The Accommodative Climate for Modifying Bank Loans

Past real estate recessions have usually been caused by oversupply and overleverage. Today, many real estate owners are facing a liquidity crisis due to a pandemic out of their control. Across commercial sectors, tenant businesses have slowed to the point where rent relief is a lifeline to avoid bankruptcy. In response, lenders have been willing to work with real estate borrowers to temporarily defer or reduce mortgage payments and bridge the liquidity gap. But as the pandemic continues and additional tenant businesses permanently close, longer-term loan restructures may be required. Looking out a year, it is unclear whether banks will continue to be as willing and able to work with borrowers to achieve longer-term restructures so that borrowers can retain ownership of their properties. That flexibility will, in large part, be based on bank regulator guidance.

As real estate owners consider loan restructure strategies, they should be familiar with the constraints and accommodations placed on their lenders by government regulators, along with the accounting and reporting rules lenders must follow when modifying a loan.^[1] This article summarizes the recent guidance given to banks by their regulators, which has encouraged banks to work with borrowers impacted by the pandemic and consider longer-term strategies given the likelihood that those accommodations will eventually expire.

The First Regulatory Response

Recognizing the extraordinary circumstances and the sound financial position of the banking industry at the inception of the pandemic, on March 22, 2020, the supervisory agencies (the Fed, FDIC, OCC, CFPB, National Credit Union Association, and the Conference of State Banking Supervisors) issued an Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working with Customers Affected by the Coronavirus (“Statement”) for all lending classes including real estate loans. In this Statement, as in many previous ones, the agencies recognized that borrower and lender negotiations to modify distressed debt is a prudent risk-management practice. The Statement was also consistent with the agencies’ policy to provide relief to borrowers impacted by national emergencies.

When a bank modifies a loan to support a borrower it is often subject to Troubled Debt Restructuring (“TDR”) accounting (see Accounting Standards Codification (ASC) Subtopic 310-40), which may result in a partial or full impairment of the loan’s value. In the simplest reading of ASC 310-40, a loan modification is considered a TDR when a bank gives a concession to a financially distressed borrower.

To induce immediate action by the banks in favor of borrowers impacted by the pandemic, the Statement indicated that the agencies will not require modifications of previously creditworthy loans to be characterized as TDRs if they meet these three criteria:

• The loan must be current: less than 30 days past due on contractual payments when the modification is made.
• The modifications are short-term: parenthetically though vaguely defined as six months.
• The modified terms are insignificant as defined in ASC 310-40.

The regulators position was that a loan modification is not a concession to the borrower if the loan was current at the outset of the pandemic and, therefore, the borrower was not distressed in the normal course of its business. The criteria suggest that the modification needs to be agreed to before the borrower misses a payment—an important consideration for real estate owners considering the timing of their forbearance or modification requests. The FASB agreed to this interpretation of the TDR rules simultaneously with the release of the Statement.

In addition to the TDR reprieve, the Statement allowed banks to make loan modifications and forbear payments without having to put the loans on nonaccrual status or downgrade the risk rating of the loan during the modification period as long as the borrower complied with the modified terms. The relaxing of these traditional rules clearly incentivized lenders to work with their borrowers to weather the storm. The question is, for how long?

The CARES Act

While lenders and borrowers were trying to interpret the short-term modification provision of the Statement, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) became law. Section 4013 somewhat clarified the timing of TDR relief, indicating that TDR treatment would not be required for “a forbearance arrangement, an interest rate modification, a repayment plan, and any other similar arrangement that defers or delays the payment of principal or interest” until the earlier of December 31, 2020, or 60 days after the national emergency is lifted. This provision gave the banks more time to pursue prudent loan restructures than the Statement, although it is impossible to predict when the state of emergency will be terminated.

The agencies then responded with a revised joint statement on April 7, 2020, that recognized the provisions of Section 4013 of the CARES Act and reaffirmed that banks do not have to report loans that meet the Section 4013 criteria as TDRs, nor do they have to determine impairment associated with loan modifications that would have been required under the TDR rules.

After Six Months of Pandemic

As the end of the original six-month period cited in the Statement approached, The Federal Financial Institutions Examination Council, on behalf of the regulators, issued a Joint Statement on Additional Loan Accommodations Related to COVID-19 on August 3, 2020. In this new joint statement, the regulators recognized that the financial distress was likely to continue beyond the originally contemplated period as well as the increasing difficulty for the banks to assess credit risk. The joint statement also acknowledged that due to continuing financial challenges even after an initial accommodation, “it may be prudent for the financial institution to consider additional accommodation options to mitigate losses for the borrower and financial institution.” That is, a second loan modification may be necessary. If finalized before the expiration date, such a second modification would still fall under the provisions of Section 4013 of the CARES Act and, therefore, still avoid TDR accounting. Moreover, the regulators reminded banks (as they did during the Great Recession) that a borrower may still be able to perform under modified loan terms even if the value of the underlying collateral declines. That is, the regulators put more emphasis on the debt coverage ratio and the borrower’s willingness to meet its obligations under the loan’s modified terms than on the loan-to-value ratio.

The August joint statement also reminded lenders that despite the temporary waivers on TDR accounting, nonaccrual classifications and rating downgrades, they must continue to maintain appropriate allowances for loan and lease losses and credit losses. Included was a cautionary statement that “borrowers facing identified financial difficulties as they near the end of the accommodation periods generally pose greater credit risk.” In fact, banks have not had to publicly report on the loan modifications entered into since the onset of the pandemic, but many did report sweeping loss reserves in the second quarter.

Impact on Borrower Strategy

Since March, the banks have been given a lot of leeway to work with borrowers to solve short-term liquidity issues through forbearance or reduced loan payments. This accommodative stance will continue until the end of 2020 or 60 days after our national emergency is terminated, unless the regulators and/or Congress extend the relief. When that happens, banks will not only have to go back to TDR accounting for loan modifications, but also publicly report modifications and nonaccruals. Such normal operations could remove the incentive to work with borrowers. Accordingly, while the banks are relaxing borrowers should not. Whether or not borrowers have already negotiated temporary modifications on their loans, they should carefully consider the need for and timing of a request for additional forbearance or other loan modifications before the expiration of regulatory and congressional relief.

[1] This article describes restructures with lenders subject to government regulations and examination, such as banks and credit unions, and does not address the very different path to restructuring for borrowers whose loans have been securitized.