Commercial Real Estate Loan Workouts Gain
Attention From Regulators
More than $1 trillion dollars in commercial real estate loans are set to mature over the next two years. Financial institutions are now preparing for a possible collapse of the commercial real estate market. The aggregate market value of commercial real estate in the United States declined almost 40 percent between early 2007 and the spring of 2009. Due in part to declining collateral values, lenders have shied away from workout arrangements, fearing disapproval and repercussions from bank regulators.
In order to address the impending problems with commercial real estate loans, the Federal Financial Institutions Examination Council (FFIEC), representing most of the federal and state bank regulators, recently issued an important policy statement that updates and replaces prior guidance on the renewal or restructuring of loans to commercial real estate borrowers. The statement from the FFIEC called, "The Policy Statement on Prudent Commercial Real Estate Loan Workouts," was released on October 30, 2009. The policy statement aims to promote consistency, enhance the transparency of commercial real estate workout transactions, and ensure that policies and actions do not inadvertently curtail the availability of credit to sound borrowers. The policy statement addresses the problem of underwater loans, and reassures lenders that the mere fact a loan is underwater should not stop a renewal or loan modification.
The theme of the policy statement is that all commercial real estate loan workouts should be structured to improve the lender's prospect for repayment. The policy statement does not provide specific types of acceptable and unacceptable loan modification structures. Instead, it lays out broad principles, provides guidance on how to translate the principles into operating procedures, and provides examples of how these principles and procedures should be applied to any given loan.
The policy statement attempts to soothe lender concerns that regulators will frown upon the renewal or modification of commercial real estate loans unless the market value of the loan collateral exceeds the loan's outstanding balance. A key provision of the policy statement states that renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification of the loan solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. In other words, if the borrower has a current ability to repay the restructured debt on reasonable terms, an under-collateralized commercial real estate loan will not receive an adverse regulatory classification solely because the value of the collateral has dwindled to less than the loan balance. This regulatory policy will allow commercial real estate lenders to retain under-secured real estate loans on their books without having to write down the value of the loan on the lender's financial statements. This approach serves to mitigate much of the anticipated losses in commercial real estate loans by financial institutions.
The policy statement contains examples of real life commercial real estate loan workout terms. The examples indicate that lenders should have an easier time extending a loan's maturity date if the extension does not alter other material terms of the loan agreement and the borrower's ability to pay its debt has not substantially deteriorated. Additionally, lenders may consider splitting an existing commercial real estate loan into two different promissory notes. The good note (Note A) would consist of a promissory note that is reasonably assured of repayment and performance. The bad note (Note B) would consist of the portion of the current loan not reasonably assured of repayment. The bad note would receive an adverse classification and would need to be charged off as appropriate, but the good not would remain a performing note on the books of the lender.
Considering that a default rate of even 10 percent on commercial real estate loans maturing during the next two years would translate into more than $100 billion in losses, the bank regulators needed to act. The policy statement appears to offer alternatives and solutions to lenders and borrowers. But, even under the flexible approach set forth in the policy statement, lenders may hesitate to modify loans that reduce short term liquidity and income, regardless of whether the lender believes a prudent modification would be best in the long-run.
Henry Efroymson is the chair of the Bankruptcy and Creditor/Debtor Disputes Practice Group. Breadth of experience and client service are the hallmarks of Efroymson’s practice. Concentrating his practice in loan workout, creditor/debtor disputes and bankruptcy for over 28 years, he helps guide small, medium and large businesses through the complexities of financial distress.
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.