Troubled Debt Restructuring (TDR)

Agenda Introduction of panelists and current trends High level overview of TDRs Examples Q&A

Troubled Debt Restructuring A bank needs to have consistent policies and procedures for reviewing and assessing loans that are potentially TDRs. There are not bright lines and determinations involve judgment.

ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring In defining TDRs, the ASC Master Glossary states: “The creditor for economic or legal reasons related to the debtor’s financial difficulties grants a concession to the debtor that it would not otherwise consider.” When evaluating whether a loan modification or restructuring constitutes a TDR, an entity assesses the following two criteria: Whether the debtor is experiencing financial difficulties, and Whether the creditor has granted a concession to the debtor.

Example 1 What are some examples of modifications that may represent TDRs?

Example 1 Answer ASC 310-40-15-9 provides the following examples of modifications that may represent TDRs: Reduction (absolute or contingent) of the stated interest rate for the remaining original life of the debt. Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risk. Reduction (absolute or contingent) of the face amount or maturity amount of the debt as stated in the instrument or other agreement. Reduction (absolute or contingent) of accrued interest. Said another way, the modification is a TDR if the borrower cannot go to another lender and qualify for and obtain a loan with similar modified terms.

Example 2 – Construction Loan  XYZ Co. is a non-public builder of apartment buildings and strip malls. To finance the construction of one of its apartment complexes, on April 1, 2009, it obtained a 15-year loan for $20MM at 7.5% interest from ABC Bank. Interest reserves were established to provide interest-only payments during the two-year construction period.   As of January 1, 2011, construction has not been completed and three months of interest reserves remain. The building has commitments to lease 75% of its space and, based on current projections, rental receipts will not be sufficient to service the loan unless the building is leased up to at least 90%. ABC Bank agrees to modify the loan by extending the interest-only period by one year and reducing the interest rate to 6.5%, which is below the current market rate. It is expected that XYZ Co. will have sufficient rental income to pay the interest-only portion. XYZ Co. believes that by the end of the additional one-year interest-only period, the building will be 85% leased and it will be able to make full principal and interest payments (based on the reduced rate and conversion to a fully amortizing permanent loan at the end of the one-year period). XYZ Co.’s financial statements for the last two years show approximately break-even net income and operating cash flows. XYZ Co. is not in default on any other debt. A recent appraisal of the property securing this loan indicated a loan-to-value (LTV) ratio of 110%. Current financial statements indicate that XYZ Co. has minimal other resources available to support this debt. Because the project has not been completed, XYZ Co. cannot obtain take-out or permanent financing. ABC Bank has not accounted for this modification as a TDR, because management does not expect a loss of principal, the loan is current, and management does not believe that XYZ Co. is experiencing financial difficulty. Did management properly assess whether this loan modification is a TDR?

XYZ Co. cannot obtain take-out financing from another lender. No, management did not properly assess this loan modification. The modification should be classified as a TDR based on an analysis of the two criteria, as summarized below:   Criteria #1: Is the borrower experiencing financial difficulties? Yes, there are several indicators that the borrower is experiencing financial difficulties: XYZ Co. was not expected to have sufficient cash flows to service the debt in accordance with the contractual terms. XYZ Co. cannot obtain take-out financing from another lender. XYZ Co.’s repayment capacity is uncertain and it has weak financial support. Criteria #2: Has a concession been granted? Yes, the modification resulted in two concessions: Reduction of interest rate to a below market rate. Extension of interest-only period.

Example 3 – Commercial Real Estate Loan ABC Bank originated a $15 million loan for the purchase of an office building with monthly payments based on an amortization of 20 years and a balloon payment of $13 million at the end of year three. At origination, the loan had an LTV ratio of 75%. ABC Bank expected to renew the loan when the balloon payment became due at the end of year three. The project’s cash flow has declined, as the borrower granted rental concessions to existing tenants in order to retain the tenants and compete with other landlords.   At the balloon payment date (end of year 3), ABC Bank renewed the $13 million loan at a market rate of interest that provides for the incremental credit risk and amortization of the principal over the remaining 17 years. The borrower had not been delinquent on prior payments and has sufficient cash flows to service the market rate terms. A recent appraisal resulted in a 104% LTV ratio. ABC Bank determined that the renewed loan should not be accounted for as a TDR, as the borrower has the ability to continue making payments on reasonable terms despite a decline in cash flow and in the fair value of the collateral. Did management properly assess whether this loan modification is a TDR?

Yes, management properly assessed this loan modification Yes, management properly assessed this loan modification. The renewed loan should not be reported as a TDR, based on an analysis of the two criteria, as follows:   Criteria #1: Is the borrower experiencing financial difficulties? While the borrower has experienced some financial deterioration, the borrower has sufficient cash flow to service the debt and has no record of payment default. Therefore, the borrower is not experiencing financial difficulties. Criteria #2: Has a concession been granted? A concession has not been granted, as the lender did not renew the loan at terms other than terms that would be offered to other borrowers with similar risk characteristics. (Note: In this case, it is not necessary to assess whether a concession has been made, as it was determined that the borrower is not considered to be experiencing financial difficulties. Both criteria need to be met for the modification to be classified as a TDR.)

Example 4 A bank has a commercial real estate loan secured by a shopping center. The loan, which was originated 13 years ago, provides for a 30-year amortization with interest at the prime rate plus 2 percent. Two financially capable guarantors, A and B, each guarantee 25 percent of the debt. The shopping center lost its anchor tenant two years ago and is not generating sufficient cash flow to service the debt. The guarantors have been providing funds to make up the shortfall. Because of the decrease in the cash flow, the borrower and guarantors asked the bank to modify the loan agreement. The bank agrees to reduce the interest rate to prime, and in return, both guarantors agreed to increase their guarantee from 25 percent to 40 percent each. The guarantors are financially able to support this guarantee. Even with the increased guarantee, however, the borrower could not have obtained similar financing from other sources at this rate. The fair market value of the shopping center is approximately 90 percent of the current loan balance. Should the debt modification be reported as a TDR because only the interest rate was reduced?

Example 4 Answer ASC 310-40 states that a restructuring of a debt is a TDR if a creditor, for economic or legal reasons related to the debtor’s financial difficulties, grants a concession that it would not otherwise consider. This may include a reduction of the stated interest rate for the remaining original life of the debt. In this case, the borrower was experiencing financial difficulties, because the primary source of repayment (cash flows from the shopping center) was insufficient to service the debt, without reliance on the guarantors. Further, it was determined that the borrower could not have obtained similar financing from other sources at this rate, even with the increase in the guarantee percentage. The capacity of the guarantor to support this debt may receive favorable consideration when determining loan classification or allowance provisions. Because the borrower was deemed to be experiencing financial difficulties and the bank granted an interest rate concession it normally would not have given, however, this restructuring would be considered a TDR.

Example 5 If a bank concludes that an individual loan specifically identified for evaluation is not impaired under ASC 310-10-35 (SFAS 114), should that loan be included in the assessment of the ALLL under ASC 450-20-25 (SFAS 5)?

Example 5 Answer Yes, that loan should be evaluated under ASC 450-20-25. If the specific characteristics of the individually evaluated loan that is not impaired indicate that it is probable that there would be an incurred loss in a group of loans with those characteristics, the loan should be included in the assessment of the ALLL for that group of loans under ASC 450-20-25. Banks should measure estimated credit losses under ASC 310-10-35 only for loans individually evaluated and determined to be impaired.

Example 6 If a bank assesses an individual loan under ASC 310-10-35 (SFAS 114) and determines that it is impaired, but it measures the amount of impairment as zero, should that loan be included in the assessment of the ALLL under ASC 450-20-25 (SFAS 5)?

Example 6 Answer No. For an impaired loan, no additional loss recognition is appropriate under ASC 450-20-25 even if the measurement of impairment under ASC 310-10-35 results in no allowance. Before concluding that an impaired ASC 310-10-35 loan needs no associated loss allowance, however, the bank should determine and document that its measurement process is appropriate and that it considered all available and relevant information. For example, for a collateral-dependent loan, the following factors should be considered in the measurement of impairment under the fair value of collateral method: Volatility of the fair value of the collateral Timing and reliability of the appraisal or other valuation Timing of the bank’s or third party’s inspection of the collateral Confidence in the bank’s lien on the collateral Historical losses on similar loans Other factors as appropriate for the loan type

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