Once a TDR, Always a TDR...... Or Not?
In an effort to clarify, once and for all, one of the most confusing and controversial loan categories, on October 24th the agencies jointly issued supervisory guidance addressing issues related to TDR's. The stated goal of the guidance was to provide further clarification and ensure consistent treatment. The guidance does not replace, but only reiterates previously issued guidance, and also reiterates the agencies encouragement of banks to work constructively with borrowers, where prudent action can have a positive impact on overall credit risk.
The agencies focused on two key aspects of troubled debt restructures:
- The definition of collateral-dependent loans
- The circumstances under which a charge-off is required for a TDR
Definition and Identification
The identification of a collateral-dependent loan is critical when a loan has been confirmed to be impaired. Any loan modified in a TDR is considered impaired. To determine if the impaired loan is also collateral-dependent, the question that must be answered relates to the expected source of repayment. Is the expectation that repayment will come from the proceeds from the sale of the collateral, cash flow from the continued operation of the collateral or both? If the answer to any of these questions is yes, then the loan meets the definition of being collateral-dependent.
One gray area that many find frustrating has to do with guarantor support. The guidance acknowledges that the existence of guarantor support should be considered, but the extent of that support must include an evaluation of the ability and willingness of that guarantor to make 'more-than-nominal' payments. (They further refer readers to an October 2009 Interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts* for clarification of how to evaluate guarantees.) Additionally, the guidance points out that a loan would not be considered collateral dependent if a portion of the repayment is expected from the collateral, as long as the other sources provide 'more-than-nominal' payments.
An impaired collateral dependent loan must be reported based on a measurement of the amount of impairment relative to the fair value of the collateral, and that fair value must include an estimate of the costs to sell if the repayment is expected from the sale. If repayment is based on the operation of the collateral then costs to sell do not have to be considered.
When a loan has been confirmed to be collateral dependent and impaired, the amount which exceeds the amount that is adequately secured by the fair value of the collateral, less the costs to sell, should be 'promptly charged off'. This is the amount that is considered uncollectible, unsecured and represents a loss. The remaining balance according to this guidance should be retained as an adversely graded credit, but not worse than substandard. If there are pending events that impact the ability to assess accurately the amount of loss, the guidance suggests that a doubtful classification can be used for a period of time, but 'should be used infrequently and for a limited time to permit the pending events to be resolved.'
When a loan is not collateral dependent, the bank must estimate the present value of expected future cash flows, using reasonable assumptions and projections. Loans which have a balloon structure should be evaluated with regard to the likelihood of the borrower being able to refinance the balloon amount at maturity. If refinance is not considered realistic as a source of repayment of the balloon, then the sale of the collateral less estimated costs to sell must be used as the final cash flow in the impairment analysis.
And other points of confusion....
In the event that a bank has to incur expenses to protect a collateral position, these expenses may be included and capitalized against the loan balance. On an impaired loan or a TDR, the calculations, estimates of loss, and analysis of repayment, need to take these necessary expenses into consideration as if they are part of the loan outstanding.
If a loan is renewed or modified before the maturity, and particularly before a scheduled payment reset date, the issue of whether or not it qualifies as a TDR must be addressed. A thorough analysis must document the willingness and ability of the borrower to continue repayment without the modification, in this example at the higher payment, in order to avoid appearing to be a concession.
As always, the regulators have provided numerous examples of these scenarios, but the burden remains on the individual banks to evaluate their portfolio and to work with their specific regulator to assess that portfolio appropriately. For further reference, the complete Financial Institution Letter can be found here: http://www.fdic.gov/news/news/financial/2013/fil13050.html