, despite the renewal or restructuring, well-defined weaknesses exist that jeopardize the orderly repayment of the loan pursuant to reasonable modified terms. C. Classification of Problem CRE Loans Dependent on the Sale of Collateral for Repayment As a general classification principle for a problem CRE loan that is dependent on the sale of the collateral for repayment, any portion of the loan balance that exceeds the amount that is adequately secured by the fair value of the real estate collateral less the costs to sell should be classified “loss.” This principle applies to loans that are collateral dependent based on the sale of the collateral in accordance with GAAP and for which there are no other available reliable sources of repayment such as a financially capable guarantor.29 The portion of the loan balance that is adequately secured by the fair value of the real estate collateral less the costs to sell generally should be adversely classified no worse than “substandard.” The amount of the loan balance in excess of the fair value of the real estate collateral, or portions thereof, should be adversely classified “doubtful” when the potential for full loss may be mitigated by the outcomes of certain pending events, or when loss is expected but the amount of the loss cannot be reasonably determined. If warranted by the underlying circumstances, an examiner may 29 See footnote 26. an balance in excess of the fair value of the real estate collateral, or portions thereof, should be adversely classified “doubtful” when the potential for full loss may be mitigated by the outcomes of certain pending events, or when loss is expected but the amount of the loss cannot be reasonably determined. If warranted by the underlying circumstances, an examiner may 29 See footnote 26. Page 12 of 39 use a “doubtful” classification on the entire loan balance. However, examiners should use a “doubtful” classification infrequently, as such a designation is temporary 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. D. Classification and Accrual Treatment of Restructured Loans with a Partial Charge-off Based on consideration of all relevant factors, an assessment may indicate that a loan has well-defined weaknesses that jeopardize collection in full of all amounts contractually due and may result in a partial charge-off as part of a restructuring. When well-defined weaknesses exist and a partial charge-off has been taken, the remaining recorded balance for the restructured loan generally should be classified no more severely than “substandard.” A more severe classification than “substandard” for the remaining recorded balance would be appropriate if the loss exposure cannot be reasonably determined. Such situations may occur when significant remaining risk exposures are identified but are not quantified, such as bankruptcy or a loan collateralized by a property with potential environmental concerns. A restructuring may involve a multiple note structure in which, for example, a loan is restructured into two notes (referred to as Note A and Note B). Lenders may separate a portion of the current outstanding debt into a new, legally enforceable note (Note A) that is reasonably assured of repayment and performance according to prudently modified terms with potential environmental concerns. A restructuring may involve a multiple note structure in which, for example, a loan is restructured into two notes (referred to as Note A and Note B). Lenders may separate a portion of the current outstanding debt into a new, legally enforceable note (Note A) that is reasonably assured of repayment and performance according to prudently modified terms. When restructuring a collateral-dependent loan using a multiple note structure, the amount of Note A should be determined using the fair value of the collateral. This note may be placed back in accrual status in certain situations. In returning the loan to accrual status, sustained historical payment performance for a reasonable time prior to the restructuring may be taken into account. Additionally, a properly structured and performing Note A generally would not be adversely classified by examiners. The portion of the debt that is unlikely to be repaid or collected and therefore is deemed uncollectible (Note B) would be adversely classified “loss” and must be charged off. In contrast, the loan should remain on, or be placed in, nonaccrual status if the financial institution does not split the loan into separate notes, but internally recognizes a partial charge-off. A partial charge-off would indicate that the financial institution does not expect full repayment of the amounts contractually due. If facts change after the charge-off is taken such that the full amounts contractually due, including the amount charged off, are expected to be collected and the loan has been brought contractually current, the remaining balance of the loan may be returned to accrual status without having to first receive payment of the charged-off amount.30 In these cases, examiners should assess whether the financial institution has well-documented support for its credit assessment of the borrower’s financial condition and the prospects for full repayment. VI e loan has been brought contractually current, the remaining balance of the loan may be returned to accrual status without having to first receive payment of the charged-off amount.30 In these cases, examiners should assess whether the financial institution has well-documented support for its credit assessment of the borrower’s financial condition and the prospects for full repayment. VI. Regulatory Reporting and Accounting Considerations 30 The charged-off amount should not be reversed or re-booked, under any condition, to increase the recorded investment in the loan or its amortized cost, as applicable, when the loan is returned to accrual status. However, expected recoveries, prior to collection, are a component of management’s estimate of the net amount expected to be collected for a loan under ASC Topic 326. Refer to relevant regulatory reporting instructions for supervisory guidance on returning a loan to accrual status. Page 13 of 39 Financial institution management is responsible for preparing regulatory reports in accordance with GAAP and regulatory reporting requirements. Management also is responsible for establishing and maintaining an appropriate governance and internal control structure over the preparation of regulatory reports. The agencies have observed this governance and control structure commonly includes policies and procedures that provide clear guidance on accounting matters. Accurate regulatory reports are critical to the transparency of a financial institution’s financial position and risk profile and are imperative for effective supervision. Decisions related to loan workout arrangements may affect regulatory reporting, particularly interest accruals and loan loss estimates nly includes policies and procedures that provide clear guidance on accounting matters. Accurate regulatory reports are critical to the transparency of a financial institution’s financial position and risk profile and are imperative for effective supervision. Decisions related to loan workout arrangements may affect regulatory reporting, particularly interest accruals and loan loss estimates. Therefore, it is important that loan workout staff appropriately communicate with the accounting and regulatory reporting staff concerning the financial institution’s loan restructurings and that the consequences of restructurings are presented accurately in regulatory reports. In addition to evaluating credit risk management processes and validating the accuracy of internal loan grades, examiners are responsible for reviewing management’s processes related to accounting and regulatory reporting. While similar data are used for loan risk monitoring, accounting, and reporting systems, this information does not necessarily produce identical outcomes. For example, loss classifications may not be equivalent to the associated allowance measurements. A. Allowance for Credit Losses Examiners need to have a clear understanding of the differences between credit risk management and accounting and regulatory reporting concepts (such as accrual status and the allowance) when assessing the adequacy of the financial institution’s reporting practices for on- and off-balance sheet credit exposures. Refer to Appendix 5 for a summary of the allowance standard under ASC Topic 326, Financial Instruments – Credit Losses. Examiners should also refer to regulatory reporting instructions in the FFIEC Call Report and the NCUA 5300 Call Report guidance as well as applicable accounting standards for further information. B on’s reporting practices for on- and off-balance sheet credit exposures. Refer to Appendix 5 for a summary of the allowance standard under ASC Topic 326, Financial Instruments – Credit Losses. Examiners should also refer to regulatory reporting instructions in the FFIEC Call Report and the NCUA 5300 Call Report guidance as well as applicable accounting standards for further information. B. Implications for Interest Accrual A financial institution needs to consider whether a loan that was accruing interest prior to the loan restructuring should be placed in nonaccrual status at the time of modification to ensure that income is not materially overstated. Consistent with FFIEC and NCUA Call Report instructions, a loan that has been restructured so as to be reasonably assured of repayment and performance according to prudent modified terms need not be placed in nonaccrual status. Therefore, for a loan to remain in accrual status, the restructuring and any charge-off taken on the loan must be supported by a current, well-documented credit assessment of the borrower’s financial condition and prospects for repayment under the revised terms. Otherwise, the restructured loan must be placed in nonaccrual status. A restructured loan placed in nonaccrual status should not be returned to accrual status until the borrower demonstrates sustained repayment performance for a reasonable period prior to the date on which the loan is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. It may also include historical periods prior to the date of the loan restructuring. While an appropriately designed restructuring should improve the collectability of the loan in accordance o the date on which the loan is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. It may also include historical periods prior to the date of the loan restructuring. While an appropriately designed restructuring should improve the collectability of the loan in accordance Page 14 of 39 with a reasonable repayment schedule, it does not relieve the financial institution from the responsibility to promptly charge off all identified losses. For more detailed instructions about placing a loan in nonaccrual status and returning a nonaccrual loan to accrual status, refer to the instructions for the FFIEC Call Report and the NCUA 5300 Call Report. Page 15 of 39 Appendix 1 Examples of CRE Loan Workout Arrangements The examples in this appendix are provided for illustrative purposes only and are designed to demonstrate an examiner’s analytical thought process to derive an appropriate classification and evaluate implications for interest accrual.31 Although not discussed in the examples below, examiners consider the adequacy of a financial institution’s supporting documentation, internal analysis, and business decision to enter into a loan workout arrangement. The examples also do not address the effect of the loan workout arrangement on the allowance and subsequent reporting requirements. Financial institutions should refer to the appropriate regulatory reporting instructions for supervisory guidance on the recognition, measurement, and regulatory reporting of loan modifications. Examiners should use caution when applying these examples to “real-life” situations, consider all facts and circumstances of the loan being evaluated, and exercise judgment before reaching conclusions related to loan classification and nonaccrual treatment.32 A porting instructions for supervisory guidance on the recognition, measurement, and regulatory reporting of loan modifications. Examiners should use caution when applying these examples to “real-life” situations, consider all facts and circumstances of the loan being evaluated, and exercise judgment before reaching conclusions related to loan classification and nonaccrual treatment.32 A. Income Producing Property – Office Building BASE CASE: A lender originated a $15 million loan for the purchase of an office building with monthly payments based on an amortization of 20 years and a balloon payment of $13.6 million at the end of year five. At origination, the loan had a 75 percent loan-to-value (LTV) based on an appraisal reflecting a $20 million market value on an “as stabilized” basis, a debt service coverage (DSC) ratio of 1.30x, and a market interest rate. The lender expected to renew the loan when the balloon payment became due at the end of year five. Due to technological advancements and a workplace culture change since the inception of the loan, many businesses switched to hybrid work- from-home arrangements to reduce longer-term costs and improve employee retention. As a result, the property’s cash flow declined as the borrower has had to grant rental concessions to either retain its existing tenants or attract new tenants, since the demand for office space has decreased. SCENARIO 1: At maturity, the lender renewed the $13.6 million loan for one year at a market interest rate that provides for the incremental risk and payments based on amortizing the principal over the remaining 15 years. The borrower had not been delinquent on prior payments and has sufficient cash flow to service the loan at the market interest rate terms with a DSC ratio of 1.12x, based on updated financial information. A review of the leases reflects that most tenants are stable occupants, with long-term leases and sufficient cash flow to pay their rent mortizing the principal over the remaining 15 years. The borrower had not been delinquent on prior payments and has sufficient cash flow to service the loan at the market interest rate terms with a DSC ratio of 1.12x, based on updated financial information. A review of the leases reflects that most tenants are stable occupants, with long-term leases and sufficient cash flow to pay their rent. The major tenants have not adopted hybrid work-from-home arrangements for their employees given the nature of the businesses. A recent appraisal reported an “as stabilized” market value of $13.3 million for the property for an LTV of 102 percent. This reflects current market conditions and the resulting decline in cash flow. Classification: The lender internally graded the loan pass and is monitoring the credit. The 31 The agencies view that the accrual treatments in these examples as falling within the range of acceptable practices under regulatory reporting instructions. 32 In addition, estimates of the fair value of collateral use assumptions based on judgment and should be consistent with measurement of fair value in ASC Topic 820, Fair Value Measurement; see Appendix 2. Page 16 of 39 examiner agreed, because the borrower has the ability to continue making loan payments based on reasonable terms, despite a decline in cash flow and in the market value of the collateral. Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower has demonstrated the ability to make the regularly scheduled payments and, even with the decline in the borrower’s creditworthiness, cash flow appears sufficient to make these payments, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. SCENARIO 2: At maturity, the lender renewed the $13.6 million loan at a market interest rate that provides for the incremental risk and payments based on amortizing the principal over the remaining 15 years itworthiness, cash flow appears sufficient to make these payments, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. SCENARIO 2: At maturity, the lender renewed the $13.6 million loan at a market interest rate that provides for the incremental risk and payments based on amortizing the principal over the remaining 15 years. The borrower had not been delinquent on prior payments. Current projections indicate the DSC ratio will not drop below 1.12x based on leases in place and letters of intent for vacant space. However, some leases are coming up for renewal, and additional rental concessions may be necessary to either retain those existing tenants or attract new tenants. The lender estimates the property’s current “as stabilized” market value is $14.5 million, which results in a 94 percent LTV, but a current valuation has not been ordered. In addition, the lender has not asked the borrower or guarantors to provide current financial statements to assess their ability to support any cash flow shortfall. Classification: The lender internally graded the loan pass and is monitoring the credit. The examiner disagreed with the internal grade and listed the credit as special mention. While the borrower has the ability to continue to make payments based on leases currently in place and letters of intent for vacant space, there has been a declining trend in the property’s revenue stream, and there is most likely a reduced collateral margin. In addition, there is potential for further deterioration in the cash flow as more leases will expire in the upcoming months, while absorption for office space in this market has slowed. Lastly, the examiner noted that the lender failed to request current financial information and to obtain an updated collateral valuation,33 representing administrative weaknesses. Nonaccrual Treatment: The lender maintained the loan in accrual status erioration in the cash flow as more leases will expire in the upcoming months, while absorption for office space in this market has slowed. Lastly, the examiner noted that the lender failed to request current financial information and to obtain an updated collateral valuation,33 representing administrative weaknesses. Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower has demonstrated the ability to make regularly scheduled payments and, even with the decline in the borrower’s creditworthiness, cash flow is sufficient at this time to make payments, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. SCENARIO 3: At maturity, the lender restructured the $13.6 million loan on a 12-month interest- only basis at a below market interest rate. The borrower has been sporadically delinquent on prior principal and interest payments. The borrower projects a DSC ratio of 1.10x based on the restructured interest-only terms. A review of the rent roll, which was available to the lender at the time of the restructuring, reflects the majority of tenants have short-term leases, with three leases expected to expire within the next three months. According to the lender, leasing has not improved since the restructuring as market conditions remain soft. Further, the borrower does not have an 33 In relation to comments on valuations within these examples, refer to the appraisal regulations applicable to the financial institution to determine whether there is a regulatory requirement for either an evaluation or appraisal. See footnote 20. ding to the lender, leasing has not improved since the restructuring as market conditions remain soft. Further, the borrower does not have an 33 In relation to comments on valuations within these examples, refer to the appraisal regulations applicable to the financial institution to determine whether there is a regulatory requirement for either an evaluation or appraisal. See footnote 20. Page 17 of 39 update as to whether the three expiring leases will renew at maturity; two of the tenants have moved to hybrid work-from-home arrangements. A recent appraisal provided a $14.5 million “as stabilized” market value for the property, resulting in a 94 percent LTV. Classification: The lender internally graded the loan pass and is monitoring the credit. The examiner disagreed with the internal grade and classified the loan substandard due to the borrower’s limited ability to service a below market interest rate loan on an interest-only basis, sporadic delinquencies, and an increase in the LTV based on an updated appraisal. In addition, there is lease rollover risk because three of the leases are expiring soon, which could further limit cash flow. Nonaccrual Treatment: The lender maintained the loan in accrual status due to the positive cash flow and collateral margin. The examiner did not concur with this treatment as the loan was not restructured with reasonable repayment terms, and the borrower has not demonstrated the ability to amortize the loan and has limited ability to service a below market interest rate on an interest-only basis. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. B. Income Producing Property – Retail Properties BASE CASE: 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 tory reporting requirements, the lender placed the loan on nonaccrual. B. Income Producing Property – Retail Properties BASE CASE: 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. At the time of origination, the appraisal reported an “as stabilized” market value of $13.5 million for the property. In addition, the borrower had a take-out commitment that would provide permanent financing at maturity. A condition of the take-out lender was that the shopping mall had to achieve a 75 percent occupancy level. Due to weak economic conditions and a shift in consumer behavior to a greater reliance on e- commerce, the property only reached a 55 percent occupancy level at the end of the 12-month lease up period. As a result, the original takeout commitment became void. In addition, there has been a considerable tightening of credit for these types of loans, and the borrower has been unable to obtain permanent financing elsewhere since the loan matured. To date, the few interested lenders are demanding significant equity contributions and much higher pricing. SCENARIO 1: The lender renewed the loan for an additional 12 months to provide the borrower time for higher lease-up and to obtain permanent financing. The extension was made at a market interest rate that provides for the incremental risk and is on an interest-only basis n matured. To date, the few interested lenders are demanding significant equity contributions and much higher pricing. SCENARIO 1: The lender renewed the loan for an additional 12 months to provide the borrower time for higher lease-up and to obtain permanent financing. The extension was made at a market interest rate that provides for the incremental risk and is on an interest-only basis. While the property’s historical cash flow was insufficient at a 0.92x debt service ratio, recent improvements in the occupancy level now provide adequate coverage based on the interest-only payments. Recent events include the signing of several new leases with additional leases under negotiation; however, takeout financing continues to be tight in the market. In addition, current financial statements reflect that the builder, who personally guarantees the debt, has cash on deposit at the lender plus other unencumbered liquid assets. These assets provide Page 18 of 39 sufficient cash flow to service the borrower’s global debt service requirements on a principal and interest basis, if necessary, for the next 12 months. The guarantor covered the initial cash flow shortfalls from the project and provided a good faith principal curtailment of $200,000 at renewal, reducing the loan balance to $9.8 million. A recent appraisal on the shopping mall reports an “as is” market value of $10 million and an “as stabilized” market value of $11 million, resulting in LTVs of 98 percent and 89 percent, respectively. Classification: The lender internally graded the loan as a pass and is monitoring the credit. The examiner disagreed with the lender’s internal loan grade and listed it as special mention. While the project continues to lease up, cash flows cover only the interest payments. The guarantor has the ability, and has demonstrated the willingness, to cover cash flow shortfalls; however, there remains considerable uncertainty surrounding the takeout financing for this loan ring the credit. The examiner disagreed with the lender’s internal loan grade and listed it as special mention. While the project continues to lease up, cash flows cover only the interest payments. The guarantor has the ability, and has demonstrated the willingness, to cover cash flow shortfalls; however, there remains considerable uncertainty surrounding the takeout financing for this loan. Nonaccrual Treatment: The lender maintained the loan in accrual status as the guarantor has sufficient funds to cover the borrower’s global debt service requirements over the one-year period of the renewed loan. Full repayment of principal and interest is reasonably assured from the project’s and guarantor’s cash resources, despite a decline in the collateral margin. The examiner concurred with the lender’s accrual treatment. SCENARIO 2: The lender restructured the loan on an interest-only basis at a below market interest rate for one year to provide additional time to increase the occupancy level and, thereby, enable the borrower to arrange permanent financing. The level of lease-up remains relatively unchanged at 55 percent, and the shopping mall projects a DSC ratio of 1.02x based on the preferential loan terms. At the time of the restructuring, the lender used outdated financial information, which resulted in a positive cash flow projection. However, other file documentation available at the time of the restructuring reflected that the borrower anticipates the shopping mall’s revenue stream will further decline due to rent concessions, the loss of a tenant, and limited prospects for finding new tenants. Current financial statements indicate the builder, who personally guarantees the debt, cannot cover any cash flow shortfall. The builder is highly leveraged, has limited cash or unencumbered liquid assets, and has other projects with delinquent payments. A recent appraisal on the shopping mall reports an “as is” market value of $9 million, which results in an LTV ratio of 111 percent enants. Current financial statements indicate the builder, who personally guarantees the debt, cannot cover any cash flow shortfall. The builder is highly leveraged, has limited cash or unencumbered liquid assets, and has other projects with delinquent payments. A recent appraisal on the shopping mall reports an “as is” market value of $9 million, which results in an LTV ratio of 111 percent. Classification: The lender internally classified the loan as substandard. The examiner disagreed with the internal grade and classified the amount not protected by the collateral value, $1 million, as loss and required the lender to charge-off this amount. The examiner did not factor costs to sell into the loss classification analysis, as the current source of repayment is not reliant on the sale of the collateral. The examiner classified the remaining loan balance, based on the property’s “as is” market value of $9 million, as substandard given the borrower’s uncertain repayment ability and weak financial support. Nonaccrual Treatment: The lender determined the loan did not warrant being placed in nonaccrual status. The examiner did not concur with this treatment because the partial charge- off is indicative that full collection of principal is not anticipated, and the lender has continued exposure to additional loss due to the project’s insufficient cash flow and reduced collateral margin and the guarantor’s inability to provide further support. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. partial charge- off is indicative that full collection of principal is not anticipated, and the lender has continued exposure to additional loss due to the project’s insufficient cash flow and reduced collateral margin and the guarantor’s inability to provide further support. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. Page 19 of 39 SCENARIO 3: The loan has become delinquent. Recent financial statements indicate the borrower and the guarantor have minimal other resources available to support this loan. The lender chose not to restructure the $10 million loan into a new single amortizing note of $10 million at a market interest rate because the project’s projected cash flow would only provide a 0.88x DSC ratio as the borrower has been unable to lease space. A recent appraisal which reasonably estimates the fair value on the shopping mall reported an “as is” market value of $7 million, resulting in an LTV of 143 percent. At the original loan’s maturity, the lender restructured the $10 million debt, which is a collateral-dependent loan, into two notes. The lender placed the first note of $7 million (Note A) on monthly payments that amortize the debt over 20 years at a market interest rate that provides for the incremental risk. The project’s DSC ratio equals 1.20x for the $7 million loan based on the shopping mall’s projected net operating income. For the second note (Note B), the lender placed the remaining $3 million, which represents the excess of the $10 million debt over the $7 million market value of the shopping mall, into a 2 percent interest-only loan that resets in five years into an amortizing payment. The lender then charged-off the $3 million note due to the project’s lack of repayment ability and to provide reasonable collateral protection for the remaining on-book loan of $7 million. The lender also reversed accrued but unpaid interest on debt over the $7 million market value of the shopping mall, into a 2 percent interest-only loan that resets in five years into an amortizing payment. The lender then charged-off the $3 million note due to the project’s lack of repayment ability and to provide reasonable collateral protection for the remaining on-book loan of $7 million. The lender also reversed accrued but unpaid interest. Since the restructuring, the borrower has made payments on both loans for more than six consecutive months and an updated financial analysis shows continued ability to repay under the new terms. Classification: The lender internally graded the on-book loan of $7 million as a pass loan due to the borrower’s demonstrated ability to perform under the modified terms. The examiner agreed with the lender’s grade as the lender restructured the original obligation into Notes A and B, the lender charged off Note B, and the borrower has demonstrated the ability to repay Note A. Using this multiple note structure with charge-off of the Note B enables the lender to recognize interest income. Nonaccrual Treatment: The lender placed the on-book loan (Note A) of $7 million loan in nonaccrual status at the time of the restructure. The lender later restored the $7 million to accrual status as the borrower has the ability to repay the loan, has a record of performing at the revised terms for more than six months, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. Interest payments received on the off-book loan have been recorded as recoveries because full recovery of principal and interest on this loan (Note B) was not reasonably assured. SCENARIO 4: Current financial statements indicate the borrower and the guarantor have minimal other resources available to support this loan expected. The examiner concurred with the lender’s accrual treatment. Interest payments received on the off-book loan have been recorded as recoveries because full recovery of principal and interest on this loan (Note B) was not reasonably assured. SCENARIO 4: Current financial statements indicate the borrower and the guarantor have minimal other resources available to support this loan. The lender restructured the $10 million loan into a new single note of $10 million at a market interest rate that provides for the incremental risk and is on an amortizing basis. The project’s projected cash flow reflects a 0.88x DSC ratio as the borrower has been unable to lease space. A recent appraisal on the shopping mall reports an “as is” market value of $9 million, which results in an LTV of 111 percent. Based on the property’s current market value of $9 million, the lender charged-off $1 million immediately after the renewal. Classification: The lender internally graded the remaining $9 million on-book portion of the loan as a pass loan because the lender’s analysis of the project’s cash flow indicated a 1.05x DSC ratio when just considering the on-book balance. The examiner disagreed with the internal grade Page 20 of 39 and classified the $9 million on-book balance as substandard due to the borrower’s marginal financial condition, lack of guarantor support, and uncertainty over the source of repayment. The DSC ratio remains at 0.88x due to the single note restructure, and other resources are scant. Nonaccrual Treatment: The lender maintained the remaining $9 million on-book portion of the loan on accrual, as the borrower has the ability to repay the principal and interest on this balance. The examiner did not concur with this treatment port, and uncertainty over the source of repayment. The DSC ratio remains at 0.88x due to the single note restructure, and other resources are scant. Nonaccrual Treatment: The lender maintained the remaining $9 million on-book portion of the loan on accrual, as the borrower has the ability to repay the principal and interest on this balance. The examiner did not concur with this treatment. Because the lender restructured the debt into a single note and had charged-off a portion of the restructured loan, the repayment of the principal and interest contractually due on the entire debt is not reasonably assured given the DSC ratio of 0.88x and nominal other resources. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. The loan can be returned to accrual status34 if the lender can document that subsequent improvement in the borrower’s financial condition has enabled the loan to be brought fully current with respect to principal and interest and the lender expects the contractual balance of the loan (including the partial charge-off) will be fully collected. In addition, interest income may be recognized on a cash basis for the partially charged-off portion of the loan when the remaining recorded balance is considered fully collectible. However, the partial charge-off would not be reversed. C. Income Producing Property – Hotel BASE CASE: A lender originated a $7.9 million loan to provide permanent financing for the acquisition of a stabilized 3-star hotel property. The borrower is a limited liability company with underlying ownership by two families who guarantee the loan. The loan term is five years, with payments based on a 25-year amortization and with a market interest rate. The LTV was 79 percent based on the hotel’s appraised value of $10 million. At the end of the five-year term, the borrower’s annualized DSC ratio was 0.95x ar hotel property. The borrower is a limited liability company with underlying ownership by two families who guarantee the loan. The loan term is five years, with payments based on a 25-year amortization and with a market interest rate. The LTV was 79 percent based on the hotel’s appraised value of $10 million. At the end of the five-year term, the borrower’s annualized DSC ratio was 0.95x. Due to competition from a well-known 4-star hotel that recently opened within one mile of the property, occupancy rates have declined. The borrower progressively reduced room rates to maintain occupancy rates, but continued to lose daily bookings. Both occupancy and Revenue per Available Room (RevPAR)35 declined significantly over the past year. The borrower then began working on an initiative to make improvements to the property (i.e., automated key cards, carpeting, bedding, and lobby renovations) to increase competitiveness, and a marketing campaign is planned to announce the improvements and new price structure. The borrower had paid principal and interest as agreed throughout the first five years, and the principal balance had reduced to $7 million at the end of the five-year term. SCENARIO 1: At maturity, the lender renewed the loan for 12 months on an interest-only basis at a market interest rate that provides for the incremental risk. The extension was granted to enable the borrower to complete the planned renovations, launch the marketing campaign, and achieve the borrower’s updated projections for sufficient cash flow to service the debt once the improvements are completed. (If the initiative is successful, the loan officer expects the loan to either be renewed on an amortizing basis or refinanced through another lending entity.) The borrower has a verified, pledged reserve account to cover the improvement expenses. Additionally, the guarantors’ updated 34 Refer to the supervisory guidance on “nonaccrual status” in the FFIEC Call Report and NCUA 5300 Call Report instructions ve is successful, the loan officer expects the loan to either be renewed on an amortizing basis or refinanced through another lending entity.) The borrower has a verified, pledged reserve account to cover the improvement expenses. Additionally, the guarantors’ updated 34 Refer to the supervisory guidance on “nonaccrual status” in the FFIEC Call Report and NCUA 5300 Call Report instructions. 35 Total guest room revenue divided by room count and number of days in the period. Page 21 of 39 financial statements indicate that they have sufficient unencumbered liquid assets. Further, the guarantors expressed the willingness to cover any estimated cash flow shortfall through maturity. Based on this information, the lender’s analysis indicates that, after deductions for personal obligations and realistic living expenses and verification that there are no contingent liabilities, the guarantors should be able to make interest payments. To date, interest payments have been timely. The lender estimates the property’s current “as stabilized” market value at $9 million, which results in a 78 percent LTV. Classification: The lender internally graded the loan as a pass and is monitoring the credit. The examiner agreed with the lender’s internal loan grade. The examiner concluded that the borrower and guarantors have sufficient resources to support the interest payments; additionally, the borrower’s reserve account is sufficient to complete the renovations as planned. Nonaccrual Treatment: The lender maintained the loan in accrual status as full repayment of principal and interest is reasonably assured from the hotel’s and guarantors’ cash flows, despite a decline in the borrower’s cash flow due to competition. The examiner concurred with the lender’s accrual treatment the borrower’s reserve account is sufficient to complete the renovations as planned. Nonaccrual Treatment: The lender maintained the loan in accrual status as full repayment of principal and interest is reasonably assured from the hotel’s and guarantors’ cash flows, despite a decline in the borrower’s cash flow due to competition. The examiner concurred with the lender’s accrual treatment. SCENARIO 2: At maturity of the original loan, the lender restructured the loan on an interest-only basis at a below market interest rate for 12 months to provide the borrower time to complete its renovation and marketing efforts and increase occupancy levels. At the end of the 12-month period, the hotel’s renovation and marketing efforts were completed but unsuccessful. The hotel continued to experience a decline in occupancy levels, resulting in a DSC ratio of 0.60x. The borrower does not have ability to offer additional incentives to lure customers from the competition. RevPAR has also declined. Current financial information indicates the borrower has limited ability to continue to make interest payments, and updated projections indicate that the borrower will be below break-even performance for the next 12 months. The borrower has been sporadically delinquent on prior interest payments. The guarantors are unable to support the loan as they have limited unencumbered liquid assets and are highly leveraged. The lender is in the process of renewing the loan again. The most recent hotel appraisal, dated as of the time of the first restructuring, reports an “as stabilized” appraised value of $7.2 million ($6.7 million for the real estate and $500,000 for the tangible personal property of furniture, fixtures, and equipment), resulting in an LTV of 97 percent. The appraisal does not account for the diminished occupancy, and its assumptions significantly differ from current projections. A new valuation is needed to ascertain the current value of the property zed” appraised value of $7.2 million ($6.7 million for the real estate and $500,000 for the tangible personal property of furniture, fixtures, and equipment), resulting in an LTV of 97 percent. The appraisal does not account for the diminished occupancy, and its assumptions significantly differ from current projections. A new valuation is needed to ascertain the current value of the property. Classification: The lender internally classified the loan as substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the borrower’s diminished ongoing ability to make payments, the guarantors’ limited ability to support the loan, and the reduced collateral position. The lender is obtaining a new valuation and will adjust the internal classification, if necessary, based on the updated value. Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the borrower demonstrated an ability to make interest payments. The examiner did not concur with this treatment as the loan was not restructured on reasonable repayment terms, the borrower has insufficient cash resources to service the below market interest rate on an interest-only basis, and Page 22 of 39 the collateral margin has narrowed and may be narrowed further with a new valuation, which collectively indicates that full repayment of principal and interest is in doubt. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. SCENARIO 3: At maturity of the original loan, the lender restructured the debt for one year on an interest-only basis at a below market interest rate to give the borrower additional time to complete renovations and increase marketing efforts. While the combined borrower/guarantors’ liquidity indicated they could cover any cash flow shortfall until maturity of the restructured note, the borrower only had 50 percent of the funds to complete its renovations in reserve debt for one year on an interest-only basis at a below market interest rate to give the borrower additional time to complete renovations and increase marketing efforts. While the combined borrower/guarantors’ liquidity indicated they could cover any cash flow shortfall until maturity of the restructured note, the borrower only had 50 percent of the funds to complete its renovations in reserve. Subsequently, the borrower attracted a sponsor to obtain the remaining funds necessary to complete the renovation plan and marketing campaign. Eight months later, the hotel experienced an increase in its occupancy and achieved a DSC ratio of 1.20x on an amortizing basis. Updated projections indicated the borrower would be at or above the 1.20x DSC ratio for the next 12 months, based on market terms and rate. The borrower and the lender then agreed to restructure the loan again with monthly payments that amortize the debt over 20 years, consistent with the current market terms and rates. Since the date of the second restructuring, the borrower has made all principal and interest payments as agreed for six consecutive months. Classification: The lender internally classified the most recent restructured loan substandard. The examiner agreed with the lender’s initial substandard grade at the time of the subject restructuring, but now considers the loan as a pass as the borrower was no longer having financial difficulty and has demonstrated the ability to make payments according to the modified principal and interest terms for more than six consecutive months. Nonaccrual Treatment: The original restructured loan was placed in nonaccrual status. The lender initially maintained the most recent restructured loan in nonaccrual status as well, but returned it to an accruing status after the borrower made six consecutive monthly principal and interest payments. The lender expects full repayment of principal and interest. The examiner concurred with the lender’s accrual treatment riginal restructured loan was placed in nonaccrual status. The lender initially maintained the most recent restructured loan in nonaccrual status as well, but returned it to an accruing status after the borrower made six consecutive monthly principal and interest payments. The lender expects full repayment of principal and interest. The examiner concurred with the lender’s accrual treatment. SCENARIO 4: The lender extended the original amortizing loan for 12 months at a market interest rate. The borrower is now experiencing a six-month delay in completing the renovations due to a conflict with the contractor hired to complete the renovation work, and the current DSC ratio is 0.85x. A current valuation has not been ordered. The lender estimates the property’s current “as stabilized” market value is $7.8 million, which results in an estimated 90 percent LTV. The lender did receive updated projections, but the borrower is now unlikely to achieve break-even cash flow within the 12-month extension timeframe due to the renovation delays. At the time of the extension, the borrower and guarantors had sufficient liquidity to cover the debt service during the twelve- month period. The guarantors also demonstrated a willingness to support the loan by making payments when necessary, and the loan has not gone delinquent. With the guarantors’ support, there is sufficient liquidity to make payments to maturity, though such resources are declining rapidly. Classification: The lender internally graded the loan as pass and is monitoring the credit. The examiner disagreed with the lender’s grading and listed the loan as special mention. While the borrower and guarantor can cover the debt service shortfall in the near-term, the duration of their is sufficient liquidity to make payments to maturity, though such resources are declining rapidly. Classification: The lender internally graded the loan as pass and is monitoring the credit. The examiner disagreed with the lender’s grading and listed the loan as special mention. While the borrower and guarantor can cover the debt service shortfall in the near-term, the duration of their Page 23 of 39 support may not extend long enough to replace lost cash flow from operations due to delays in the renovation work. The primary source of repayment does not fully cover the loan as evidenced by a DSC ratio of 0.85x. It appears that competition from the new hotel will continue to adversely affect the borrower's cash flow until the renovations are complete, and if cash flow deteriorates further, the borrower and guarantors may be required to use more liquidity to support loan payments and ongoing business operations. The examiner also recommended the lender obtain a new valuation. Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower and guarantors have demonstrated the ability and willingness to make the regularly scheduled payments and, even with the decline in the borrower’s creditworthiness, global cash resources appear sufficient to make these payments, and the ultimate full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. D. Acquisition, Development and Construction – Residential BASE CASE: The lender originated a $4.8 million acquisition and development (A&D) loan and a $2.4 million construction revolving line of credit (revolver) for the development and construction of a 48-lot single-family project. The maturity for both loans is three years, and both are priced at a market interest rate; both loans also have an interest reserve. The LTV on the A&D loan is 75 percent based on an “as complete” value of $6.4 million uisition and development (A&D) loan and a $2.4 million construction revolving line of credit (revolver) for the development and construction of a 48-lot single-family project. The maturity for both loans is three years, and both are priced at a market interest rate; both loans also have an interest reserve. The LTV on the A&D loan is 75 percent based on an “as complete” value of $6.4 million. Up to 12 units at a time will be funded under the construction revolver at the lesser of 80 percent LTV or 100 percent of costs. The builder is allowed two speculative (“spec”) units (including one model). The remaining units must be pre- sold with an acceptable deposit and a pre-qualified mortgage. As units are settled, the construction revolver will be repaid at 100 percent (or par); the A&D loan will be repaid at 120 percent, or $120,000 ($4.8 million/48 units x 120 percent). The average sales price is projected to be $500,000, and total construction cost to build each unit is estimated to be $200,000. Assuming total cost is lower than value, the average release price will be $320,000 ($120,000 A&D release price plus $200,000 construction costs). Estimated time for development is 12 months; the appraiser estimated absorption of two lots per month for total sell-out to occur within three years (thus, the loan would be repaid upon settlement of the 40th unit, or the 32nd month of the loan term). The borrower is required to curtail the A&D loan by six lots, or $720,000, at the 24th month, and another six lots, or $720,000, by the 30th month. SCENARIO 1: Due to issues with the permitting and approval process by the county, the borrower’s development was delayed by 18 months. Further delays occurred because the borrower was unable to pave the necessary roadways due to excessive snow and freezing temperatures. The lender waived both $720,000 curtailment requirements due to the delays. Demand for the housing remains unchanged . SCENARIO 1: Due to issues with the permitting and approval process by the county, the borrower’s development was delayed by 18 months. Further delays occurred because the borrower was unable to pave the necessary roadways due to excessive snow and freezing temperatures. The lender waived both $720,000 curtailment requirements due to the delays. Demand for the housing remains unchanged. At maturity, the lender renewed the $4.8 million outstanding A&D loan balance and the $2.4 million construction revolver for 24 months at a market interest rate that provides for the incremental risk. The interest reserve for the A&D loan has been depleted as the lender had continued to advance funds to pay the interest charges despite the delays in development. Since depletion of the interest reserve, the borrower has made the last several payments out-of- pocket. Development is now complete, and construction has commenced on eight units (two “spec” units and six pre-sold units). Combined borrower and guarantor liquidity show they can cover any debt service shortfall until the units begin to settle and the project is cash flowing. The lender Page 24 of 39 estimates that the property’s current “as complete” value is $6 million, resulting in an 80 percent LTV. The curtailment schedule was re-set to eight lots, or $960,000, by month 12, and another eight lots, or $960,000, by month 18. A new appraisal has not been ordered; however, the lender noted in the file that, if the borrower does not meet the absorption projections of six lots/quarter within six months of booking the renewed loan, the lender will obtain a new appraisal. Classification: The lender internally graded the restructured loans as pass and is monitoring the credits. The examiner agreed, as the borrower and guarantor can continue making payments on reasonable terms and the project is moving forward supported by housing demand and is consistent with the builder’s development plans of booking the renewed loan, the lender will obtain a new appraisal. Classification: The lender internally graded the restructured loans as pass and is monitoring the credits. The examiner agreed, as the borrower and guarantor can continue making payments on reasonable terms and the project is moving forward supported by housing demand and is consistent with the builder’s development plans. However, the examiner noted weaknesses in the lender’s loan administrative practices as the financial institution did not (1) suspend the interest reserve during the development delay and (2) obtain an updated collateral valuation. Nonaccrual Treatment: The lender maintained the loans in accrual status. The project is moving forward, the borrower has demonstrated the ability to make the regularly scheduled payments after depletion of the interest reserve, global cash resources from the borrower and guarantor appears sufficient to make these payments, and full repayment of principal and interest is expected. The examiner concurred with the lender’s accrual treatment. SCENARIO 2: Due to weather and contractor issues, development was not completed until month 24, a year behind the original schedule. The borrower began pre-marketing, but sales have been slow due to deteriorating market conditions in the region. The borrower has achieved only eight pre- sales during the past six months. The borrower recently commenced construction on the pre-sold units. At maturity, the lender renewed the $4.8 million A&D loan balance and $2.4 million construction revolver on a 12-month interest-only basis at a market interest rate, with another 12-month option predicated upon $1 million in curtailments having occurred during the first renewal term (the lender had waived the initial term curtailment requirements). The lender also renewed the construction revolver for a one-year term and reduced the number of “spec” units to just one, which also will serve as the model -month interest-only basis at a market interest rate, with another 12-month option predicated upon $1 million in curtailments having occurred during the first renewal term (the lender had waived the initial term curtailment requirements). The lender also renewed the construction revolver for a one-year term and reduced the number of “spec” units to just one, which also will serve as the model. A recent appraisal estimates that absorption has dropped to four lots per quarter for the first two years and assigns an “as complete” value of $5.3 million, for an LTV of 91 percent. The interest reserve is depleted, and the borrower has been paying interest out-of-pocket for the past few months. Updated borrower and guarantor financial statements indicate the continued ability to cover interest-only payments for the next 12 to 18 months. Classification: The lender internally classified the loan as substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the deterioration and uncertainty surrounding the market (as evidenced by slower than anticipated sales on the project), the lack of principal reduction, and the reduced collateral margin. Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the development is complete, the borrower has pre-sales and construction has commenced, and the borrower and guarantor have sufficient means to make interest payments at a market interest rate until the earlier of maturity or the project begins to cash flow. The examiner concurred with the lender’s accrual treatment. al Treatment: The lender maintained the loan on an accrual basis because the development is complete, the borrower has pre-sales and construction has commenced, and the borrower and guarantor have sufficient means to make interest payments at a market interest rate until the earlier of maturity or the project begins to cash flow. The examiner concurred with the lender’s accrual treatment. Page 25 of 39 SCENARIO 3: Lot development was completed on schedule, and the borrower quickly sold and settled the first 10 units. At maturity, the lender renewed the $3.6 million A&D loan balance ($4.8 million reduced by the sale and settlement of the 10 units ($120,000 release price x 10) to arrive at $3.6 million) and $2.4 million construction revolver on a 12-month interest-only basis at a below market interest rate. The borrower then sold an additional 10 units to an investor; the loan officer (new to the financial institution) mistakenly marked these units as pre-sold and allowed construction to commence on all 10 units. Market conditions then deteriorated quickly, and the investor defaulted under the terms of the bulk contract. The units were completed, but the builder has been unable to re-sell any of the units, recently dropping the sales price by 10 percent and engaging a new marketing firm, which is working with several potential buyers. A recent appraisal estimates that absorption has dropped to three lots per quarter and assigns an “as complete” value of $2.3 million for the remaining 28 lots, resulting in an LTV of 156 percent. A bulk appraisal of the 10 units assigns an “as-is” value of the units of $4.0 million ($400,000/unit). The loans are cross-defaulted and cross-collateralized; the LTV on a combined basis is 95 percent ($6 million outstanding debt (A&D plus revolver) divided by $6.3 million in combined collateral value) ete” value of $2.3 million for the remaining 28 lots, resulting in an LTV of 156 percent. A bulk appraisal of the 10 units assigns an “as-is” value of the units of $4.0 million ($400,000/unit). The loans are cross-defaulted and cross-collateralized; the LTV on a combined basis is 95 percent ($6 million outstanding debt (A&D plus revolver) divided by $6.3 million in combined collateral value). Updated borrower and guarantor financial statements indicate a continued ability to cover interest-only payments for the next 12 months at the reduced rate; however, this may be limited in the future given other troubled projects in the borrower’s portfolio that have been affected by market conditions. The lender modified the release price for each unit to net proceeds; any additional proceeds as units are sold will go towards repayment of the A&D loan. Assuming the units sell at a 10 percent reduction, the lender calculates the average sales price would be $450,000. The financial institution’s prior release price was $320,000 ($120,000 for the A&D loan and $200,000 for the construction revolver). As such (by requiring net proceeds), the financial institution will be receiving an additional $130,000 per lot, or $1.3 million for the completed units, to repay the A&D loan ($450,000 average sales price less $320,000 bank’s release price equals $130,000). Assuming the borrower will have to pay $30,000 in related sales/settlement costs leaves approximately $100,000 remaining per unit to apply towards the A&D loan, or $1 million total for the remaining 10 units ($100,000 times 10). Classification: The lender internally classified the loan as substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the borrower and guarantor’s diminished ability to make interest payments (even at the reduced rate), the stalled status of the project, and the reduced collateral protection lion total for the remaining 10 units ($100,000 times 10). Classification: The lender internally classified the loan as substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the borrower and guarantor’s diminished ability to make interest payments (even at the reduced rate), the stalled status of the project, and the reduced collateral protection. Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the borrower had previously demonstrated an ability to make interest payments. The examiner disagreed as the loan was not restructured on reasonable repayment terms. While the borrower and guarantor may be able to service the debt at a below market interest rate in the near term using other unencumbered liquid assets, other projects in their portfolio are also affected by poor market conditions and may require significant liquidity contributions, which could affect their ability to support the loan. After a discussion with the examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. E. Construction Loan – Single Family Residence Page 26 of 39 BASE CASE: The lender originated a $1.2 million construction loan on a single-family “spec” residence with a 15-month maturity to allow for completion and sale of the property. The loan required monthly interest-only payments at a market interest rate and was based on an “as completed” LTV of 70 percent at origination. During the original loan construction phase, the borrower was able to make all interest payments from personal funds. At maturity, the home had been completed, but not sold, and the borrower was unable to find another lender willing to finance this property under similar terms. SCENARIO 1: At maturity, the lender restructured the loan for one year on an interest-only basis at a below market interest rate to give the borrower more time to sell the “spec” home ake all interest payments from personal funds. At maturity, the home had been completed, but not sold, and the borrower was unable to find another lender willing to finance this property under similar terms. SCENARIO 1: At maturity, the lender restructured the loan for one year on an interest-only basis at a below market interest rate to give the borrower more time to sell the “spec” home. Current financial information indicates the borrower has limited ability to continue to make interest-only payments from personal funds. If the residence does not sell by the revised maturity date, the borrower plans to rent the home. In this event, the lender will consider modifying the debt into an amortizing loan with a 20-year maturity, which would be consistent with this type of income- producing investment property. Any shortfall between the net rental income and loan payments would be paid by the borrower. Due to declining home values, the LTV at the renewal date was 90 percent. Classification: The lender internally classified the loan substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the borrower’s diminished ongoing ability to make payments and the reduced collateral position. Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the borrower demonstrated an ability to make interest payments during the construction phase. The examiner did not concur with this treatment because the loan was not restructured on reasonable repayment terms. The borrower had limited ability to continue to service the debt, even on an interest-only basis at a below market interest rate, and the deteriorating collateral margin indicated that full repayment of principal and interest was not reasonably assured. The examiner instructed the lender to place the loan in nonaccrual status cause the loan was not restructured on reasonable repayment terms. The borrower had limited ability to continue to service the debt, even on an interest-only basis at a below market interest rate, and the deteriorating collateral margin indicated that full repayment of principal and interest was not reasonably assured. The examiner instructed the lender to place the loan in nonaccrual status. SCENARIO 2: At maturity of the original loan, the lender restructured the debt for one year on an interest-only basis at a below market interest rate to give the borrower more time to sell the “spec” home. Eight months later, the borrower rented the property. At that time, the borrower and the lender agreed to restructure the loan again with monthly payments that amortize the debt over 20 years at a market interest rate for a residential investment property. Since the date of the second restructuring, the borrower had made all payments for over six consecutive months. Classification: The lender internally classified the restructured loan substandard. The examiner agreed with the lender’s initial substandard grade at the time of the restructuring, but now considered the loan as a pass due to the borrower’s demonstrated ability to make payments according to the reasonably modified terms for more than six consecutive months. Nonaccrual Treatment: The lender initially placed the restructured loan in nonaccrual status but returned it to accrual after the borrower made six consecutive monthly payments. The lender expects full repayment of principal and interest from the rental income. The examiner concurred ability to make payments according to the reasonably modified terms for more than six consecutive months. Nonaccrual Treatment: The lender initially placed the restructured loan in nonaccrual status but returned it to accrual after the borrower made six consecutive monthly payments. The lender expects full repayment of principal and interest from the rental income. The examiner concurred Page 27 of 39 with the lender’s accrual treatment. SCENARIO 3: The lender restructured the loan for one year on an interest-only basis at a below market interest rate to give the borrower more time to sell the “spec” home. The restructured loan has become more than 90 days past due, and the borrower has not been able to rent the property. Based on current financial information, the borrower does not have the ability to service the debt. The lender considers repayment to be contingent upon the sale of the property. Current market data reflects few sales, and similar new homes in this property’s neighborhood are selling within a range of $750,000 to $900,000 with selling costs equaling 10 percent, resulting in anticipated net sales proceeds between $675,000 and $810,000. Classification: The lender graded $390,000 loss ($1.2 million loan balance less the maximum estimated net sales proceeds of $810,000), $135,000 doubtful based on the range in the anticipated net sales proceeds, and the remaining balance of $675,000 substandard. The examiner agreed, as this classification treatment results in the recognition of the credit risk in the collateral-dependent loan based on the property’s value less costs to sell. The examiner instructed management to obtain information on the current valuation on the property. Nonaccrual Treatment: The lender placed the loan in nonaccrual status when it became 60 days past due (reversing all accrued but unpaid interest) because the lender determined that full repayment of principal and interest was not reasonably assured on the property’s value less costs to sell. The examiner instructed management to obtain information on the current valuation on the property. Nonaccrual Treatment: The lender placed t [Text truncated at 120,000 characters. The full text is on the page linked above.] ## Nearby sections - [SR 00-3 (SUP) Information Technology Examination Frequency](https://www.frixlaw.com/law-library/statutes/FRB_SR0003.md) - [SR 00-8 (SUP) Revised Uniform Retail Credit Classification and Account Management Policy](https://www.frixlaw.com/law-library/statutes/FRB_SR0008.md) - [SR 00-9 (SPE) Supervisory Guidance on Equity Investment and Merchant Banking Activities](https://www.frixlaw.com/law-library/statutes/FRB_SR0009.md) - [SR 00-13 (SUP) Framework for Financial Holding Company Supervision](https://www.frixlaw.com/law-library/statutes/FRB_SR0013.md) - [SR 00-14 (SUP) Enhancements to the Interagency Program for Supervising the U.S. Operations of Foreign Banking Organizations](https://www.frixlaw.com/law-library/statutes/FRB_SR0014.md) - [SR 01-4 (GEN) Subprime Lending](https://www.frixlaw.com/law-library/statutes/FRB_SR0104.md) - [SR 01-5 (SUP) Examination of Fiduciary Activities](https://www.frixlaw.com/law-library/statutes/FRB_SR0105.md) - [SR 01-11 (SUP) Identity Theft and Pretext Calling](https://www.frixlaw.com/law-library/statutes/FRB_SR0111.md) - [SR 01-12 (SUP) Interagency Guidance on Loans Held for Sale](https://www.frixlaw.com/law-library/statutes/FRB_SR0112.md) - [SR 01-14 (SUP) Joint Agency Advisory on Rate-Sensitive Deposits](https://www.frixlaw.com/law-library/statutes/FRB_SR0114.md) - [SR 01-15 (SUP) Standards for Safeguarding Customer Information](https://www.frixlaw.com/law-library/statutes/FRB_SR0115.md) - [SR 01-17 (SUP) Final Interagency Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions](https://www.frixlaw.com/law-library/statutes/FRB_SR0117.md) - [SR 01-21 (GEN) Communications with Foreign Bank Regulatory and Supervisory Authorities](https://www.frixlaw.com/law-library/statutes/FRB_SR0121.md) - [SR 01-25 (GEN) Guidelines for Using External Experts on Examinations, Inspections, and Other Bank Supervision Matters](https://www.frixlaw.com/law-library/statutes/FRB_SR0125.md) --- Source: Frix Law Library, https://www.frixlaw.com/law-library/statutes/FRB_SR2305. Check the current official text before relying on it. Not legal advice.