Policy Statement on Prudent Commercial Real Estate Loan Workouts

Read What Regulatory Agencies Are Telling Examiners to Look For When Examining Your CRE Loan Portfolio

To Sum It Up:
The FFIEC CRE Loan Workout Guidance is well-written in plain English that everyone can understand. I've summed up the first 13 pages in the key points below, and the last 20 pages give real life examples of just about every situation that arises in a CRE loan workout during an economic downturn.

Key Points:

1. ADVERSE CLASSIFICATION - Regulators are acknowledging the decline in CRE property values, which is measured to be 35-40% from their peak in 2007, and that this phenomenon is not the sole basis for an adverse classification in an examination. Regulating agencies assure financial institutions that their performing loans "will not be subject to adverse classification solely because the value of the underlying collateral declined."
   
   
2. CONCENTRATION RISK - Risk management elements that are essential to loan workout programs are listed in detail on page 2. Included in this list is “Adequacy of management information systems and internal controls to identify and track loan performance and risk, including concentration risk.” This element should be no surprise to anyone, but take note that regulators are making it clear to bankers that stringent segmentation, monitoring, and reporting of concentrations is expected in every institution. Concentrations carry inherent risk regardless of the underwriting standards applied during the origination phase of the loan.
   
   
3. FINANCIAL STATEMENTS - Regulators are expecting bankers to obtain and analyze borrowers' and guarantors' CURRENT financial information, as detailed on page 3. Without this documentation, a banker can expect some type of criticism, and possibly an adverse classification. Scenario 2 for an income producing office building, presented on page 15, reveals that the examiner listed the credit as "Special Mention" in the report of examination because the “failure to request current financial information...represents administrative deficiencies”.
   
   This practice is also in a banker’s best interest because it offers the opportunity to be aware of a borrower's declining financial position. At a recent Town Hall Meeting in Tampa, FL, a top regional representative from the Atlanta Federal Reserve stated that the issue that keeps him up at night is the second wave of defaults. The industry has already experienced the first wave of defaults on borrowers/guarantors who clearly wouldn’t support their project but now the individuals who have stepped up during this crisis maybe running out of money, and even with the best intentions to make good on their commitments, they won’t have the ability.
   
4. COLLATERAL VALUES – “Financial institutions should have policies and procedures that dictate when collateral valuations should be updated as part of its ongoing credit review, as market conditions change….” The guidance goes on to state that if weaknesses in this process, including the appraisal review process, are evident and haven’t been addressed that examiners may make adjustments to the collateral’s value to reflect current market conditions and events.
   
   Bankers should make every effort to have current valuations on CRE properties, even for loans that are performing as agreed. As part of the examination process regulators will also review an institution’s “pass credits”. If examiners see a pattern of old valuations a red flag may go up. Typically these loans are not written with very long terms and renewal will soon be approaching. Examples of assumptions used in the CRE valuation process are detailed on page 6 and include, current and projected vacancy rates; capitalization rates; and net operating incomes.
   
   A CRE stress testing model can apply calculations, including property value trends and current capitalization rates to the loan’s basic information, such as the balance and terms, and arrive at a “derived value” (see image below). From that point all loans will have a current valuation and can be stress tested using the assumptions detailed previously to project a possible collateral shortfall.