Regulators and financial institutions have been trying for some time now to come to an understanding of what type of how workout strategies affect the classification of loans and the corresponding impact on estimates of loan losses. On October 30 the federal banking regulators published guidance on prudent commercial real estate loan workouts that addresses these issues. The guidance addresses some of the most contentious areas of disagreement between banks and examiners.  One of those areas is the impact of a decline in value of collateral in situations where the borrower or guarantors have the ability to service the loan. The new guidance tells examiners that renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified 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. This is a significant change from the manner in which examiners have been classifying acquisition and development loans in the past and time will tell exactly how the examiners will in fact deal with such loans in the future.

A problem loan workout can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions.  The key to any loan workout is that the renewal or restructuring should improve the lender’s prospects for repayment of principal and interest and be consistent with sound banking, supervisory, and accounting practices.

The primary focus of an examiner’s review of a commercial 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.  The support provided by guarantees will also be a consideration in determining the credit classification for a workout.  The presence of a guarantee from a financially responsible guarantor may improve the prospects for repayment of the debt obligation and may be sufficient in and of itself to preclude classification or reduce the severity of classification.

Appraisals continue to be an area of considerable concern for lenders. The new guidance provides that assumptions, when recently made by qualified appraisers (and, as appropriate, by the financial institution) should be given a reasonable amount of deference by examiners.  In addition, examiners are instructed to use the appropriate market value conclusion in their collateral assessments.  For example, when the 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.

Another criticism of current regulatory actions is that all borrowers in a particular industry are presumed to be substandard. The new guidance provides that loans should not be adversely classified solely because the borrower is associated with a particular industry that is experiencing financial difficulties.

All in all the new guidance provides some welcome relief to lenders who believe that examiners have been arbitrary in their classification of loans.  Of course, only experience under the new guidance will show whether there will be any significant changes in the regulators’ approach.