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Notice2022-16471

Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts

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Published

August 2, 2022

Issuing agencies

Treasury DepartmentComptroller of the CurrencyFederal Deposit Insurance CorporationNational Credit Union Administration

Abstract

The Office of the Comptroller of the Currency (OCC), Federal Deposit Insurance Corporation (FDIC), and National Credit Union Administration (NCUA) (the agencies), in consultation with state bank and credit union regulators, are inviting comment on an updated policy statement for prudent commercial real estate loan accommodations and workouts, which would be relevant to all financial institutions supervised by the agencies. This updated policy statement would build on existing guidance on the need for financial institutions to work prudently and constructively with creditworthy borrowers during times of financial stress, update existing interagency guidance on commercial real estate loan workouts, and add a new section on short-term loan accommodations. The updated statement also would address relevant accounting changes on estimating loan losses and provide updated examples of how to classify and account for loans modified or affected by loan accommodations or loan workout activity.

Full Text

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<title>Federal Register, Volume 87 Issue 147 (Tuesday, August 2, 2022)</title>
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[Federal Register Volume 87, Number 147 (Tuesday, August 2, 2022)]
[Notices]
[Pages 47273-47293]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2022-16471]

[[Page 47273]]

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DEPARTMENT OF TREASURY

Office of the Comptroller of the Currency

[Docket ID OCC-2022-0017]

FEDERAL DEPOSIT INSURANCE CORPORATION

RIN 3064-ZA33

NATIONAL CREDIT UNION ADMINISTRATION

[Docket ID NCUA-2022-0123]

Policy Statement on Prudent Commercial Real Estate Loan
Accommodations and Workouts

AGENCY: Office of the Comptroller of the Currency, Treasury; Federal
Deposit Insurance Corporation; and National Credit Union
Administration.

ACTION: Proposed policy statement with request for comment.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), Federal
Deposit Insurance Corporation (FDIC), and National Credit Union
Administration (NCUA) (the agencies), in consultation with state bank
and credit union regulators, are inviting comment on an updated policy
statement for prudent commercial real estate loan accommodations and
workouts, which would be relevant to all financial institutions
supervised by the agencies. This updated policy statement would build
on existing guidance on the need for financial institutions to work
prudently and constructively with creditworthy borrowers during times
of financial stress, update existing interagency guidance on commercial
real estate loan workouts, and add a new section on short-term loan
accommodations. The updated statement also would address relevant
accounting changes on estimating loan losses and provide updated
examples of how to classify and account for loans modified or affected
by loan accommodations or loan workout activity.

DATES: Comments must be received by October 3, 2022.

ADDRESSES: Interested parties are encouraged to submit written comments
to any or all of the agencies listed below. The agencies will share
comments with each other. Comments should be directed to:
OCC: You may submit comments to the OCC by any of the methods set
forth below. Commenters are encouraged to submit comments through the
Federal eRulemaking Portal, if possible. Please use the title
``Interagency Policy Statement on Prudent Commercial Real Estate Loan
Workouts'' to facilitate the organization and distribution of the
comments. Federal eRulemaking Portal--``<a href="http://Regulations.gov">Regulations.gov</a>'': Go to
<a href="http://www.regulations.gov">www.regulations.gov</a>. Enter ``Docket ID OCC-2022-0017'' in the Search
Box and click ``Search.'' Click on ``Comment Now'' to submit public
comments. For help with submitting effective comments please click on
``View Commenter's Checklist.'' Click on the ``Help'' tab on the
<a href="http://Regulations.gov">Regulations.gov</a> home page to get information on using <a href="http://Regulations.gov">Regulations.gov</a>,
including instructions for submitting public comments.
<bullet> Mail: Chief Counsel's Office, Attention: Comment
Processing, Office of the Comptroller of the Currency, 400 7th Street
SW, Suite 3E-218, Washington, DC 20219.
<bullet> Hand Delivery/Courier: 400 7th Street SW, Suite 3E-218,
Washington, DC 20219.
Instructions: You must include ``OCC'' as the agency name and
``Docket ID OCC-2022-0017'' in your comment.
In general, the OCC will enter all comments received into the
docket and publish the comments on the <a href="http://Regulations.gov">Regulations.gov</a> website without
change, including any business or personal information provided such as
name and address information, email addresses, or phone numbers.
Comments received, including attachments and other supporting
materials, are part of the public record and subject to public
disclosure. Do not include any information in your comment or
supporting materials that you consider confidential or inappropriate
for public disclosure.
You may review comments and other related materials that pertain to
this action by the following method:
Viewing Comments Electronically: Go to <a href="http://www.regulations.gov">www.regulations.gov</a>. Enter
``Docket ID OCC-2022-0017'' in the Search box and click ``Search.''
Click on ``Open Docket Folder'' on the right side of the screen.
Comments and supporting materials can be viewed and filtered by
clicking on ``View all documents and comments in this docket'' and then
using the filtering tools on the left side of the screen. Click on the
``Help'' tab on the <a href="http://Regulations.gov">Regulations.gov</a> home page to get information on
using <a href="http://Regulations.gov">Regulations.gov</a>. The docket may be viewed after the close of the
comment period in the same manner as during the comment period.
FDIC: You may submit comments, identified by FDIC RIN 3064-ZA33, by
any of the following methods:
<bullet> Agency website: <a href="https://www.fdic.gov/resources/regulations/federal-register-publications/">https://www.fdic.gov/resources/regulations/federal-register-publications/</a>. Follow the instructions for
submitting comments on the Agency website.
<bullet> Mail: James P. Sheesley, Assistant Executive Secretary,
Attention: Comments RIN 3064-ZA33, Federal Deposit Insurance
Corporation, 550 17th Street NW, Washington, DC 20429.
<bullet> Hand Delivery/Courier: Comments may be hand-delivered to
the guard station at the rear of the 550 17th Street NW building
(located on F Street NW) on business days between 7:00 a.m. and 5:00
p.m., ET.
<bullet> Email: <a href="/cdn-cgi/l/email-protection#ccafa3a1a1a9a2b8bf8caaa8a5afe2aba3ba">[email&#160;protected]</a>. Include the RIN 3064-ZA33 in the
subject line of the message.
<bullet> Public Inspection: Comments received, including any
personal information provided, may be posted without change to <a href="https://www.fdic.gov/resources/regulations/federal-register-publications/">https://www.fdic.gov/resources/regulations/federal-register-publications/</a>.
Commenters should submit only information that the commenter wishes
to make available publicly. The FDIC may review, redact, or refrain
from posting all or any portion of any comment that it may deem to be
inappropriate for publication, such as irrelevant or obscene material.
The FDIC may post only a single representative example of identical or
substantially identical comments, and in such cases will generally
identify the number of identical or substantially identical comments
represented by the posted example. All comments that have been
redacted, as well as those that have not been posted, that contain
comments on the merits of this notice will be retained in the public
comment file and will be considered as required under all applicable
laws. All comments may be accessible under the Freedom of Information
Act.
NCUA: You may submit comments by any one of the following methods
(please send comments by one method only):
<bullet> Federal rulemaking Portal: <a href="http://www.regulations.gov">http://www.regulations.gov</a>.
Follow the instructions for submitting comments.
<bullet> Mail: Address to Melane Conyers-Ausbrooks, Secretary of
the Board, National Credit Union Administration, 1775 Duke Street,
Alexandria, Virginia 22314-3428.
<bullet> Hand Delivery/Courier: Same as mail address.
Public Inspection: You can view all public comments on the Federal
eRulemaking Portal at <a href="http://www.regulations.gov">http://www.regulations.gov</a> as submitted, except
for those we cannot post for technical reasons. NCUA will not edit or
remove any identifying or contact information from the public comments
submitted. Due to social distancing measures in effect, the usual

[[Page 47274]]

opportunity to inspect paper copies of comments in the NCUA's law
library is not currently available. After social distancing measures
are relaxed, visitors may make an appointment to review paper copies by
calling (703) 518-6540 or emailing <a href="/cdn-cgi/l/email-protection#125d55515f737b7e527c7167733c757d64">[email&#160;protected]</a>.

FOR FURTHER INFORMATION CONTACT:
OCC: Beth Nalyvayko, Credit Risk Specialist, Bank Supervision
Policy, (202) 649-6670; or Kevin Korzeniewski, Counsel, Chief Counsel's
Office, (202) 649-5490. If you are deaf, hard of hearing, or have a
speech disability, please dial 7-1-1 to access telecommunications relay
services.
FDIC: Thomas F. Lyons, Associate Director, Risk Management Policy,
<a href="/cdn-cgi/l/email-protection#ea9e8693858499aa8c8e8389c48d859c">[email&#160;protected]</a>, (202) 898-6850; Peter A. Martino, Senior Examination
Specialist, Risk Management Policy, <a href="/cdn-cgi/l/email-protection#9feff2feedebf6f1f0dff9fbf6fcb1f8f0e9">[email&#160;protected]</a>, (813) 973-7046
x8113, Division of Risk Management Supervision; Gregory Feder, Counsel,
<a href="/cdn-cgi/l/email-protection#c7a0a1a2a3a2b587a1a3aea4e9a0a8b1">[email&#160;protected]</a>, (202) 898-8724; or Kate Marks, Counsel,
<a href="/cdn-cgi/l/email-protection#b5ded8d4c7dec6f5d3d1dcd69bd2dac3">[email&#160;protected]</a>, (202) 898-3896, Supervision and Legislation Branch,
Legal Division, Federal Deposit Insurance Corporation; 550 17th Street
NW, Washington, DC 20429.
NCUA: Simon Hermann, Senior Credit Specialist, Naghi H. Khaled,
Director of Credit Markets, Office of Examination and Insurance, (703)
518-6360; Ian Marenna, Associate General Counsel, Ariel Pereira, Senior
Staff Attorney, Office of General Counsel, (703) 518-6540; or by mail
at National Credit Union Administration, 1775 Duke Street, Alexandria,
VA 22314.

SUPPLEMENTARY INFORMATION:

I. Background

On October 30, 2009, the agencies, along with the Board of
Governors of the Federal Reserve System (Board), the Federal Financial
Institutions Examination Council (FFIEC) State Liaison Committee, and
the former Office of Thrift Supervision, adopted the Policy Statement
on Prudent Commercial Real Estate Loan Workouts, which was issued by
the FFIEC (2009 Statement).\1\ The agencies view the 2009 Statement as
being useful for both agency staff and financial institutions in
understanding risk management and accounting practices for commercial
real estate (CRE) loan workouts.
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\1\ See FFIEC Press Release, October 30, 2009, available at:
<a href="https://www.ffiec.gov/press/pr103009.htm">https://www.ffiec.gov/press/pr103009.htm</a>; See OCC Bulletin 2009-32
(October 30, 2009); FDIC Financial Institution Letter FIL-61-2009
(October 30, 2009); Federal Reserve Supervision and Regulation (SR)
letter 09-7 (October 30, 2009); NCUA Letter to Credit Unions 10-CU-
07 (June 2010).
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The agencies are proposing to update and expand the 2009 Statement
by incorporating recent policy guidance on loan accommodations and
accounting developments for estimating loan losses (proposed
Statement). In developing the proposed Statement, the agencies
consulted with state bank and credit union regulators. If finalized,
the proposed Statement would supersede the 2009 Statement for all
supervised financial institutions.\2\
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\2\ For purposes of this guidance, financial institutions are
those supervised by the FDIC, NCUA, or OCC.
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II. Overview of the Proposed Statement

The proposed Statement discusses the importance of working
constructively with CRE borrowers who are experiencing financial
difficulty and would be appropriate for all supervised financial
institutions engaged in CRE lending that apply U.S. generally accepted
accounting principles (GAAP).\3\ The proposed Statement addresses
supervisory expectations with respect to a financial institution's
handling of loan accommodations and loan workouts on matters including
(1) risk management elements, (2) classification of loans, (3)
regulatory reporting, and (4) accounting considerations. While focused
on CRE loans, the proposed Statement includes general principles that
are relevant to a financial institution's commercial loans that are
collateralized by either real property or other business assets (e.g.,
furniture, fixtures, or equipment) of a borrower. Additionally, the
proposed Statement would include updated references to supervisory
guidance,\4\ and would revise language to incorporate current industry
terminology.
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\3\ Federally insured credit unions with less than $10 million
in assets are not required to comply with GAAP, unless the credit
union is state-chartered and GAAP compliance is mandated by state
law (86 FR 34924, July 1, 2021).
\4\ Supervisory guidance outlines the agencies' supervisory
practices or priorities and articulates the agencies' general views
regarding appropriate practices for a given subject area. The
agencies have each adopted regulations setting forth Statements
Clarifying the Role of Supervisory Guidance. See 12 CFR 4, subpart F
(OCC); 12 CFR 302, appendix A (FDIC); and 12 CFR 791, subpart D
(NCUA).
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Prudent CRE loan accommodations and workouts are often in the best
interest of both the financial institution and the borrower. As such,
and consistent with safety and soundness standards, the proposed
Statement reaffirms two key principles from the 2009 Statement: (1)
financial institutions that implement prudent CRE loan accommodation
and workout arrangements after performing a comprehensive review of a
borrower's financial condition will not be subject to criticism for
engaging in these efforts, even if these arrangements result in
modified loans that have weaknesses that result in adverse credit
classification; and (2) modified loans to borrowers who have the
ability to repay their debts according to reasonable terms will not be
subject to adverse classification solely because the value of the
underlying collateral has declined to an amount that is less than the
loan balance.
The proposed Statement includes the following changes: (1) a new
section on short-term loan accommodations; (2) information about
changes in accounting principles since 2009; and (3) revisions and
additions to examples of CRE loan workouts.

Short-Term Loan Accommodations

The agencies recognize that financial institutions may benefit from
the proposed Statement's inclusion of a discussion on the use of short-
term and less complex CRE loan accommodations before a loan requires a
longer term or more complex workout scenario. The proposed Statement
would identify short-term loan accommodations as a tool that can be
used to mitigate adverse effects on borrowers and would encourage
financial institutions to work prudently with borrowers who are or may
be unable to meet their contractual payment obligations during periods
of financial stress. This section of the proposed Statement would
incorporate principles consistent with existing interagency guidance on
accommodations.\5\
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\5\ See Joint Statement on Additional Loan Accommodations
Related to COVID-19. FIL-74-2020 (FDIC), and Bulletin 2020-72 (OCC).
See also Interagency Statement on Loan Modifications and Reporting
for Financial Institutions Working With Customers Affected by the
Coronavirus (Revised); FIL-36-2020 (FDIC); Bulletin 2020-35 (OCC);
and Joint Press Release April 7, 2020 (NCUA).
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Accounting Changes

The proposed Statement also would reflect changes in GAAP since
2009, including those in relation to current expected credit losses
(CECL).\6\ The discussion would align with existing regulatory
reporting guidance and instructions that have also been updated to
reflect current accounting requirements under GAAP.\7\ In

[[Page 47275]]

particular, the section for Regulatory Reporting and Accounting
Considerations would be modified to include CECL references. Appendices
5 and 6 of the proposed Statement would address the relevant accounting
and regulatory guidance on estimating loan losses for financial
institutions that use the CECL methodology, or incurred loss
methodology, respectively.
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\6\ The Financial Accounting Standards Board's (FASB's)
Accounting Standards Update 2016-13, Financial Instruments--Credit
Losses (Topic 326): Measurement of Credit Losses on Financial
Instruments and subsequent amendments issued since June 2016 are
codified in Accounting Standards Codification (ASC) Topic 326,
Financial Instruments--Credit Losses (FASB ASC Topic 326). FASB ASC
Topic 326 revises the accounting for the allowances for credit
losses (ACLs) and introduces CECL.
\7\ For FDIC-insured depository institutions, the FFIEC
Consolidated Reports of Condition and Income (FFIEC Call Report);
and for credit unions, the NCUA 5300 Call Report.
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The agencies also note that the Financial Accounting Standards
Board (FASB) has issued ASU 2022-02, ``Financial Instruments--Credit
Losses (Topic 326): Troubled Debt Restructurings and Vintage
Disclosures,'' which amended ASC Topic 326, Financial Instruments--
Credit Losses. Once adopted, ASU 2022-02 will eliminate the need for
financial institutions to identify and account for loan modifications
as troubled debt restructuring (TDR) and will enhance disclosure
requirements for certain modifications by creditors when a borrower is
experiencing financial difficulty.\8\ The agencies plan to remove the
TDR determination from the examples once all financial institutions are
required to report in accordance with ASU 2022-02 and ASC Topic 326 by
year-end 2023. In the interim, the agencies have modified sections of
the proposed Statement to reflect updates that have occurred pertaining
to TDR accounting since 2009, for financial institutions that are still
required to report TDRs.
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\8\ Financial institutions may only early adopt ASU 2022-02 if
ASC Topic 326 is adopted. Financial institutions that have not
adopted ASC Topic 326 will continue to report TDRs and will only
report in accordance with ASU 2022-02 concurrently with the adoption
of ASC Topic 326.
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CRE Workout Examples

The proposed Statement would include updated information about
current industry loan workout practices and revisions to examples of
CRE loan workouts. The examples in the proposed Statement are intended
to illustrate the application of existing guidance on (1) credit
classification, (2) determination of nonaccrual status, and (3)
determination of TDR status. The proposed Statement also would revise
the 2009 Statement to provide Appendix 2, which contains an updated
summary of selected references to relevant supervisory guidance and
accounting standards for real estate lending, appraisals, restructured
loans, fair value measurement, and regulatory reporting matters such as
a loan's nonaccrual status.
The proposed Statement would retain information in Appendix 3 about
valuation concepts for income-producing real property included in the
2009 Statement. Further, Appendix 4 of the proposed Statement restates
the agencies' long-standing special mention and classification
definitions that are referenced and applied in the examples in Appendix
1.
The proposed Statement would be consistent with the Interagency
Guidelines Establishing Standards for Safety and Soundness issued by
the FDIC and OCC,\9\ which articulate safety and soundness standards
for insured depository institutions to establish and maintain prudent
credit underwriting practices and to establish and maintain systems to
identify problem assets and manage deterioration in those assets
commensurate with a financial institution's size and the nature and
scope of its operations. The NCUA is issuing this proposed Statement
pursuant to its regulation in 12 CFR part 723, governing member
business loans and commercial lending, 12 CFR 741.3(b)(2) on written
lending policies that cover loan workout arrangements and nonaccrual
standards, and appendix B to 12 CFR part 741, regarding nonaccrual
policy, and regulatory reporting of TDRs.\10\
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\9\ 12 CFR part 30, appendix A (OCC); and 12 CFR part 364
appendix A (FDIC).
\10\ Additional guidance is available in NCUA letter to credit
unions 10-CU-02 ``Current Risks in Business Lending and Sound Risk
Management Practices,'' issued January 2010, and in the Commercial
and Member Business Loans section of the NCUA Examiner's Guide.
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III. Request for Comment

The agencies request comments on all aspects of the proposed
Statement and responses to the questions set forth below:
Question 1: To what extent does the proposed Statement reflect safe
and sound practices currently incorporated in a financial institution's
CRE loan accommodation and workout activities? Should the agencies add,
modify, or remove any elements, and, if so, which and why?
Question 2: What additional information, if any, should be included
to optimize the guidance for managing CRE loan portfolios during all
business cycles and why?
Question 3: Some of the principles discussed in the proposed
Statement are appropriate for Commercial & Industrial (C&I) lending
secured by personal property or other business assets. Should the
agencies further address C&I lending more explicitly, and if so, how?
Question 4: What additional loan workout examples or scenarios
should the agencies include or discuss? Are there examples in Appendix
1 of the proposed statement that are not needed, and if so, why not?
Should any of the examples in the proposed Statement be revised to
better reflect current practices, and if so, how?
Question 5: To what extent do the TDR examples continue to be
relevant in 2023 given that ASU 2022-02 eliminates the need for a
financial institution to identify and account for a new loan
modification as a TDR?

IV. Paperwork Reduction Act

The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3521) states
that no agency may conduct or sponsor, nor is the respondent required
to respond to, an information collection unless it displays a currently
valid Office of Management and Budget (OMB) control number. The
Agencies have determined that this proposed Policy Statement does not
create any new, or revise any existing, collections of information
pursuant to the Paperwork Reduction Act. Consequently, no information
collection request will be submitted to the OMB for review.

V. Proposed Guidance

The text of the proposed Statement is as follows:

Policy Statement on Prudent Commercial Real Estate Loan Accommodations
and Workouts

The agencies \1\ recognize that financial institutions \2\ face
significant challenges when working with commercial real estate (CRE)
\3\ borrowers who are

[[Page 47276]]

experiencing diminished operating cash flows, depreciated collateral
values, prolonged sales and rental absorption periods, or other issues
that may hinder repayment. While borrowers may experience deterioration
in their financial condition, many continue to be creditworthy and have
the willingness and capacity to repay their debts. In such cases,
financial institutions may find it beneficial to work constructively
with borrowers. Such constructive efforts may involve loan
accommodations \4\ or more extensive loan workout arrangements.\5\
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\1\ 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 FDIC, NCUA, or OCC.
\3\ Consistent with the 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 also
include land development and construction loans (including 1- to 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.
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This statement provides a broad set of principles relevant to CRE
loan accommodations and workouts in all business cycles, particularly
in challenging economic environments. A variety of factors can drive
challenging economic environments, including economic downturns,
natural disasters, and local, national, and international events. This
statement also describes how examiners will review CRE loan
accommodation and workout arrangements and provides examples of CRE
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. Examiners are expected to take a balanced approach in
assessing the adequacy of a financial institution's risk management
practices for loan accommodation and workout activities. Consistent
with the Interagency Guidelines Establishing Standards for Safety and
Soundness,\6\ (safety and soundness standards), 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.
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\6\ 12 CFR part 30, appendix A (OCC); 12 CFR part 364 appendix A
(FDIC); and 12 CFR part 741.3(b)(2), 12 CFR 741, appendix B, 12 CFR
723, and NCUA letters 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.
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I. Purpose

Consistent with the safety and soundness standards, this statement
updates and supersedes existing 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
ensure that supervisory policies and actions do not inadvertently
curtail the availability of credit to sound borrowers.
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\7\ This statement replaces the interagency Policy Statement on
Prudent Commercial Real Estate Loan Workouts (October 2009).
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This statement addresses prudent risk management practices
regarding short-term accommodations, risk management elements 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 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.
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\8\ For banks, the FFIEC Consolidated Reports of Condition and
Income (FFIEC Call Report), and for credit unions, the NCUA 5300
Call Report.
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Six appendices are incorporated into this statement:
<bullet> Appendix 1 contains examples of CRE loan workout
arrangements illustrating the application of this statement to
classification of loans, and determination of accrual treatment.
<bullet> Appendix 2 lists selected relevant rules as well as
supervisory and accounting guidance for real estate lending,
appraisals, allowance methodologies,\9\ restructured loans, fair value
measurement, and regulatory reporting matters such as nonaccrual
status. This statement is intended to be used in conjunction with
materials identified in Appendix 2 to reach appropriate conclusions
regarding loan classification and regulatory reporting.
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\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; or allowance for loan and lease losses
(ALLL) under ASC 310, Receivables and ASC Subtopic 450-20,
Contingencies--Loss Contingencies, as applicable.
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<bullet> Appendix 3 discusses valuation concepts for income-
producing real property.\10\
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\10\ Valuation concepts applied to regulatory reporting
processes also should be consistent with ASC Topic 820, Fair Value
Measurement.
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<bullet> Appendix 4 provides the classification definitions used by
the FDIC and OCC.\11\
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\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.
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<bullet> Appendices 5 and 6 address the relevant accounting and
supervisory guidance on estimating loan losses for financial
institutions that use the current expected credit losses (CECL)
methodology, or incurred loss methodology, respectively.

II. Short-Term Loan Accommodations

The agencies encourage financial institutions to work 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 but 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 capacity 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 the 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. Failed or imprudent risk management practices and
internal controls can adversely affect borrowers, and expose a
financial institution to increases in

[[Page 47277]]

credit, compliance, operational, or other risks. Imprudent practices
that are widespread at a financial institution may also pose 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 appropriate policies and procedures, updating and
assessing financial and collateral information, maintaining appropriate
risk grading, and ensuring proper tracking and accounting for loan
accommodations. Prudent internal controls related to loan
accommodations include comprehensive policies and practices, proper
management approvals, and timely and accurate reporting and
communication.

III. Loan Workout Programs

When short-term accommodation measures are not sufficient or have
not been successful to address credit problems, the 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:
<bullet> Renewing or extending loan terms;
<bullet> Granting additional credit to improve prospects for
overall repayment; or
<bullet> Restructuring \12\ with or without concessions.
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\12\ A restructuring involves a formal, legally enforceable
modification in the loan's terms.
---------------------------------------------------------------------------

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 guidance, real estate lending standards,\13\ and
relevant regulatory reporting requirements. Examiners will evaluate the
effectiveness of practices, which typically address:
---------------------------------------------------------------------------

\13\ 12 CFR part 34, subpart D (OCC); and 12 CFR part 365
(FDIC). For NCUA, refer to 12 CFR part 723 for member business loan
and commercial loan regulations which addresses commercial real
estate lending and 12 CFR part 741, Appendix B, which addresses loan
workouts, nonaccrual policy, and regulatory reporting of troubled
debt restructurings.
---------------------------------------------------------------------------

<bullet> A prudent workout policy that establishes appropriate loan
terms and amortization schedules and that permits the financial
institution to reasonably adjust the workout plan if sustained
repayment performance is not demonstrated or if collateral values do
not stabilize; \14\
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\14\ 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)).
---------------------------------------------------------------------------

<bullet> Management infrastructure to identify, measure, and
monitor the volume and complexity of workout activity;
<bullet> Documentation standards to verify a borrower's
creditworthiness, including financial condition, repayment capacity,
and collateral values;
<bullet> Management information systems and internal controls to
identify and track loan performance and risk, including impact on
concentration risk and the allowance;
<bullet> Processes designed to ensure that the financial
institution's regulatory reports are consistent with regulatory
reporting requirements;
<bullet> Loan collection procedures;
<bullet> Adherence to statutory, regulatory, and internal lending
limits;
<bullet> Collateral administration to ensure proper lien perfection
of the financial institution's collateral interests for both real and
personal property; and
<bullet> An ongoing credit risk review function.

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 capacity,
evaluating the support provided by guarantors, and assessing the value
of any collateral pledged.
Consistent with safety and soundness standards, while loans in
workout arrangements may be adversely classified, a financial
institution will not be criticized for engaging in loan workout
arrangements so long as management has:
<bullet> 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:
[rtarr8] Updated and comprehensive financial information on the
borrower, real estate project, and all guarantors and sponsors;
[rtarr8] Current valuations of the collateral supporting the loan
and the workout plan;
[rtarr8] Appropriate loan structure (e.g., term and amortization
schedule), covenants, and requirements for curtailment or re-margining;
and
[rtarr8] Appropriate legal analyses and agreements, including those
for changes to loan terms;
<bullet> Analyzed the borrower's global debt \15\ service coverage
that reflects a realistic projection of the borrower's available cash
flow;
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\15\ Global debt represents the aggregate of a borrower's or
guarantor's financial obligations, including contingent obligations.
---------------------------------------------------------------------------

<bullet> Analyzed the available cash flow of guarantors;
<bullet> Demonstrated the willingness and ability to monitor the
ongoing performance of the borrower and guarantor under the terms of
the workout arrangement;
<bullet> Maintained an internal risk rating or loan grading system
that accurately and consistently reflects the risk in the workout
arrangement; and
<bullet> 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 enacting appropriate charge-
offs.\16\
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\16\ Additionally, if applicable, financial institutions should
recognize in other liabilities an allowance for estimated 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.
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A. Supervisory Assessment of Repayment Capacity of Commercial Borrowers

The primary focus of an examiner's review of a CRE loan, including
binding commitments, is an assessment of the borrower's ability to
repay the loan. The major factors that influence this analysis are the
borrower's willingness and capacity 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:
<bullet> The borrower's character, overall financial condition,
resources, and payment history;
<bullet> The nature and degree of protection provided by the cash
flow from business operations or the collateral on a global basis that
considers the borrower's total debt obligations;
<bullet> Market conditions that may influence repayment prospects
and the cash flow potential of the business operations or underlying
collateral; and
<bullet> The prospects for repayment support from guarantors.

[[Page 47278]]

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 classification or reduce the severity of
classification. A financially responsible guarantor possesses the
financial capacity, 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 capacity, 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 capacity to fulfill the obligation. An effective assessment
includes consideration of whether the guarantor has the financial
capacity to fulfill the total number and amount of guarantees currently
extended by the guarantor. A similar analysis should be made for any
material sponsors that support the loan.
Examiners should consider whether a guarantor has demonstrated the
willingness to fulfill all current and previous obligations, has
sufficient economic incentive, and has a significant investment in the
project. An important consideration is whether any previous performance
under its guarantee(s) was voluntary or the result of legal or other
actions by the lender to enforce the guarantee(s).

C. Supervisory Assessment of Collateral Values

As the primary sources of loan repayment decline, the importance of
collateral value as another repayment source increases when analyzing
credit risk and developing an appropriate 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. An examiner 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 appraisal regulations of the Federal financial institution
supervisory agencies \17\ require financial institutions to review
appraisals for compliance with the Uniform Standards of Professional
Appraisal Practice.\18\ As part of that process, and when reviewing
evaluations, financial institutions should ensure that assumptions and
conclusions used are reasonable. Further, financial institutions
typically have policies \19\ and procedures that dictate when
collateral valuations should be updated as part of their ongoing credit
monitoring processes, as market conditions change, or as a borrower's
financial condition deteriorates.\20\
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\17\ The Board of Governors of the Federal Reserve System
(Board), FDIC, NCUA, and OCC.
\18\ See 12 CFR part 34, subpart C (OCC); 12 CFR part 323
(FDIC); and 12 CFR part 722 (NCUA).
\19\ See 12 CFR 34.62(a) (OCC); and 12 CFR 365.2(a) (FDIC). For
NCUA, refer to 12 CFR part 723 for member business loan and
commercial loan regulations that address commercial real estate
lending and 12 CFR part 741, appendix B, which addresses loan
workouts, nonaccrual policy, and regulatory reporting of troubled
debt restructurings.
\20\ For further reference, see Interagency Appraisal and
Evaluation Guidelines, 75 FR 77450 (December 10, 2010).
---------------------------------------------------------------------------

CRE loans in workout arrangements consider 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 collateral's fair value.\21\ If new money is advanced, financial
institutions should refer to the Federal financial institution
supervisory agencies' appraisal regulations to determine whether a new
appraisal is required.\22\
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\21\ 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.''
\22\ See footnote 18.
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The market value provided by an appraisal and the fair value for
accounting purposes are based on similar valuation concepts.\23\ The
analysis of the 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 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.
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\23\ 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.
---------------------------------------------------------------------------

Financial institutions typically use the market value conclusion
(and not the fair value) that corresponds to the workout plan objective
and the loan commitment. For example, if the financial institution
intends to work with the borrower so that a project will achieve
stabilized occupancy, then the financial institution can consider the
``as stabilized'' market value in its collateral assessment for credit
risk grading after confirming that the appraisal's assumptions and
conclusions are reasonable. Conversely, if the financial institution
intends to foreclose, then it is more appropriate for the financial
institution to use the fair value (less costs to sell) \24\ of the
property in its current ``as is'' condition in its collateral
assessment.
---------------------------------------------------------------------------

\24\ 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.
---------------------------------------------------------------------------

If weaknesses are noted in the financial institution's supporting
documentation or appraisal or evaluation review process, examiners
should direct the financial institution to address the weaknesses,
which may

[[Page 47279]]

require the financial institution to obtain a new collateral valuation.
However, if the financial institution is unable or unwilling to address
deficiencies in a timely manner, examiners will have to assess the
degree of protection that the collateral affords when analyzing and
classifying the loan. In performing this assessment of collateral
support, examiners may adjust the collateral's value to reflect current
market conditions and events. When reviewing the reasonableness of the
facts and assumptions associated with the value of an income-producing
property, examiners evaluate:
<bullet> Current and projected vacancy and absorption rates;
<bullet> Lease renewal trends and anticipated rents;
<bullet> Effective rental rates or sale prices, considering sales
and financing concessions;
<bullet> Time frame for achieving stabilized occupancy or sellout;
<bullet> Volume and trends in past due leases;
<bullet> Net operating income of the property as compared with
budget projections, reflecting reasonable operating and maintenance
costs; and
<bullet> Discount rates and direct capitalization rates (refer to
Appendix 3 for more information).
Assumptions, when recently made by qualified appraisers (and, as
appropriate, by 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 analysis.
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
estimated value of the collateral may be adjusted for credit analysis
purposes when the examiner can establish that any underlying facts or
assumptions are inappropriate and when the examiner can support
alternative assumptions.
Many CRE borrowers may have their 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, the financial institution
should have appropriate policies and practices for quantifying the
value of such collateral, determining the acceptability of the assets
as collateral, and perfecting its security interests. The financial
institution also should have appropriate procedures for ongoing
monitoring of this type of collateral and the financial institution's
interests and security protection.

V. Classification of Loans

Loans that are adequately protected by the current sound worth and
debt service capacity of the borrower, guarantor, or the underlying
collateral generally are not adversely classified.\25\ Similarly, loans
to sound borrowers that are modified in accordance with prudent
underwriting standards should not be adversely classified unless well-
defined weaknesses exist that jeopardize repayment. However, such loans
could be flagged for management's attention or other designated ``watch
lists'' of loans that management is more closely monitoring.
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\25\ 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.
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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 definitions.

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 of loan performance is based upon an assessment as
to whether the borrower is contractually current on principal or
interest payments. For many loans, this definition is sufficient and
accurately portrays the status of the loan. 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 may 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 such cases, 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, especially 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 these situations, 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

[[Page 47280]]

over the loan's tenure. Therefore, the loan classification is meant to
measure risk over the term 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:
<bullet> The borrower's financial strength as reflected by its
historical and projected balance sheet and income statement outcomes;
and
<bullet> The prospects for a CRE property in light of 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 loans to finance recently completed CRE
projects for the period to achieve stabilized occupancy. 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 their
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 loans. 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 are 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 Troubled CRE Loans Dependent on the Sale of
Collateral for Repayment

As a general classification principle for a troubled 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 there are no other available reliable sources of
repayment such as a financially capable guarantor.\26\
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\26\ Under ASC Topic 310, applicable for financial institutions
reporting an ALLL, a loan is collateral dependent if repayment of
the loan is expected to be provided solely by sale or operation of
the collateral. Under ASC Topic 326, applicable for financial
institutions reporting an ACL, 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.
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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 use a ``doubtful''
classification on the entire loan balance. However, examiners should
use a ``doubtful'' classification infrequently and for a limited time
period to permit the pending events to be resolved.

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 where 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 troubled loan is restructured into two notes. Lenders may
separate a portion of the current outstanding debt into a new, legally
enforceable note (i.e., Note A) that is reasonably assured of repayment
and performance according to prudently modified terms. This note may be
placed back on 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 not reasonably assured of repayment (i.e., Note B) must be
adversely classified and charged-off.
In contrast, the loan should remain on, or be placed on, nonaccrual
status if the lender 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.\27\ 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.
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\27\ 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 costs, 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 guidance on returning a loan
to accrual status.
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VI. Regulatory Reporting and Accounting Considerations

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

[[Page 47281]]

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 guidelines on accounting matters.
Accurate regulatory reports are critical to the transparency of a
financial institution's financial position and risk profile and
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 reporting 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, restructurings, and the allowance)
when assessing the adequacy of the financial institution's reporting
practices for on- and off-balance sheet credit exposures. Refer to the
appropriate Appendix that provides a summary of the allowance standards
under the incurred loss methodology (Appendix 6) or the CECL
methodology for institutions that have adopted ASC Topic 326, Financial
Instruments--Credit Losses (Appendix 5). Examiners should also refer to
regulatory reporting instructions in the FFIEC Call Report and the NCUA
5300 Call Report guidance and applicable GAAP 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 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 on
accrual status, the restructuring and any charge-off taken on the loan
have to be supported by a current, well-documented credit assessment of
the borrower's financial condition and prospects for repayment under
the revised terms. Otherwise, in accordance with outstanding Call
Report instructions, 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 a period of
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 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.

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 and appropriate
regulatory reporting, such as whether a loan should be reported as a
troubled debt restructuring (TDR).\28\ Although not discussed in the
examples below, examiners consider the adequacy of a lender'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.
---------------------------------------------------------------------------

\28\ The agencies view that the accrual treatments in these
examples as falling within the range of acceptable practices under
regulatory reporting instructions.
---------------------------------------------------------------------------

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 classifications, accrual treatment, and
TDR reporting.\29\
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\29\ In addition, estimates of the fair value of collateral
require the use of assumptions requiring judgment and should be
consistent with measurement of fair value in ASC Topic 820, Fair
Value Measurement; see Appendix 2.
---------------------------------------------------------------------------

The TDR determination requires consideration of all of the facts
and circumstances surrounding the modification. No single factor, by
itself, is determinative of whether a modification is a TDR. To make
this determination, the lender assesses whether (a) the borrower is
experiencing financial difficulties and (b) the lender has granted a
concession. For purposes of these examples, if the borrower was not
experiencing financial difficulties, the example does not assess
whether a concession was granted. However, in distressed situations,
lenders may make concessions because borrowers are experiencing
financial difficulties. Accordingly, lenders and examiners should
exercise judgment in evaluating whether a restructuring is a TDR. In
addition, some examples refer to disclosures of TDRs, which pertain
only to the reporting in Schedules RC-C or RC-N of the Call Report
or Schedule A, Section 2 of NCUA Form 5300 and not the applicable
measurement in determining an appropriate allowance pursuant to the
accounting standards.

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

[[Page 47282]]

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 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 on 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.
TDR Treatment: The lender determined that the renewed loan
should not be reported as a TDR. While the borrower is experiencing
some financial deterioration, the borrower has sufficient cash flow
to service the debt and has no record of payment default; therefore,
the borrower is not experiencing financial difficulties. The
examiner concurred with the lender's TDR 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,\30\ representing administrative
weaknesses.
---------------------------------------------------------------------------

\30\ In relation to comments on valuations within these
examples, refer to the appraisal regulations of the applicable
Federal financial institution supervisory agency to determine
whether there is a regulatory requirement for either an evaluation
or appraisal. See footnote 18.
---------------------------------------------------------------------------

Nonaccrual Treatment: The lender maintained the loan on 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.
TDR Treatment: The lender determined that the renewed loan
should not be reported as a TDR. While the borrower is experiencing
some financial deterioration, the borrower is not experiencing
financial difficulties as the borrower has sufficient cash flow to
service the debt, and there is no history of default. The examiner
concurred with the lender's TDR 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 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 on 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
capacity 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.
TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties (the
project's ongoing ability to generate sufficient cash flow to
service the debt is questionable as lease income is declining, loan
payments have been sporadic, leases are expiring with uncertainty as
to renewal or replacement, and collateral values have declined) and
the lender granted a concession by reducing the interest rate to a
below market level and deferring principal payments. The examiner
concurred with the lender's TDR treatment.

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. 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 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

[[Page 47283]]

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 type of loan.
Nonaccrual Treatment: The lender maintained the loan on 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.
TDR Treatment: The lender concluded that while the borrower has
been affected by declining economic conditions and a shift to e-
commerce, the deterioration has not led to financial difficulties.
The borrower was not experiencing financial difficulties because the
borrower and guarantor have the ability to service the renewed loan,
which was underwritten at a market interest rate, plus the
borrower's other obligations on a timely basis. In addition, the
lender expects to collect the full amount of principal and interest
from the borrower's or guarantor's cash sources (i.e., not from
interest reserves). Therefore, the lender is not treating the loan
renewal as a TDR. The examiner concurred with the lender's rationale
that the loan renewal is not a TDR.
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.
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 capacity 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.
TDR Treatment: The lender reported the restructured loan as a
TDR because (a) the borrower is experiencing financial difficulties
as evidenced by the high leverage, delinquent payments on other
projects, and inability to meet the proposed exit strategy because
of the inability to lease the property in a reasonable timeframe;
and (b) the lender granted a concession as evidenced by the
reduction in the interest rate to a below market interest rate. The
examiner concurred with the lender's TDR treatment.
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 on the
shopping mall reported an ``as is'' market value of $7 million,
which results in an LTV of 143 percent.
At the original loan's maturity, the lender restructured the $10
million debt into two notes. The lender placed the first note of $7
million (i.e., the 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. The lender then charged-off the $3 million note due to the
project's lack of repayment capacity and to provide reasonable
collateral protection for the remaining on-book loan of $7 million.
The lender also reversed accrued but unpaid interest. The lender
placed the second note (i.e., the Note B) consisting of the charged-
off principal balance of $3 million into a 2 percent interest-only
loan that resets in five years into an amortizing payment. 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 and limit the amount reported as a TDR in
future periods.
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.
TDR Treatment: The lender considered both Note A and Note B as
TDRs because the borrower is experiencing financial difficulties and
the lender granted a concession. The lender reported the
restructured on-book loan (Note A) of $7 million as a TDR, while the
second loan (Note B) was charged off. The financial difficulties are
evidenced by the borrower's high leverage, delinquent payments on
other projects, inability to lease the property in a reasonable
timeframe, and the unlikely collectability of the charged-off loan
(Note B). The concessions on Note A include extending the on-book
loan beyond expected timeframes.
The lender plans to stop disclosing the on-book loan as a TDR
after the regulatory reporting defined time period expires because
the loan was restructured with a market interest rate and is in
compliance with its modified terms.\31\ The examiner agreed with the
lender's TDR treatment.
---------------------------------------------------------------------------

\31\ Refer to the guidance on ``Troubled debt restructurings''
in the FFIEC Call Report and NCUA 5300 Call Report instructions.
---------------------------------------------------------------------------

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

[[Page 47284]]

a 1.05x DSC ratio when just considering the on-book balance. The
examiner disagreed with the internal grade 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. 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 status \32\ 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 cannot be reversed.
---------------------------------------------------------------------------

\32\ Refer to the guidance on ``nonaccrual status'' in the FFIEC
Call Report and NCUA 5300 Call Report instructions.
---------------------------------------------------------------------------

TDR Treatment: The lender reported the restructured loan as a
TDR according to the requirements of its regulatory reports because
(a) the borrower is experiencing financial difficulties as evidenced
by the high leverage, delinquent payments on other projects, and
inability to meet the original exit strategy because the borrower
was unable to lease the property in a reasonable timeframe; and (b)
the lender granted a concession as evidenced by deferring payment
beyond the repayment ability of the borrower. The charge-off
indicates that the lender does not expect full repayment of
principal and interest, yet the borrower remains obligated for the
full amount of the debt and payments, which is at a level that is
not consistent with the borrower's repayment capacity. Because the
borrower is not expected to be able to comply with the loan's
restructured terms, the lender would likely continue to disclose the
loan as a TDR. The examiner concurs with reporting the renewed loan
as a TDR.

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. 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) \33\ 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.
---------------------------------------------------------------------------

\33\ Total guest room revenue divided by room count and number
of days in the period.
---------------------------------------------------------------------------

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 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 on 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.
TDR Treatment: The lender concluded that while the borrower has
been affected by competition, the level of deterioration does not
warrant TDR treatment. The borrower was not experiencing financial
difficulties because the combined cash flow generated by the
borrower and the liquidity provided by the guarantors should be
sufficient to service the debt. Further, there was no history of
default by the borrower or guarantors. The examiner concurred with
the lender that the loan renewal is not a TDR.
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 capacity 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 unencumbered limited
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.
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, 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 the collateral margin
has narrowed and may be narrowed further with a new valuation, which
collectively indicate 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.

[[Page 47285]]

TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties: the
hotel's ability to generate sufficient cash flows to service the
debt is questionable as the occupancy levels and resultant net
operating income (NOI) continue to decline, the borrower has been
delinquent, and collateral value has declined. The lender made a
concession by extending the loan on an interest-only basis at a
below market interest rate. The examiner concurred with the lender's
TDR treatment.
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. 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.
TDR Treatment: The lender reported the first restructuring as a
TDR. With the first restructuring, the lender determined that the
borrower was experiencing financial difficulties as indicated by
depleted cash resources and deteriorating financial condition. The
lender granted a concession on the first restructuring by providing
a below market interest rate. At the time of the second
restructuring, the borrower's financial condition had improved, and
the borrower was no longer experiencing financial difficulty; the
lender did not grant a concession on the second restructuring as the
renewal was granted at a market interest rate and amortizing terms,
thus the latest restructuring is no longer classified as a TDR. The
examiner concurred with the lender.
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 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 on accrual
status. The borrower and legally obligated 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.
TDR Treatment: While the borrower is experiencing some financial
deterioration, the borrower is not experiencing financial
difficulties as the borrower and guarantors have sufficient cash
resources to service the debt. The lender expects full collection of
principal and interest from the borrower's operating income and
global cash resources. The examiner concurred with the lender's
rationale that the loan is not a TDR.

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. 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.
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 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

[[Page 47286]]

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. 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 on 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.
TDR Treatment: The borrower is not experiencing financial
difficulties as the borrower and guarantor have sufficient means to
service the debt, and there is no history of default. With the
continued supportive housing market conditions, the lender expects
full collection of principal and interest from sales of the lots.
The examiner concurred with the lender's rationale that the renewal
is not a TDR.
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. 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.
TDR Treatment: While the borrower is experiencing some financial
deterioration, the borrower is not experiencing financial
difficulties as the borrower and guarantor have sufficient means to
service the debt. The lender expects full collection of principal
and interest from the sale of the units. The examiner concurred with
the lender's rationale that the renewal is not a TDR.
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). 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.
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.
TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties as
evidenced by the borrower's inability to re-sell the units, their
diminished ability to make interest payments (even at a reduced
rate), and other troubled projects in the borrower's portfolio. The
lender granted a concession with the interest-only terms at a below
market interest rate. The examiner concurred with the lender's TDR
treatment.

E. Construction Loan--Single Family Residence

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. 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

[[Page 47287]]

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 capacity 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.
TDR Treatment: The lender reported the restructured loan as a
TDR. The borrower was experiencing financial difficulties as
indicated by depleted cash reserves, inability to refinance this
debt from other sources with similar terms, and the inability to
repay the loan at maturity in a manner consistent with the original
exit strategy. A concession was provided by renewing the loan with a
deferral of principal payments, at a below market interest rate
(compared to the rate charged on an investment property) for an
additional year when the loan was no longer in the construction
phase. The examiner concurred with the lender's TDR treatment.
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 with the lender's accrual treatment.
TDR Treatment: The lender reported the first restructuring as a
TDR. At the time of the first restructure, the lender determined
that the borrower was experiencing financial difficulties as
indicated by depleted cash resources and a weak financial condition.
The lender granted a concession on the first restructuring as
evidenced by the below market rate.
At the second restructuring, the lender determined that the
borrower was not experiencing financial difficulties due to the
borrower's improved financial condition. Further, the lender did not
grant a concession on the second restructuring as that loan is at
market interest rate and terms. Therefore, the lender determined
that the second restructuring is no longer a TDR. The examiner
concurred with the lender.
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 capacity 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. The examiner
concurred with the lender's nonaccrual treatment.
TDR Treatment: The lender reported the loan as a TDR until
foreclosure of the property and its transfer to other real estate
owned. The lender determined that the borrower was continuing to
experience financial difficulties as indicated by depleted cash
reserves, inability to refinance this debt from other sources with
similar terms, and the inability to repay the loan at maturity in a
manner consistent with the original exit strategy. In addition, the
lender granted a concession by reducing the interest rate to a below
market level. The examiner concurred with the lender's TDR
treatment.
Scenario 4: The lender committed an additional $48,000 for an
interest reserve and extended the $1.2 million loan for 12 months at
a below market interest rate with monthly interest-only payments. At
the time of the examination, $18,000 of the interest reserve had
been added to the loan balance. Current financial information
obtained during the examination reflects the borrower has no other
repayment sources and has not been able to sell or rent the
property. An updated appraisal supports an ``as is'' value of
$952,950. Selling costs are estimated at 15 percent, resulting in
anticipated net sales proceeds of $810,000.
Classification: The lender internally graded the loan as pass
and is monitoring the credit. The examiner disagreed with the
internal grade. The examiner concluded that the loan was not
restructured on reasonable repayment terms because the borrower has
limited capacity to service the debt, and the reduced collateral
margin indicated that full repayment of principal and interest was
not assured. After discussing regulatory reporting requirements with
the examiner, the lender reversed the $18,000 interest capitalized
out of the loan balance and interest income. Further, the examiner
classified $390,000 loss based on the adjusted $1.2 million loan
balance less estimated net sales proceeds of $810,000, which was
classified substandard. This classification treatment recognizes the
credit risk in the collateral-dependent loan based on the property's
market value less costs to sell. The examiner also provided
supervisory feedback to management for the inappropriate use of
interest reserves and lack of current financial information in
making that decision. The remaining interest reserve of $30,000 is
not subject to adverse classification because the loan should be
placed in nonaccrual status.
Nonaccrual Treatment: The lender maintained the loan on accrual
status. The examiner did not concur with this treatment. The loan
was not restructured on reasonable repayment terms, the borrower has
limited capacity to service a below market interest rate on an
interest-only basis, and the reduced collateral margin indicates
that full repayment of principal and interest is not assured. The
lender's decision to provide a $48,000 interest reserve was not
supported, given the borrower's inability to repay it. After a
discussion with the examiner on regulatory reporting requirements,
the lender placed the loan on nonaccrual, and reversed the
capitalized interest to be consistent with regulatory reporting
instructions. The lender also agreed to not recognize any further
interest income from the interest reserve.
TDR Treatment: The lender reported the restructured loan as a
TDR. The borrower is experiencing financial difficulties as
indicated by depleted cash reserves, inability to refinance this
debt from other sources with similar terms, and the inability to
repay the loan at maturity in a manner consistent with the original
exit strategy. A concession was provided by renewing the loan with a
deferral of principal payments, at a below market interest rate
(compared to other investment properties) for an additional year
when the loan was no longer in the construction phase. The examiner
concurred with the lender's TDR treatment.

F. Construction Loan--Land Acquisition, Condominium Construction
and Conversion

Base Case: The lender originally extended a $50 million loan for
the purchase of vacant

[[Page 47288]]

land and the construction of a luxury condominium project. The loan
was interest-only and included an interest reserve to cover the
monthly payments until construction was complete. The developer
bought the land and began construction after obtaining purchase
commitments for \1/3\ of the 120 planned units, or 40 units. Many of
these pending sales were speculative with buyers committing to buy
multiple units with minimal down payments. The demand for luxury
condominiums in general has declined since the borrower launched the
project, and sales have slowed significantly over the past year. The
lack of demand is attributed to a slowdown in the economy. As a
result, most of the speculative buyers failed to perform on their
purchase contracts and only a limited number of the other planned
units have been pre-sold.
The developer experienced cost overruns on the project and
subsequently determined it was in the best interest to halt
construction with the property 80 percent completed. The outstanding
loan balance is $44 million with funds used to pay construction
costs, including cost overruns and interest. The borrower estimates
an additional $10 million is needed to complete construction.
Current financial information reflects that the developer does not
have sufficient cash flow to pay interest (the interest reserve has
been depleted); and, while the developer does have equity in other
assets, there is doubt about the borrower's ability to complete the
project.
Scenario 1: The borrower agrees to grant the lender a second
lien on an apartment project in its portfolio, which provides $5
million in additional collateral support. In return, the lender
advanced the borrower $10 million to finish construction. The
condominium project was completed shortly thereafter. The lender
also agreed to extend the $54 million loan ($44 million outstanding
balance plus $10 million in new money) for 12 months at a market
interest rate that provides for the incremental risk, to give the
borrower additional time to market the property. The borrower agreed
to pay interest whenever a unit was sold, with any outstanding
balance due at maturity.
The lender obtained a recent appraisal on the condominium
building that reported a prospective ``as complete'' market value of
$65 million, reflecting a 24-month sell-out period and projected
selling costs of 15 percent of the sales price. Comparing the $54
million loan amount against the $65 million ``as complete'' market
value plus the $5 million pledged in additional collateral (totaling
$70 million) results in an LTV of 77 percent. The lender used the
prospective ``as complete'' market value in its analysis and
decision to fund the completion and sale of the units and to
maximize its recovery on the loan.
Classification: The lender internally classified the $54 million
loan as substandard due to the units not selling as planned and the
project's limited ability to service the debt despite the 1.3x gross
collateral margin. The examiner agreed with the lender's internal
grade.
Nonaccrual Treatment: The lender maintained the loan on accrual
status due to the protection afforded by the collateral margin. The
examiner did not concur with this treatment due to the uncertainty
about the borrower's ability to sell the units and service the debt,
raising doubts as to the full repayment of principal and interest.
After a discussion with the examiner on regulatory reporting
requirements, the lender placed the loan on nonaccrual.
TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties, as
demonstrated by the insufficient cash flow to service the debt,
concerns about the project's viability, and, given current market
conditions and project status, the unlikely possibility of
refinance. In addition, the lender provided a concession by
advancing additional funds to finish construction, deferring
interest payments until a unit was sold, and deferring principal pay
downs on any unsold units until the maturity date when any remaining
accrued interest plus principal are due. The examiner concurred with
the lender's TDR treatment.
Scenario 2: A recent appraisal of the property reflects that the
highest and best use would be conversion to an apartment building.
The appraisal reports a prospective ``as complete'' market value of
$60 million upon conversion to an apartment building and a $67
million prospective ``as stabilized'' market value upon the property
reaching stabilized occupancy. The borrower agrees to grant the
lender a second lien on an apartment building in its portfolio,
which provides $5 million in additional collateral support.
In return, the lender advanced the borrower $10 million, which
is needed to finish construction and convert the project to an
apartment complex. The lender also agreed to extend the $54 million
loan for 12 months at a market interest rate that provides for the
incremental risk, to give the borrower time to lease the apartments.
Interest payments are deferred. The $60 million ``as complete''
market value plus the $5 million in other collateral results in an
LTV of 83 percent. The prospective ``as complete'' market value is
primarily relied on as the loan is funding the conversion of the
condominium to apartment building.
Classification: The lender internally classified the $54 million
loan as substandard due to the units not selling as planned and the
project's limited ability to service the debt. The collateral
coverage provides adequate support to the loan with a 1.2x gross
collateral margin. The examiner agreed with the lender's internal
grade.
Nonaccrual Treatment: The lender determined the loan should be
placed in nonaccrual status due to an oversupply of units in the
project's submarket, and the borrower's untested ability to lease
the units and service the debt, raising concerns as to the full
repayment of principal and interest. The examiner concurred with the
lender's nonaccrual treatment.
TDR Treatment: The lender reported the restructured loan as a
TDR as the borrower is experiencing financial difficulties, as
demonstrated by the insufficient cash flow to service the debt,
concerns about the project's viability, and, given current market
conditions and project status, the unlikely possibility for the
borrower to refinance at this time. In addition, the lender provided
a concession by advancing additional funds to finish construction
and deferring interest payments until the maturity date without a
defined exit strategy. The examiner concurred with the lender's TDR
treatment.

G. Commercial Operating Line of Credit in Connection With Owner
Occupied Real Estate

Base Case: Two years ago, the lender originated a CRE loan at a
market interest rate to a borrower whose business occupies the
property. The loan was based on a 20-year amortization period with a
balloon payment due in three years. The LTV equaled 70 percent at
origination. A year ago, the lender financed a $5 million operating
line of credit for seasonal business operations at market terms. The
operating line of credit had a one-year maturity with monthly
interest payments and was secured with a blanket lien on all
business assets. Borrowings under the operating line of credit are
based on accounts receivable that are reported monthly in borrowing
base reports, with a 75 percent advance rate against eligible
accounts receivable that are aged less than 90 days old. Collections
of accounts receivable are used to pay down the operating line of
credit. At maturity of the operating line of credit, the borrower's
accounts receivable aging report reflected a growing trend of
delinquency, causing the borrower temporary cash flow difficulties.
The borrower has recently initiated more aggressive collection
efforts.
Scenario 1: The lender renewed the $5 million operating line of
credit for another year, requiring monthly interest payments at a
market interest rate, and principal to be paid down by accounts
receivable collections. The borrower's liquidity position has
tightened but remains satisfactory, cash flow available to service
all debt is 1.20x, and both loans have been paid according to the
contractual terms. The primary repayment source for the operating
line of credit is conversion of accounts receivable to cash.
Although payments have slowed for some customers, most customers are
paying within 90 days of invoice. The primary repayment source for
the real estate loan is from business operations, which remain
satisfactory, and an updated appraisal is not considered necessary.
Classification: The lender internally graded both loans as pass
and is monitoring the credits. The examiner agreed with the lender's
analysis and the internal grades. The lender is monitoring the trend
in the accounts receivable aging report and the borrower's ongoing
collection efforts.
Nonaccrual Treatment: The lender determined that both the real
estate loan and the renewed operating line of credit may remain on
accrual status as the borrower has demonstrated an ongoing ability
to perform, has the financial capacity to pay a market interest
rate, and full repayment of principal and interest is reasonably
assured. The examiner concurred with the lender's accrual treatment.
TDR Treatment: The lender concluded that while the borrower has
been affected by

[[Page 47289]]

declining economic conditions, the renewal of the operating line of
credit did not result in a TDR because the borrower is not
experiencing financial difficulties and has the ability to repay
both loans (which represent most of its outstanding obligations) at
a market interest rate. The lender expects full collection of
principal and interest from the collection of accounts receivable
and the borrower's operating income. The examiner concurred with the
lender's rationale that the loan renewal is not a TDR.
Scenario 2: The lender restructured the operating line of credit
by reducing the line amount to $4 million, at a below market
interest rate. This action is expected to alleviate the borrower's
cash flow problem. The borrower is still considered to be a viable
business even though its financial performance has continued to
deteriorate, with sales and profitability declining. The trend in
accounts receivable delinquencies is worsening, resulting in reduced
liquidity for the borrower. Cash flow problems have resulted in
sporadic over advances on the $4 million operating line of credit,
where the loan balance exceeds eligible collateral in the borrowing
base. The borrower's net operating income has declined but reflects
the capacity to generate a 1.08x DSC ratio for both loans, based on
the reduced rate of interest for the operating line of credit. The
terms on the real estate loan remained unchanged. The lender
estimated the LTV on the real estate loan to be 90 percent. The
operating line of credit currently has sufficient eligible
collateral to cover the outstanding line balance, but customer
delinquencies have been increasing.
Classification: The lender internally classified both loans
substandard due to deterioration in the borrower's business
operations and insufficient cash flow to repay the debt at market
terms. The examiner agreed with the lender's analysis and the
internal grades. The lender will monitor the trend in the business
operations, accounts receivable, profitability, and cash flow. The
lender may need to order a new appraisal if the DSC ratio continues
to fall and the overall collateral margin further declines.
Nonaccrual Treatment: The lender reported both the restructured
operating line of credit and the real estate loan on a nonaccrual
basis. The operating line of credit was not renewed on market
interest rate repayment terms, the borrower has an increasingly
limited capacity to service the below market interest rate debt, and
there is insufficient support to demonstrate an ability to meet the
new payment requirements. The borrower's ability to continue to
perform on the operating line of credit and real estate loan is not
assured due to deteriorating business performance caused by lower
sales and profitability and higher customer delinquencies. In
addition, the collateral margin indicates that full repayment of all
of the borrower's indebtedness is questionable, particularly if the
borrower fails to continue being a going concern. The examiner
concurred with the lender's nonaccrual treatment.
TDR Treatment: The lender reported the restructured operating
line of credit as a TDR because the borrower is experiencing
financial difficulties (as evidenced by the borrower's sporadic over
advances, an increasing trend in accounts receivable delinquencies,
and uncertain ability to repay the loans) and the lender granted a
concession on the line of credit through a below market interest
rate. The lender concluded that the real estate loan should not be
reported as TDR since that loan is performing and had not been
restructured. The examiner concurred with the lender's TDR
treatments.

H. Land Loan

Base Case: Three years ago, the lender originated a $3.25
million loan to a borrower for the purchase of raw land that the
borrower was seeking to have zoned for residential use. The loan
terms were three years interest-only at a market interest rate; the
borrower had sufficient funds to pay interest from cash flow. The
appraisal at origination assigned an ``as is'' market value of $5
million, which resulted in a 65 percent LTV. The zoning process took
longer than anticipated, and the borrower did not obtain full
approvals until close to the maturity date. Now that the borrower
successfully obtained the residential zoning, the borrower has been
seeking construction financing to repay the land loan. At maturity,
the borrower requested a 12-month extension to provide additional
time to secure construction financing which would include repayment
of the subject loan.
Scenario 1: The borrower provided the lender with current
financial information, demonstrating the continued ability to make
monthly interest payments and principal curtailments of $150,000 per
quarter. Further, the borrower made a principal payment of $250,000
in exchange for a 12-month extension of the loan. The borrower also
owned an office building with an ``as stabilized'' market value of
$1 million and pledged the property as additional unencumbered
collateral, granting the lender a first lien. The borrower's
personal financial information also demonstrates that cash flow from
personal assets and the rental income generated by the newly pledged
office building are sufficient to fully amortize the land loan over
a reasonable period. A decline in market value since origination was
due to a change in density; the project was originally intended as
60 lots but was subsequently zoned as 25 single-family lots because
of a change in the county's approval process. A recent appraisal of
the raw land reflects an ``as is'' market value of $3 million, which
results in a 75 percent LTV when combined with the additional
collateral and after the principal reduction. The lender
restructured the loan into a $3 million loan with quarterly
curtailments for another year at a market interest rate that
provides for the incremental risk.
Classification: The lender internally graded the loan as pass
due to adequate cash flow from the borrower's personal assets and
rental income generated by the office building to make principal and
interest payments. Also, the borrower provided a principal
curtailment and additional collateral to maintain a reasonable LTV.
The examiner agreed with the lender's internal grade.
Nonaccrual Treatment: The lender maintained the loan on accrual
status, as the borrower has sufficient funds to cover the debt
service requirements for the next year. Full repayment of principal
and interest is reasonably assured from the collateral and the
borrower's financial resources. The examiner concurred with the
lender's accrual treatment.
TDR Treatment: The lender concluded that the borrower was not
experiencing financial difficulties because the borrower has the
ability to service the renewed loan, which was prudently
underwritten and has a market interest rate. The examiner concurred
with the lender's rationale that the renewed loan is not a TDR.
Scenario 2: The borrower provided the lender with current
financial information that indicated the borrower is unable to
continue to make interest-only payments. The borrower has been
sporadically delinquent up to 60 days on payments. The borrower is
still seeking a loan to finance construction of the project, and has
not been able to obtain a takeout commitment; it is unlikely the
borrower will be able to obtain financing, since the borrower does
not have the equity contribution most lenders require as a condition
of closing a construction loan. A decline in value since origination
was due to a change in local zoning density; the project was
originally intended as 60 lots but was subsequently zoned as 25
single-family lots. A recent appraisal of the property reflects an
``as is'' market value of $3 million, which results in a 108 percent
LTV. The lender extended the $3.25 million loan at a market interest
rate for one year with principal and interest due at maturity.
Classification: The lender internally graded the loan as pass
because the loan is currently not past due and is at a market
interest rate. Also, the borrower is trying to obtain takeout
construction financing. The examiner disagreed with the internal
grade and adversely classified the loan, as discussed below. The
examiner concluded that the loan was not restructured on reasonable
repayment terms because the borrower does not have the capacity to
service the debt and full repayment of principal and interest is not
assured. The examiner classified $550,000 loss ($3.25 million loan
balance less $2.7 million, based on the current appraisal of $3
million less estimated cost to sell of 10 percent or $300,000). The
examiner classified the remaining $2.7 million balance substandard.
This classification treatment recognizes the credit risk in this
collateral dependent loan based on the property's market value less
costs to sell.
Nonaccrual Treatment: The lender maintained the loan on accrual
status. The examiner did not concur with this treatment and
instructed the lender to place the loan in nonaccrual status because
the borrower does not have the capacity to service the debt, value
of the collateral is permanently impaired, and full repayment of
principal and interest is not assured.
TDR Treatment: The lender reported the restructured loan as a
TDR. The borrower is experiencing financial difficulties as
indicated by the inability to refinance this debt, the inability to
repay the loan at

[[Page 47290]]

maturity in a manner consistent with the original exit strategy, and
the inability to make interest-only payments going forward. A
concession was provided by renewing the loan with a deferral of
principal and interest payments for an additional year when the
borrower was unable to obtain takeout financing. The examiner
concurred with the lender's TDR designation.

I. Multi-Family Property

Base Case: The lender originated a $6.4 million loan for the
purchase of a 25-unit apartment building. The loan maturity is five
years, and principal and interest payments are based on a 30-year
amortization at a market interest rate. The LTV was 75 percent
(based on an $8.5 million value), and the DSC ratio was 1.50x at
origination (based on a 30-year principal and interest
amortization).
Leases are typically 12-month terms with an additional 12-month
renewal option. The property is 88 percent leased (22 of 25 units
rented). Due to poor economic conditions, delinquencies have risen
from two units to eight units, as tenants have struggled to make
ends meet. Six of the eight units are 90 days past due, and these
tenants are facing eviction.
Scenario 1: At maturity, the lender renewed the $5.9 million
loan balance on principal and interest payments for 12 months at a
market interest rate that provides for the incremental risk. The
borrower had not been delinquent on prior payments. Current
financial information indicates that the DSC ratio dropped to 0.80x
because of the rent payment delinquencies. Combining borrower and
guarantor liquidity shows they can cover cash flow shortfall until
maturity (including reasonable capital expenditures since the
building was recently renovated). Borrower projections show a return
to break-even within six months since the borrower plans to decrease
rents to be more competitive and attract new tenants. The lender
estimates that the property's current ``as stabilized'' market value
is $7 million, resulting in an 84 percent LTV. A new appraisal has
not been ordered; however, the lender noted in the file that, if the
borrower does not meet current projections within six months of
booking the renewed loan, the lender will obtain a new appraisal.
Classification: The lender internally graded the renewed loan as
pass and is monitoring the credit. The examiner disagreed with the
lender's analysis and classified the loan as substandard. While the
borrower and guarantor can cover the debt service shortfall in the
near-term using additional guarantor liquidity, the duration of the
support may be less than the lender anticipates if the leasing fails
to materialize as projected. Economic conditions are poor, and the
rent reduction may not be enough to improve the property's
performance. Lastly, the lender failed to obtain an updated
collateral valuation, which represents an administrative weakness.
Nonaccrual Treatment: The lender maintained the loan on accrual
status. The borrower has demonstrated the ability to make the
regularly scheduled payments and, even with the decline in the
borrower's creditworthiness, the borrower and guarantor appear to
have sufficient cash resources to make these payments if projections
are met, and full repayment of principal and interest is expected.
The examiner concurred with the lender's accrual treatment.
TDR Treatment: While the borrower is experiencing some financial
deterioration, the borrower is not experiencing financial
difficulties as the borrower and guarantor have sufficient means to
service the debt, and there was no history of default. The lender
expects full collection of principal and interest from the
borrower's operating income if they meet projections. The examiner
concurred with the lender's rationale and TDR treatment.
Scenario 2: At maturity, the lender renewed the $5.9 million
loan balance on a 12-month interest-only basis at a below market
interest rate. In response to an event that caused severe economic
conditions, the federal and state governments enacted moratoriums on
all rent payments. The borrower has been paying as agreed; however,
cash flow has been severely impacted by the rent moratoriums. While
the moratoriums do not forgive the rent (or unpaid fees), they do
prevent evictions for unpaid rent and have been in effect for the
past six months. As a result, the borrower's cash flow is severely
stressed, and the borrower has asked for temporary relief of the
interest payments. In addition, a review of the current rent roll
indicates that five of the 25 units are now vacant. A recent
appraisal values the property at $6 million (98 percent LTV).
Updated borrower and guarantor financial statements indicate the
continued ability to cover interest-only payments for the next 12 to
18 months at the reduced rate of interest. Updated projections that
indicate below break-even performance over the next 12 months remain
uncertain given that the end of the moratorium (previously extended)
is a ``soft'' date and that tenant behaviors may not follow
historical norms.
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 ability to
make interest payments (even at the reduced rate) and lack of
principal reduction, the uncertainty surrounding the rent
moratoriums, and the reduced and tight collateral position.
Nonaccrual Treatment: The lender maintained the loan on an
accrual basis because the borrower demonstrated an ability to make
principal and interest payments and has some capacity to make
payments on the interest-only terms at a below market interest rate.
The examiner did not concur with this treatment as the loan was not
restructured on reasonable repayment terms, the borrower has
insufficient cash flow to amortize the debt, and the slim collateral
margin indicates that full repayment of principal and interest may
be in doubt. After a discussion with the examiner on regulatory
reporting requirements, the lender placed the loan on nonaccrual.
TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties as
evidenced by the reported reduced, stressed cash flow that prompted
the borrower's request for payment relief in the restructure. The
lender granted a concession (interest-only at a below market
interest rate) in response. The examiner concurred with the lender's
TDR treatment.
Scenario 3: At maturity, the lender renewed the $5.9 million
loan balance 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. A review of the current rent
roll indicates that 10 of the 25 units are vacant after tenant
evictions. The vacated units were previously in an advanced state of
disrepair, and the borrower and guarantors have exhausted their
liquidity after repairing the units. The repaired units are expected
to be rented at a lower rental rate. A post-renovation appraisal
values the property at $5.5 million (107 percent LTV). Updated
projections indicate the borrower will be below break-even
performance for the next 12 months.
Classification: The lender internally classified the loan as
substandard and is monitoring the credit. The examiner agreed with
the lender's concerns due to the borrower's diminished ability to
make principal or interest payments, the guarantor's limited ability
to support the loan, and insufficient collateral protection.
However, the examiner classified $900,000 loss ($5.9 million loan
balance less $5 million (based on the current appraisal of $5.5
million less estimated cost to sell of 10 percent, or $500,000)).
The examiner classified the remaining $5 million balance
substandard. This classification treatment recognizes the collateral
dependency.
Nonaccrual Treatment: The lender maintained the loan on accrual
basis because the borrower demonstrated a previous ability to make
principal and interest payments. The examiner did not concur with
the lender's treatment as the loan was not restructured on
reasonable repayment terms, the borrower has insufficient cash flow
to service the debt at a below market interest rate on an interest-
only basis, and the impairment of value 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.
TDR Treatment: The lender reported the restructured loan as a
TDR because the borrower is experiencing financial difficulties as
evidenced by sporadic delinquencies, fully dissipated liquidity, and
reduced collateral protection. The lender granted a concession with
the interest-only terms at a below market interest rate. The
examiner concurred with the lender's TDR treatment.

Appendix 2

Selected Rules, Supervisory Guidance, and Authoritative Accounting
Guidance

Rules

<bullet> Federal regulations on real estate lending standards
and the Interagency Guidelines for Real Estate Lending Policies:
OCC: 12 CFR part 34, subpart D, and appendix A to subpart D; and
FDIC: 12 CFR part 365 and appendix A. For NCUA, refer to 12 CFR part

[[Page 47291]]

723 for member business loan and commercial loan regulation which
addresses commercial real estate lending and 12 CFR part 741,
Appendix B, which addresses loan workouts, nonaccrual policy, and
regulatory reporting of troubled debt restructurings.
<bullet> Federal regulations on the Interagency Guidelines
Establishing Standards for Safety and Soundness: 12 CFR part 30,
appendix A (OCC); 12 CFR part 364 appendix A (FDIC). For NCUA safety
and soundness regulations and guidance, see 12 CFR 741.3(b)(2), 12
CFR part 741, appendix B, 12 CFR part 723, and NCUA letters to
credit unions 10-CU-02 ``Current Risks in Business Lending and Sound
Risk Management Practices'' issued January 2010 (NCUA). Credit
unions should also refer to the Commercial and Member Business Loans
section of the NCUA Examiner's Guide.
<bullet> Federal appraisal regulations: OCC: 12 CFR part 34,
subpart C; FDIC: 12 CFR part 323; and NCUA: 12 CFR part 722.

Supervisory Guidance

<bullet> FFIEC Instructions for Preparation of Consolidated
Reports of Condition and Income (FFIEC 031, FFIEC 041, and FFIEC 051
Instructions) and NCUA 5300 Call Report Instructions.
<bullet> Interagency Policy Statement on Allowances for Credit
Losses, issued May 2020, as applicable.
<bullet> Interagency Guidance on Credit Risk Review Systems,
issued May 2020.
<bullet> Interagency Supervisory Examiner Guidance for
Institutions Affected by a Major Disaster, issued December 2017.
<bullet> Board, FDIC, and OCC joint guidance entitled Statement
on Prudent Risk Management for Commercial Real Estate Lending,
issued December 2015.
<bullet> Interagency Supervisory Guidance Addressing Certain
Issues Related to Troubled Debt Restructurings, issued October 2013.
<bullet> Interagency Appraisal and Evaluation Guidelines, issued
October 2010.
<bullet> Board, FDIC, and OCC joint guidance on Concentrations
in Commercial Real Estate Lending, Sound Risk Management Practices,
issued December 2006.
<bullet> Interagency Policy Statement on the Allowance for Loan
and Lease Losses, issued December 2006, as applicable.
<bullet> Interagency FAQs on Residential Tract Development
Lending, issued September 2005.
<bullet> Interagency Policy Statement on Allowance for Loan and
Lease Losses Methodologies and Documentation for Banks and Savings
Institutions, issued July 2001, as applicable.\34\
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\34\ The guidance in the July 2001 Policy Statement was
substantially adopted by the NCUA through its Interpretative Ruling
and Policy Statement 02-3, Allowance for Loan and Lease Losses
Methodologies and Documentation for Federally Insured Credit Unions,
in May 2002.
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Authoritative Accounting Standards 35
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\35\ ASC Topic 326, Financial Instruments--Credit Losses, when
adopted by a financial institution, replaces the incurred loss
methodology included in ASC Subtopic 310-10, Receivables--Overall
and ASC Subtopic 450-20, Contingencies--Loss Contingencies, for
financial assets measured at amortized cost, net investments in
leases, and certain off balance-sheet credit exposures.'' ASC Topic
326 also, when adopted by a financial institution, supersedes ASC
Subtopic 310-40 Troubled Debt Restructurings by Creditors.
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<bullet> ASC Topic 310, Receivables
<bullet> ASC Subtopic 310-40, Receivables--Troubled Debt
Restructurings by Creditors
<bullet> ASC Topic 326, Financial Instruments--Credit losses
<bullet> ASC Subtopic 450-20, Contingencies--Loss Contingencies
<bullet> ASC Topic 820, Fair Value Measurement
<bullet> ASC Subtopic 825-10, Financial Instruments--Overall

Appendix 3

Valuation Concepts for Income Producing Real Estate

Several conceptual issues arise during the process of reviewing
a real estate loan and in using the net present value approach of
collateral valuation. The following discussion sets forth the
meaning and use of those key concepts.
The Discount Rate and the Net Present Value Approach: The
discount rate used in the net present value approach to convert
future net cash flows of income-producing real estate into present
market value terms is the rate of return that market participants
require for the specific type of real estate investment. The
discount rate will vary over time with changes in overall interest
rates and in the risk associated with the physical and financial
characteristics of the property. The riskiness of the property
depends both on the type of real estate in question and on local
market conditions.
The Direct Capitalization (``Cap'' Rate) Technique: Many market
participants and analysts use the ``cap'' rate technique to relate
the value of a property to the net operating income it generates. In
many applications, a ``cap'' rate is used as a short cut for
computing the discounted value of a property's income streams.
The direct income capitalization method calculates the value of
a property by dividing an estimate of its ``stabilized'' annual
income by a factor called a ``cap'' rate. Stabilized annual income
generally is defined as the yearly net operating income produced by
the property at normal occupancy and rental rates; it may be
adjusted upward or downward from today's actual market conditions.
The ``cap'' rate, usually defined for each property type in a market
area, is viewed by some analysts as the required rate of return
stated in terms of current income. The ``cap'' rate can be
considered a direct observation of the required earnings-to-price
ratio in current income terms. The ``cap'' rate also can be viewed
as the number of cents per dollar of today's purchase price
investors would require annually over the life of the property to
achieve their required rate of return.
The ``cap'' rate method is an appropriate valuation technique if
the net operating income to which it is applied is representative of
all future income streams or if net operating income and the
property's selling price are expected to increase at a fixed rate.
The use of this technique assumes that either the stabilized annual
income or the ``cap'' rate used accurately captures all relevant
characteristics of the property relating to its risk and income
potential. If the same risk factors, required rate of return,
financing arrangements, and income projections are used, the net
present value approach and the direct capitalization technique will
yield the same results.
The direct capitalization technique is not an appropriate
valuation technique for troubled real estate since income generated
by the property is not at normal or stabilized levels. In evaluating
troubled real estate, ordinary discounting typically is used for the
period before the project reaches its full income potential. A
``terminal cap rate'' is then utilized to estimate the value of the
property (its reversion or sales price) at the end of that period.
Differences Between Discount and Cap Rates: When used for
estimating real estate market values, discount and ``cap'' rates
should reflect the current market requirements for rates of return
on properties of a given type. The discount rate is the required
rate of return including the expected increases in future prices and
is applied to income streams reflecting inflation. In contrast, the
``cap'' rate is used in conjunction with a stabilized net operating
income figure. The fact that discount rates for real estate are
typically higher than ``cap'' rates reflects the principal
difference in the treatment of expected increases in net operating
income and/or property values.
Other factors affecting the ``cap'' rate (but not the discount
rate) include the useful life of the property and financing
arrangements. The useful life of the property being evaluated
affects the magnitude of the ``cap'' rate because the income
generated by a property, in addition to providing the required
return on investment, has to be sufficient to compensate the
investor for the depreciation of the property over its useful life.
The longer the useful life, the smaller is the depreciation in any
one year, hence, the smaller is the annual income required by the
investor, and the lower is the ``cap'' rate. Differences in terms
and the extent of debt financing and the related costs are also
taken into account.
Selecting Discount and Cap Rates: The choice of the appropriate
values for discount and ``cap'' rates is a key aspect of income
analysis. In markets marked by both a lack of transactions and
highly speculative or unusually pessimistic attitudes, analysts
consider historical required returns on the type of property in
question. Where market information is available to determine current
required yields, analysts carefully analyze sales prices for
differences in financing, special rental arrangements, tenant
improvements, property location, and building characteristics. In
most local markets, the estimates of discount and ``cap'' rates used
in an income analysis generally should fall within a fairly narrow
range for comparable properties.
Holding Period Versus Marketing Period: When the net present
value approach is applied to troubled properties, the chosen time
frame should reflect the period over

[[Page 47292]]

which a property is expected to achieve stabilized occupancy and
rental rates (stabilized income). That time period is sometimes
referred to as the ``holding period.'' The longer the period is
before stabilization, the smaller the reversion value will be within
the total value estimate. The marketing period is the length of time
that may be required to sell the property in an open market.

Appendix 4

Special Mention and Adverse Classification Definitions 36
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\36\ Federal banking agencies loan classification definitions of
Substandard, Doubtful, and Loss may be found in the Uniform
Agreement on the Classification and Appraisal of Securities Held by
Depository Institutions Attachment 1--Classification Definitions
(OCC: OCC Bulletin 2013-28; and FDIC: FIL-51-2013). The Federal
banking agencies definition of Special Mention may be found in the
Interagency Statement on the Supervisory Definition of Special
Mention Assets (June 10, 1993). The NCUA does not require credit
unions to adopt the definition of special mention or a uniform
regulatory classification schematic of loss, doubtful, 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 (see Section 723.4(g)(3))
or the equivalent state regulation as applicable. 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.
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The FDIC and OCC use the following definitions for assets
adversely classified for supervisory purposes as well as those
assets listed as special mention:

Special Mention

A Special Mention asset has potential weaknesses that deserve
management's close attention. If left uncorrected, these potential
weaknesses may result in deterioration of the repayment prospects
for the asset or in the institution's credit position at some future
date. Special Mention assets are not adversely classified and do not
expose an institution to sufficient risk to warrant adverse
classification.

Adverse Classifications

Substandard Assets: A substandard asset is inadequately
protected by the current sound worth and paying capacity of the
obligor or of the collateral pledged, if any. Assets so classified
must have a well-defined weakness or weaknesses that jeopardize the
liquidation of the debt. They are characterized by the distinct
possibility that the institution will sustain some loss if the
deficiencies are not corrected.
Doubtful Assets: An asset classified doubtful has all the
weaknesses inherent in one classified substandard with the added
characteristic that the weaknesses make collection or liquidation in
full, on the basis of currently existing facts, conditions, and
values, highly questionable and improbable.
Loss Assets: Assets classified loss are considered uncollectible
and of such little value that their continuance as bankable assets
is not warranted. This classification does not mean that the asset
has absolutely no recovery or salvage value, but rather it is not
practical or desirable to defer writing off this basically worthless
asset even though partial recovery may be effected in the future.

Appendix 5

Accounting--Current Expected Credit Losses Methodology (CECL)

This appendix addresses the relevant accounting and regulatory
guidance for financial institutions that have adopted Accounting
Standards Update (ASU) 2016-13, Financial Instruments--Credit Losses
(Topic 326): Measurement of Credit Losses on Financial Instruments
and its subsequent amendments (collectively, ASC Topic 326) in
determining the allowance for credit losses (ACL). Additional
guidance for the financial institution's estimate of the ACL and for
examiners' responsibilities to evaluate these estimates is presented
in the Interagency Policy Statement on Allowances for Credit Losses
(June 2020). Additional information related to identifying and
disclosing modifications for regulatory reporting under ASC Topic
326 is located in the FFIEC Call Report and NCUA 5300 Call Report
instructions.
Expected credit losses on loans under ASC Topic 326 are
estimated under the same CECL methodology as all other loans in the
portfolio. Loans, including loans modified in a restructuring,
should be evaluated on a collective basis unless they do not share
similar risk characteristics with other loans. Changes in credit
risk, borrower circumstances, recognition of charge-offs, or cash
collections that have been fully applied to principal, often require
reevaluation to determine if the modified loan should be included in
a different pool of assets with similar risks for measuring expected
credit losses.
Although ASC Topic 326 allows a financial institution to use any
appropriate loss estimation method to estimate the ACL, there are
some circumstances when specific measurement methods are required.
If a financial asset is collateral dependent,\37\ the ACL is
estimated using the fair value of the collateral. For a collateral-
dependent loan, regulatory reporting requires that if the amortized
cost of the loan exceeds the fair value \38\ of the collateral (less
costs to sell if the costs are expected to reduce the cash flows
available to repay or otherwise satisfy the loan, as applicable),
this excess is included in the amount of expected credit losses when
estimating the ACL. However, some or all of this difference may
represent a Loss for classification purposes that should be charged
off against the ACL in a timely manner.
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\37\ The repayment of a collateral-dependent loan 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. Refer to
the glossary entry in the Call Report instructions for ``Allowance
for Credit Losses--Collateral-Dependent Financial Assets.''
\38\ The fair value of collateral should be measured in
accordance with FASB ASC Topic 820, Fair Value Measurement. For
impairment analysis purposes, the fair value of collateral should
reflect the current condition of the property, not the potential
value of the collateral at some future date.
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Financial institutions also should consider the need to
recognize an allowance for expected credit losses on off-balance
sheet credit exposures, such as loan commitments, in other
liabilities consistent with ASC Topic 326.

Appendix 6

Accounting--Incurred Loss Methodology

This Appendix addresses the relevant accounting and regulatory
guidance for financial institutions using the incurred loss
methodology to estimate the allowance for loan and lease losses
under ASC Subtopics 310-10, Receivables--Overall and 450-20,
Contingencies--Loss Contingencies and have not adopted Accounting
Standards Update (ASU) 2016-13, Financial Instruments--Credit Losses
(Topic 326).

Restructured Loans

The restructuring of a loan or other debt instrument should be
undertaken in ways that improve the likelihood that the maximum
credit repayment will be achieved under the modified terms in
accordance with a reasonable repayment schedule. A financial
institution should evaluate each restructured loan to determine
whether the loan should be reported as a TDR. For reporting
purposes, a restructured loan is considered a TDR when the financial
institution, for economic or legal reasons related to a borrower's
financial difficulties, grants a concession to the borrower in
modifying or renewing a loan that the financial institution would
not otherwise consider. To make this determination, the financial
institution assesses whether (a) the borrower is experiencing
financial difficulties and (b) the financial institution has granted
a concession.\39\
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\39\ Refer to ASC Subtopic 310-40, Receivables--Troubled Debt
Restructurings by Creditors. Refer also to the FFIEC Call Report and
NCUA 5300 Call Report instructions.
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The determination of whether a restructured loan is a TDR
requires consideration of all relevant facts and circumstances
surrounding the modification. No single factor, by itself, is
determinative of whether a restructuring is a TDR. An overall
general decline in the economy or some deterioration in a borrower's
financial condition does not automatically mean that the borrower is
experiencing financial difficulties. Accordingly, financial
institutions and examiners should use judgment in evaluating whether
a modification is a TDR.

Allowance for Loan and Lease Losses (ALLL)

Guidance for the financial institution's estimate of loan losses
and examiners' responsibilities to evaluate these estimates is
presented in Interagency Policy Statement on the Allowance for Loan
and Lease Losses (December 2006) and Interagency Policy Statement on
Allowance for Loan and Lease Losses Methodologies and Documentation
for Banks and Savings Institutions (July 2001).\40\
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\40\ Credit unions should follow interagency supervisory
guidance relative to the ALLL in the financial and regulatory
reporting of loans.

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[[Page 47293]]

Financial institutions are required to estimate credit losses
based on a loan-by-loan assessment for certain loans and on a group
basis for the remaining loans in the held-for-investment loan
portfolio. All loans that are reported as TDRs are considered
impaired and are typically evaluated on an individual loan basis in
accordance with ASC Subtopics 310-40, and 310-10. Generally, if an
individually assessed loan \41\ is impaired, but is not collateral
dependent, management allocates in the ALLL for the amount of the
recorded investment in the loan that exceeds the present value of
expected future cash flows, discounted at the original loan's
effective interest rate.
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\41\ The recorded investment in the loan for accounting purposes
may differ from the loan balance as described elsewhere in this
statement. The recorded investment in the loan for accounting
purposes is the loan balance adjusted for any unamortized premium or
discount and unamortized loan fees or costs, less any amount
previously charged off, plus recorded accrued interest.
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For an individually evaluated impaired collateral dependent
loan,\42\ regulatory reporting requires the amount of the recorded
investment in the loan that exceeds the fair value of the collateral
\43\ (less costs to sell) \44\ if the costs are expected to reduce
the cash flows available to repay or otherwise satisfy the loan, as
applicable), to be charged off to the ALLL in a timely manner.
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\42\ Under ASC Subtopic 310-10, a loan is collateral dependent
when the loan for which repayment is expected to be provided solely
by the underlying collateral. Refer to the glossary entry in the
Call Report instructions for ``Allowance for Credit Losses--
Collateral-Dependent Financial Assets.''
\43\ The fair value of collateral should be measured in
accordance with FASB ASC Topic 820, Fair Value Measurement. For
impairment analysis purposes, the fair value of collateral should
reflect the current condition of the property, not the potential
value of the collateral at some future date.
\44\ See footnote 24.
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Financial institutions also should consider the need to
recognize an allowance for estimated credit losses on off-balance
sheet credit exposures, such as loan commitments in other
liabilities consistent with ASC Subtopic 825-10, Financial
Instruments--Overall. For additional information, refer to the FFIEC
Call Report and NCUA 5300 Call Report instructions pertaining to
regulatory reporting.
For performing CRE loans, supervisory policies do not require
automatic increases in the ALLL solely because the value of the
collateral has declined to an amount that is less than the recorded
investment in the loan. However, declines in collateral values
should be considered when applying qualitative factors to calculate
loss rates for affected groups of loans when estimating loan losses
under ASC Subtopic 450-20.

Michael J. Hsu,
Acting Comptroller of the Currency.

Federal Deposit Insurance Corporation.

By order of the Board of Directors.

Dated at Washington, DC, on July 19, 2022.
Debra A. Decker,
Executive Secretary.

By order of the Board of the National Credit Union
Administration.

Dated at Alexandria, VA, on July 19, 2022.
Melane Conyers-Ausbrooks,
Secretary of the Board, National Credit Union Administration.

[FR Doc. 2022-16471 Filed 8-1-22; 8:45 am]
BILLING CODE 4810-33-P; 6714-01-P; 7535-01-P

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