Clarified Guidance Issued on TDRs
By Matt Prunier, Audit Principal
The federal financial institution regulatory agencies issued Financial Institution Letter (FIL) 50-2013 on October 24, 2013 related to troubled debt restructuring loans (TDRs) and impaired loans. While the letter doesn’t substantively change any current guidance or rules, there are several clarifications which are worth noting.
(FILs can be found here.)
The FIL clarifies several points relating to the accrual status of TDRs.
A loan which is determined to be a TDR and is on nonaccrual status at the time of the modification does not need to be maintained on nonaccrual status for the life of the loan. Rather, accrual of interest could resume should the loan meet the accrual conditions set forth in the Call Report Instructions. Generally this would require a repayment history of six months under the modified terms, as well as a well-documented credit analysis demonstrating the borrower’s ability to meet the modified repayment terms going forward.
Similarly, a loan which is determined to be a TDR and is on accrual status at the time of the modification does not necessarily need to be moved to nonaccrual. Generally this would require a sustained repayment history prior to the modification, in addition to a well-documented credit analysis demonstrating the borrower’s ability to meet the modified repayment terms.
Collateral Dependent Determination
A loan is considered collateral dependent when the repayment of the note is considered to be primarily from the operation or liquidation of the collateral. If more than a nominal amount of repayment is expected from other sources, such as a guarantor or operation of the borrower’s underlying business, the loan is not considered collateral dependent. This is a key factor in determining any impairment loss and charge-off. For instance, a loan secured by a four-unit apartment would be considered collateral dependent. On the other hand, a loan to a consulting firm secured by its general purpose office building would not be considered collateral dependent, since the business could operate elsewhere. A key factor though, is that if the consulting business begins to suffer and can’t support the loan, then repayment would be dependent on the sale of the building and the loan would be considered collateral dependent at that point.
Impairment for accounting purposes is measured based upon the fair value of the collateral, less estimated selling costs, for loans which are considered collateral dependent, and based on the present value of expected cash flows for non-collateral dependent loans. This is not new guidance but is reinforced in the FIL.
Classification and Charge-Off
The FIL also indicates that all TDR loans are impaired for accounting purposes but don’t necessarily need to be adversely classified for their remaining lives.
The FIL puts in writing some guidance that had not been widely communicated until now: a charge-off should be recorded for any portion of the loan which exceeds the value of the collateral, less cost to sell, if the repayment of a loan is dependent solely on the sale of the collateral. Any remaining portion of the loan should generally be classified as substandard or better. The use of a doubtful risk rating is not specifically disallowed; however it is emphasized that its use should be infrequent and should be limited to situations where the amount of loss cannot be reasonably determined
If the repayment of the loan includes the operation of the collateral, a charge-off of any collateral deficiency is not automatic. An analysis of the cash flow under the modified terms of the loan should be performed to determine whether the modified cash flows support a full collection of the recorded balance.
The FIL also gives this example: a non-collateral dependent loan is cash flowing but has a balloon payment and there are concerns about the borrower’s ability to pay off or refinance the balloon payment. In this case, an acceptable approach for estimating future cash flows is to consider the current fair value of the collateral, less costs to sell.
We encourage all financial institutions to review their current practices to make sure they conform to the FIL. At the policy review dates, the loan and loan policies should be reviewed to ensure they reflect the updated guidance.
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