Incorporating lessons learned from providing relief to financial institutions during the Great Financial Crisis, the Board of Governors of the Federal Reserve, the Office of the Comptroller of the Currency, FDIC and the National Credit Union Administration developed a statement on proposed policy for commercial real estate loan accommodations and workouts recently that seeks to help borrowers amid a rising interest environment and a potential downturn. And they are asking for comments from industry participants on the proposed statement, which are due to be submitted by Nov. 14. The statement itself is identical to the one proposed by the OCC, FDIC and NCUA this August.
The proposal builds on existing guidance issued during previous crisis on the need for financial institutions “to work prudently and constructively with creditworthy borrowers during times of financial stress, update existing interagency guidance on commercial real estate loan workouts, and add a new section on short-term loan accommodations.” It also addresses recent accounting changes on estimating loan losses and provides updated examples of how to classify and account for loans subject to loan accommodations or loan workout activity.
The proposed statement says an update on existing practices is called for in the post-pandemic era, as trends such as increased remote working may shift historic patterns of demand for commercial properties in ways that adversely affect the financial condition and repayment capacity of borrowers.
The proposal formalizes flexibility the regulators provided early in the COVID-19 pandemic, which allowed lenders to work with their borrowers more effectively when the economy was shut down, says David McCarthy, managing director and head of policy with the CRE Finance Council (CREFC), a trade association.
“If banks are able to make short-term accommodations without having to negatively classify or downgrade these loans on their books and take either a reserve or accounting hit on them, that could make it less costly to work out some of these temporary blips on the short-term accommodations,” says McCarthy, who refers to it as a positive for both lenders and regulators. “The flexibility is helpful, but it’s not a free pass by any means. They have to support it and it has to be with their underwriting and policies too. It’s a different category for something that is more temporary.”
Several groups in the lending and real estate industries, including CREFC, plan to submit their responses to the existing proposals after further evaluations.
Regulators learned some lessons over the course of the pandemic and are trying to distinguish between loan workouts when a loan is at risk and needs more capital vs. a borrower who maybe needs 60 days to get back on track, says Mike Flood, senior vice president, commercial/multifamily, for the Mortgage Bankers Association.
“I think what the regulators are trying to do is update it to reflect the present time and try to give (stopgaps) for institutions to do the right thing, which happened quite a bit during COVID,” Flood notes. “It's to do the right thing for a temporary situation versus a true loan workout where you need to hold more capital against it and maybe review it a little more.”
The pandemic led to a significant amount of short-term restructuring in the commercial real estate space that wasn’t formally captured in the previous guidance issued in 2009, according to Sumit Grover, senior product director, commercial real estate solutions, with research firm Trepp. The new statement provides clear guidance and examples to better enable banks to address short-term deficiencies for specific borrowers/properties.
“COVID-19 provided the industry with the most significant market disruption since the Great Financial Crisis and will inevitably lead to additional guidance, oversight and regulation going forward,” Grover says.
The guidance formalizes the suggestions that many examiners were likely giving banks during the pandemic, Grover says. The new risk rating systems may have some long-term impact as banks try to adjust internal frameworks to better align with Fed’s guidance. Changes related to troubled debt restructuring will have an impact on risk rating procedures and systems as they will need to be adjusted mostly for the FASB (Financial Accounting Standards Board) guidance, though that goes into effect only at the end of 2023, he says.
Industry feedback
The MBA is still analyzing the proposal with its member banks and trying to find any potential “unintended consequences” of the proposed changes, according to Flood. The regulators’ “intent is positive,” but whenever something is written down as a formal framework, regulators want industry organizations’ help to gauge if the guidelines might have unintended effects, he adds.
The regulators are keenly focused on addressing commercial real estate loans at all levels—those underwritten by big and small banks—and they talk a lot about concentration risk in good times and bad, McCarthy says. This is another tool at their disposal for managing the consequences of a potential downturn and looking at it across various property sectors and lenders, he notes.
The big question right now is what concentration risks look like and how to underwrite them, McCarthy says. There are rumors about whether regulators are asking banks to pull back, but that’s not in the currently issued statement, he notes.
Nothing in the proposal is a “warning shot” that regulators are trying to rein in commercial real estate lending, in McCarthy’s view, and none of the proposed changes are “groundbreaking.”
But it is an appropriate time to update existing recommendations because the industry has come through a different type of crisis with the pandemic—a medical one vs. a financial crisis, McCarthy says.
“It was due for a refresh, and it’s a welcome addition, especially as regulators are looking at the economic downturn and whether commercial real estate can weather that, as well as how our members and lenders and borrowers are looking at that too,” he notes. “It’s generally a positive development and, in particular, takes some valuable lessons that we and the regulators learned during the pandemic and some of the policy flexibility that we advocated for during the pandemic.”
A good example is how hotels experienced a lot of distress during the pandemic because they had to close down, but in many cases, their difficulties were temporary.
With the new proposals, regulators are taking steps to avoid the mistake that was made during the recession and financial crisis of the late 2000s, says Kyle Nagy, director of CommCap Advisors, a West Coast-based commercial mortgage banking firm. “Declining CRE values and NOIs forced banks to right-size or call loans to satisfy regulatory requirements,” Nagy says. “Even though borrowers were paying mortgages, they could not simultaneously right-size all properties across their portfolios and the dominos started to fall.”
Nagy cites how the proposed policy statement says prudent commercial real estate loan accommodations are often in the best interest of both the financial institution and borrower and that any institution that implements accomodations after a comprehensive review of the borrower’s financial condition “will not be subject to criticism for engaging in these efforts,” even if it results in modified loans that have weaknesses.
In addition, modified loans to borrowers who have the ability to repay their debts according to reasonable 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,” the proposal says.
“Allowing banks to create customized solutions for each client without fear of regulatory repercussion could have reduced the financial carnage of the Great Recession,” Nagy says “Right now it is proposed, but let's hope the new language is implemented before the next downturn.”
The proposed statement would also reflect changes in generally accepting accounting principles (GAPP) applied since 2009, including those in relation to current expected credit losses (CECL). The discussion would align with existing regulatory reporting guidance and instructions that have also been updated to reflect current accounting requirements under GAAP.
“In some ways because of the way CECL works in terms of putting reserves ahead when you make the loan, a TDR (total debt restructuring) designation can almost be redundant, and there’s some criticism in the accounting community because of that,” says McCarthy.
MBA’s Flood calls it a “natural progression” for the regulators to make. Over the last couple of years, the new standard in CECL made changes at the highest level. Banks and institutions used to say they make a loan and, if there’s a loss, they put capital aside. CECL updated that practice to putting capital aside for the life of the loan, he notes.
“For loan workouts, the regulators need to update their regs to reflect CECL,” Flood says. “Part of this is simply doing their business and doing it right. ‘Hey, we have this new accounting rule, and we have loan workout rules because you can imagine if a loan goes into workout, it is probably at more risk and going to have more capital behind it.’”
The commercial real estate finance industry is “not that excited about the rule” because many people don’t think that it matches with how things work, Flood notes. But “the law is the law,” he adds, and the industry has to work with it.