ALLOWANCE FOR LOAN AND LEASE LOSSES—Interagency Supervisory Guidance Addressing Certain Issues Related to Troubled Debt Restructurings

This supervisory guidance for financial institutions¹ addresses certain issues related to the accounting treatment and regulatory credit risk grade or classification² of commercial and residential real estate loans that have undergone troubled debt restructurings (TDRs).³ This document reiterates key aspects of previously issued regulatory guidance and discusses the definition of collateral-dependent loans and the circumstances under which a charge-off is required for TDRs. The guidance for these two concepts is included to provide further clarification and ensure consistent treatment.

When conducted in a prudent manner, modifications of problem loans are generally in the best interest of both the institution and the borrower and can lead to improved loan performance and reduced credit risk. Such modifications may occur before, at, or after the maturity date of a loan. The Federal Reserve, the FDIC, the NCUA and the OCC (collectively, “the agencies”) encourage financial institutions to work constructively with borrowers and view prudent modifications as positive actions when they mitigate credit risk. The agencies generally will not criticize financial institutions for engaging in prudent workout arrangements, even if the modified loans result in adverse credit classifications or constitute TDRs.

This guidance is consistent with the October 2009 interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts [at 3-1578] and GAAP.⁴ The principal source of guidance on accounting for TDRs under GAAP is Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Subtopic 310-40, Receivables—Troubled Debt Restructurings by Creditors.⁵ Impairment measurement for TDRs is addressed in ASC Subtopic 310-10, Receivables—Overall.⁶ For banks and savings associations, the Glossary section of the Federal Financial Institutions Examination Council’s (FFIEC) Instructions for the Consolidated Reports of Condition and Income (Call Report), together with the Call Report Supplemental Instructions, provides additional guidance on accounting and regulatory reporting for TDRs.⁷ Similar guidance for holding companies can be found in the Glossary section of the Instructions for the Preparation of Consolidated Financial Statements for Holding Companies (FR Y-9C) and its associated Supplemental Instructions.⁸ For credit unions, the 5300 Call Report includes revised schedules and additional instructions capturing enhanced TDR data collections beginning with the quarter that ended December 31, 2012.⁹

A loan that is modified and determined to be a TDR in accordance with GAAP can be in either accrual or nonaccrual status at the time of the modification. A loan modified in a TDR that is on nonaccrual at the time of the loan’s modification need not be maintained for its remaining life in nonaccrual status, but can be restored to accrual status if the loan meets the return-to-accrual conditions set forth in the Call Report Glossary (for banks and savings associations) or 12 CFR 741.3(b)(2) and appendix C to part 741 (for credit unions).

To restore a nonaccrual loan that has been formally restructured in a TDR to accrual status, an institution must perform a current, well-documented credit analysis supporting a return to accrual status based on the borrower’s financial condition and prospects for repayment under the revised terms. Otherwise, the TDR must remain in nonaccrual status. The analysis must consider the borrower’s sustained historical repayment performance for a reasonable period prior to the return-to-accrual date, but may take into account payments made for a reasonable period prior to the restructuring if the payments are consistent with the modified terms. A sustained period of repayment performance generally would be a minimum of six months and would involve payments in the form of cash or cash equivalents.¹⁰

An accruing loan that is modified in a TDR can remain in accrual status if, based on a current, well-documented credit analysis, collection of principal and interest in accordance with the modified terms is reasonably assured, and the borrower has demonstrated sustained historical repayment performance for a reasonable period before the modification.

Historical repayment performance in the form of interest-only payments may well raise questions about whether collection of loan principal is reasonably assured. Furthermore, a restructuring must improve collectibility of the loan in accordance with a reasonable repayment schedule.

A modified loan’s regulatory credit risk grade or classification and its TDR analysis are separate and distinct decisions, but the processes are related. A TDR designation means the loan is impaired for accounting purposes, but it does not automatically result in an adverse classification or credit risk grade. However, at the time of the modification, an assessment of the credit risk grade or classification should be made. All relevant factors, including the extent of the borrower’s financial difficulty, should be considered when making the risk-rating assessment.¹¹ Further, a TDR designation does not automatically mean that a loan should remain adversely credit risk graded or classified for its remaining life if it already was or becomes adversely credit risk graded or classified at the time of the modification. A TDR loan should be adversely credit risk graded or classified if the loan, as modified, is inadequately protected by the current sound worth and paying capacity of the borrower or the collateral pledged, if any. In determining the credit risk grade or classification of a TDR loan at the time of a modification or at a subsequent evaluation date, a well-documented assessment of the cash flows available to service the modified loan and the extent of any collateral protection and guarantor support should be performed to form the basis for determining whether an adverse credit risk grade or classification is warranted.¹²

Under GAAP, any loan modified in a TDR is an impaired loan.¹³ Impaired loans must be evaluated to determine if they are collateral dependent. Evaluating whether an impaired loan is collateral dependent is important because, for regulatory reporting purposes, an institution must measure impairment on impaired collateral-dependent loans based on the fair value of the collateral rather than the present value of expected future cash flows. An impaired loan is collateral dependent if “repayment is expected to be provided solely by the underlying collateral,”¹⁴ which includes repayment from the proceeds from the sale of the collateral,¹⁵ cash flow from the continued operation of the collateral, or both. Whether the underlying collateral is expected to be the sole source of repayment for an impaired loan is a matter requiring judgment as to the availability, reliability, and capacity of sources other than the collateral to repay the debt. Generally, repayment of an impaired loan would be expected to be provided solely by the sale or continued operation of the underlying collateral if cash flows to repay the loan from all other available sources (including guarantors) are expected to be no more than nominal. For example, the existence of a guarantor is one factor to consider when determining whether an impaired loan, including a TDR loan, is collateral dependent. To assess the extent to which a guarantor provides repayment support, the ability and willingness of the guarantor to make more-than-nominal payments on the loan should be evaluated.¹⁶

The repayment of some impaired loans collateralized by real estate may depend on cash flow generated by the operation of a business or from sources outside the scope of the lender’s security interest in the collateral, such as cash flows from borrower resources other than the collateral. These loans are generally not considered collateral dependent due to the more-than-nominal payments expected to come from these other repayment sources. For such loans, even if a portion of the cash flow for repayment is expected to come from the sale or operation of the collateral (but not solely from the sale or operation of the collateral), the loan would not be considered collateral dependent.

For example, an impaired loan collateralized by an apartment building, shopping mall, or other income-producing property where the anticipated cash flows for loan repayment are expected to be derived solely from the property’s rental income, and there are no other available and reliable repayment sources, would be considered collateral dependent because repayment is expected to be provided only from the continued operation of the collateral. However, an impaired loan secured by the owner-occupied real estate of a business (such as a manufacturer or retail store) where the anticipated cash flows to repay the loan are expected to be derived from the borrower’s ongoing business operations and activities would not be considered collateral dependent because the loan is not expected to be repaid solely from cash flows from the sale or operation of the collateral. Nevertheless, if the borrower’s condition worsens so that any payments from the operation of the business are expected to be nominal and repayment instead is expected to depend solely on the sale or operation of the underlying collateral, the loan would then be considered collateral dependent.

Pursuant to the FFIEC Call Report instructions and interagency guidance,¹⁷ for regulatory reporting purposes an impaired collateral-dependent loan must be measured for the amount of impairment based on the fair value of the collateral regardless of whether foreclosure is probable. When the fair value of the collateral is used to measure impairment on an impaired collateral-dependent loan and repayment or satisfaction of the loan is dependent on the sale of the collateral, the fair value of the collateral must be adjusted to consider estimated costs to sell. If repayment is dependent only on the operation of the collateral, the fair value of the collateral would not be adjusted for estimated costs to sell.

Under GAAP, a credit loss on a loan, which may be for all or part of a particular loan, should be deducted from the ALLL, and the related loan balance should be charged off in the period in which the loan is deemed uncollectible.¹⁸ The following discussion of the classification and charge-off treatment for impaired collateral-dependent loans is consistent with GAAP.

Repayment from the sale of the collateral. As a general regulatory credit risk grading or classification principle, for an impaired loan that is dependent solely on the sale of the collateral for repayment, any portion of the recorded investment in the loan exceeding the amount adequately secured by the fair value of the collateral less the estimated costs to sell¹⁹ is deemed to be uncollectible and, therefore, should be credit risk graded or classified loss and promptly charged off.

Any portion of the recorded investment in the loan not charged off generally should be adversely credit risk rated or classified no worse than substandard. The amount of the loan exceeding the fair value of the collateral, or portions thereof, should be adversely graded or 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 loss cannot be reasonably determined. If warranted by the underlying circumstances, a doubtful classification or credit risk grade may be used on the entire loan balance. However, as discussed in the October 2009 interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts, a doubtful classification or credit risk grade should be used infrequently and for a limited time to permit the pending events to be resolved.

Repayment from the operation of the collateral. A regulatory credit risk grade or classification of loss with partial charge-off requires judgment and may not be warranted for a collateral-dependent TDR loan if repayment is dependent only on the operation of the collateral provided the modification is in accordance with a prudent workout strategy,²⁰ which includes modified terms that are reasonable for the type and risk of the credit,²¹ and the best estimate of the expected future cash flows supports the full collection of the recorded investment in the loan. In this case, the collateral-dependent TDR loan might not be adversely credit risk graded or classified depending on the facts and circumstances of the cash flow analysis.

In other circumstances, a regulatory credit risk grade or classification of loss with a partial charge-off is warranted on a collateral-dependent TDR loan for which repayment is dependent only on the operation of the collateral. For example, this treatment may be warranted for such a loan when well-defined weaknesses exist in the credit that jeopardize full, orderly repayment, such as the modified terms are not reasonable for the type and risk of the credit or the expected cash flows do not support full collection of the recorded investment in the loan.

While the amount of impairment for regulatory reporting purposes on a collateral-dependent TDR loan where repayment is dependent on the operation of the collateral represents the difference between the recorded investment in the loan and the fair value of the collateral, the charged-off amount should be based on the amount of impairment deemed uncollectible. For such a collateral-dependent TDR, when determining the amount deemed uncollectible, and therefore credit risk rated or classified loss and charged off, the institution should use the collateral’s market value²² conclusion that corresponds to the workout plan, provided it represents a prudent strategy.²³ For example, if the workout plan will bring a construction project for an income-producing property to completion, but not to a stabilized occupancy, the amount assigned a regulatory credit risk grade or classification of loss, if any, should be based on the collateral’s prospective “as complete” market value using a new or updated appraisal or evaluation, as appropriate. If the workout plan will bring the construction project to completion and stabilization based on a reasonable lease-up period and market expectations, the regulatory credit risk grade or classification of loss, if any, should be based on the prospective “as stabilized” market value.²⁴ Any portion of the recorded investment in the loan not charged off generally should be adversely credit risk graded or classified no worse than substandard.²⁵

When measuring impairment on an impaired loan (including a TDR loan) that is not collateral dependent, an institution must use the present value of expected future cash flows method, except that as a practical expedient, the creditor may measure impairment based on the loan’s observable market price.²⁶ An institution should determine its best estimate of these cash flows based on reasonable and supportable assumptions and projections. An institution should not presume that the contractual payment amounts required under the newly modified loan terms are the best estimate of the expected future cash flows. When making this estimate, an institution should consider default and prepayment assumptions, as well as existing environmental factors (for example, existing industry, geographical, economic, and political factors), relevant to the collectibility of the loan.

When a contractual balloon payment is required at maturity under the modified terms of a TDR loan that is not collateral dependent, significant uncertainty may exist regarding the borrower’s ability to refinance or repay the debt at maturity. When estimating expected future cash flows for impairment measurement purposes, all available evidence should be considered, with greater weight given to evidence that can be objectively verified. When no sources of cash flows are reasonably expected to be available to support the assumption that the borrower will be able to repay or refinance a secured loan at maturity, an acceptable approach for estimating expected future cash flows can be to base the expected payment at maturity on the current fair value of the collateral, less estimated costs to sell. If the contractual balloon payment at maturity is lower than the fair value of the collateral, less estimated costs to sell, the balloon payment amount should be used as the final cash flow in the impairment analysis.

Consistent with GAAP and as a general regulatory credit risk grading or classification principle, for an impaired loan (including a TDR loan) that is not collateral dependent, when available information confirms that a specific loan, or a portion thereof, is uncollectible, this amount should be classified loss and promptly charged off against the ALLL.

Disbursements by an institution to protect its collateral position on a loan, such as payments of real estate taxes or hazard insurance premiums, may be capitalized (that is, added to the loan’s recorded investment rather than expensed) provided the applicable loan agreement authorizes such capitalization. Capitalized protective advances on an impaired loan, including a TDR loan, increase the recorded investment in the loan. Therefore, the measurement of impairment on the loan and, accordingly, any valuation allowance (as well as any regulatory credit risk grade or classification of loss and partial charge-off, when appropriate) will be based on this higher recorded investment.

Loan renewals, extensions, and modifications that occur before a payment reset date or conversion to amortizing status are not automatically considered TDRs, but should be evaluated to assess whether they meet the criteria for a TDR under GAAP.²⁷ For example, a modification of the terms of a home equity line of credit before it approaches the date of a payment shock²⁸ should be evaluated to determine whether the modification meets the TDR criteria. In determining whether a borrower is experiencing financial difficulties, an institution generally should perform and document a current credit analysis. This analysis should include an evaluation of the borrower’s willingness and ability to meet the loan terms assuming no modification takes place and the loan resets to the higher payment.²⁹ If the borrower is experiencing financial difficulties, an institution should also assess and document whether it has granted a concession to the borrower.