Troubled Debt Restructuring: The New Rules

05/14/2013

 by Louis J. Dunham Senior Vice President & Senior Director, Credit Risk Consulting & Suzanne Storm, Senior Consultant for Credit Policy and Risk Management


Commercial and Commercial Real Estate (commercial) TDRs, like non-accruals, are a point of intersection for credit judgment and accounting rules.  One of the major sources of confusion about commercial TDRs seems to be the intertwining of these two very different perspectives.  This article will endeavor to separate TDR guidance into what Credit Administration needs to know and consider and, more briefly, the accounting requirements,  based on the updated guidance issued in OCC’s bulletin 2012-10 and FASB’s Accounting Standard Update No. 2011-02.  Our focus is on continuing indebtedness; while partial settlement of a loan may also trigger TDR accounting, that situation is not addressed here.

The definition of a commercial TDR remains unchanged:  if a creditor for economic or legal reasons related to the borrower’s financial difficulties grants a concession that it would not otherwise consider, the loan is a TDR and must be reported as such. There is considerable additional guidance and each situation must be decided on its facts.  

There are three separate judgments that must be made to determine whether a loan is a TDR.  For the most part, these are credit judgments; however, the definition of “concession” is in the accounting standards, so the final decision should be a joint one.  The three conditions to be met are:

1.Is the borrower in financial difficulty?
2.Has any concession been made?
3.Is this a “restructuring”?

Financial Difficulty

Management must utilize its best credit judgment as to whether a commercial borrower is in financial difficulty or not. Typically, this will be a fairly obvious decision and will be clear before the occurrence of any of the indicators laid out in the guidance.  
 
These indicators create a presumption of financial difficulty:
  • Bankruptcy
  • Non-accrual
  • Payment default on any debt
  • Substantial doubt as to whether the borrower can continue as an ongoing concern
  • Probability that the borrower would be in payment default on some or all of its debt in the foreseeable future without the transaction being considered
  • Commercial borrower is classified as a Substandard credit

Concession

There are a number of indicators that a concession has been made.  The most common litmus test is whether the borrower has access to funds at a market rate of interest for debt with similar risk characteristics as the restructuring.  To put it another way:  Would you make this loan, structured and priced as it has been restructured, to a new borrower with the same risk profile?  

When a potential restructuring is considered where Management acknowledges that it is not ideal, but they are making the best of a bad situation, it would probably be considered a TDR.  

Here are some of the concessions that may be made:
  • Reduction of the interest rate 
  • Extension or renewal with a below market interest rate.  If the original loan was made to a satisfactory risk borrower which has since deteriorated, then renewal of that loan at the same rate probably constitutes below market for the higher level of risk being taken.
  • Extension of maturity or amortization period beyond bank best practices and/or bank policy in order to reduce payment amount to make the loan “affordable” to the borrower
  • Reduction of the face amount or balloon payment
  • Forgiveness of accrued interest or principal
Restructure

Any modification of a loan, including the extension of maturity or a “straight renewal”, is considered a restructure for purposes of this guidance.  Any commercial loan that is rated Substandard or worse (or any loan having any of the other indicators listed above) creates a presumption of financial difficulty, therefore, any credit action taken with regard to that loan must be evaluated to determine whether the resulting facility is a TDR.  

This evaluation must be documented. Given that the regulators view these borrowers as being in financial difficulty, the regulators expect to find “robust” documentation if Management determines that a renewal, extension or modification is not a TDR.
 
Making the TDR Determination

If a loan is being modified, extended or renewed and the borrower is in financial difficulty, then the key determinant (and the critical evaluation to document) is whether a concession has been made.  This is not always as obvious as one might think.
  • If a Substandard accruing commercial loan is renewed with no change in pricing (and the pricing was not previously increased as the risk increased) and no additional consideration is given for the renewal, the loan is presumed to be a TDR.
  • If the price is increased, but not to a market rate for the risk, the loan is presumed to be a TDR.  (“Market rate for the risk” is what the bank would offer for a new loan with comparable risk.  In many cases of financial difficulty, of course, there is no rate at which the bank would take on a comparable amount of risk in a new loan, so the interest rate becomes irrelevant.  The loan is a TDR.)
  • If additional consideration is given for the renewal – a guarantor added, additional collateral granted, etc. – and it can be demonstrated, through underwriting and valuations, that the additional consideration represents adequate compensation for the risk, the loan may not be a TDR.  
The key test remains:  Would this loan at the new price and term be made to a new borrower with similar credit characteristics, or is the transaction an effort by the Bank to protect as much of the principal and interest as possible?  If the latter, it is a TDR.

Once the loan is restructured, if there is any expectation that all amounts due under the original terms (including accrued interest at the original contract rate) will not be collected, the loan is a TDR.  (Realizable value of the collateral may be considered as principal to be collected for purposes of this analysis.)

There is one specific exception to the TDR determination:  If the restructuring results in only a delay in payment that is insignificant, it is not a TDR.  Based on the accounting guidance, this seems unlikely to occur in a commercial or commercial real estate portfolio.  
 
Residential real estate provides the example contained in the guidance, and seems the most likely to have an insignificant delay in payment.  Both the amount of delayed payment (relative to the total loan amount) and the period of time delayed (relative to the total term of the loan) must be insignificant. So if only a few months’ payments were missed on a 30-year mortgage, and the restructure is such that the missed payments will be repaid within a few more months, the delay would be considered insignificant. Consult with your accounting group if this seems like a possibility on your particular transaction.  

TDRs and Non-Accruals

The accrual status of a loan is determined separately from TDR determination.  Once the loan has been restructured, a credit assessment of the borrower’s financial condition and ability to repay the principal and interest under the terms of the modified agreement in a timely matter must be made.  If an accruing borrower is expected to pay as agreed under the restructure, it may remain accruing.  A borrower already on non-accrual must demonstrate at least six months of continuous repayment performance before return to accrual could be considered.

TDRs must be tagged as such and reported separately in the bank’s call reports.  

The Accounting Perspective

When a loan is extended, modified, or renewed in such circumstances that it becomes a TDR, it also automatically becomes an impaired loan, subject to ASC Subtopic 310-10 (formerly FAS 114).  Though the impairment calculation may theoretically be based on the present value of expected future cash flows, the regulators seem to be taking a more pragmatic approach in exams. It would appear examiners often require banks to obtain a current appraisal (within 12 months) on the assumption that if a borrower is in enough financial difficulty to require a TDR, then that loan is probably collateral dependent and therefore impairment is based on the fair value of the collateral less estimated costs to sell. 

Once a loan is impaired, it remains impaired until paid off.  The impairment must be recalculated quarterly, taking into account payments made and any changes in collateral valuation.  If the restructured loan goes on to perform in accordance with its terms, impairment calculation using the present value of expected future cash flows (discounted at the original interest rate) may become a more appropriate measure of impairment.

If a TDR (or portion of a TDR) (a) yields a market interest rate at the time of restructuring; (b) is in accrual status; and (c) is not 30 or more days delinquent under the modified terms of the loan, it no longer needs to be reported as a TDR.  This is most likely to happen when the TDR includes forgiveness of some amount of the principal or when the restructure creates an “A” note at market terms and moves the portion of debt the borrower is unable to repay into a “B” note.   

Even if the TDR label can be dropped, however, it remains an impaired loan as long as it is on the books.

Policy and Process

Regulators expect banks to have clear policies and documented procedures for identifying and reviewing potential TDRs. There should be a process for flagging a modified or renewed loan for review, a person or group responsible for considering the facts of that borrower to determine whether TDR status is appropriate, and a specific approval mechanism for the TDR designation. As mentioned earlier, each decision should also be documented and supported for each extension, modification or renewal of a troubled loan.
 
If Ardmore can answer any questions or assist you in developing policies or processes, please feel free to contact Louis Dunham (ldunham@ardmoreadvisors.com) at 847-687-7353 or Suzanne Storm  (sstorm@ardmoreadvisors.com) at 704-562-9877.