New FDIC Guidelines Offer Helpful Hints for Real Estate Workouts

On October 30, 2009, the Federal Deposit Insurance Corporation (“FDIC”), together with other federal regulatory agencies, adopted a “Policy Statement on Prudent Commercial Real Estate Loan Regulation.” (http://www.fdic.gov/news/news/press/2009).  The policy statement stresses that prudent workouts of commercial real estate loans are often in the best interest of both the lender and the borrower, and that regulators will support efforts by regulated financial institutions to modify performing loans to creditworthy borrowers, even if the value of commercial real estate collateral for such loans has declined.

In addition to the broad policy statement endorsing prudent loan workouts, the guidelines also identify several key themes that are given considerable weight by bank examiners when determining if banks have acted properly in modifying a commercial real estate loan. Examiners specifically look for signs that the loan modification will successfully enable both the lender and borrower to shepherd the loan through troubled economic times without default or future difficulty. Borrowers who strive to perform in accordance with these themes have an increased chance of success in getting their loan modifications approved.

1)  Stay current with loan payments: A primary consideration of examiners in reviewing loan modifications is whether the borrower is and has remained “sound” and whether the loan is “performing,” despite economic frustration. The more “sound” the borrower and the loan, the more comfortable the examiner will be with the likely success of the loan restructure. A borrower who has consistently stayed current with loan payments, perhaps in spite of some financial strain, signifies a responsible borrower who places a premium on meeting its financial obligations – a positive sign to examiners.

In order to ensure that the borrower can stay current with loan payments even while negotiating a modification, the borrower and lender should work together to negotiate a restructured loan package when the borrower foresees trouble ahead, rather than when they are already unable to make payments. If the borrower foresees declining market trends, future rental concessions, the potential loss of tenants, or other changing circumstances that are likely to cause financial difficulty, he should begin talking with the lender about modification of the loan before these factors actually cause the borrower to skip loan payments.

2)  Provide current financial information: Even if the loan is currently performing and the borrower is “sound,” a borrower seeking modification should provide the lender with up-to-date and comprehensive financial statements and appraisal information. This information should be provided to the lender, even if the lender does not ask for it, because the guidelines penalize lenders who do not have this information.

The guidelines expect lenders to develop a workout plan based on current financial information of the borrower and any guarantors, as well as current appraisals of the collateral supporting the loan. Lenders have to analyze the borrowers’ current global debt service obligations to gain a realistic projection of the borrowers’ and guarantors’ ability to repay the loan under the new terms.

3)  Show progress in efforts to lease space, sell condos, etc.: When an examiner sees a project that has stalled – e.g., a shopping mall unable to lease an adequate percentage of space, a condominium project unable to sell units – he or she is more likely to criticize and downgrade any loan modification regarding that project. Borrowers should show continuous, productive efforts to maintain and increase the project’s income stream, even if those efforts are slower and realize a lower income than originally anticipated. A borrower who has “given up” in light of poor economic conditions is not a favorable risk for a successful loan restructure.

4)  Modify the loan at “market” interest rates: It sends up a red flag for examiners when a loan is restructured at a below market rate of interest, especially in conjunction with other modified terms and issues of concern. Workout plans can be developed that provide for interest-only repayment periods, extend the loan maturity, reduce the interest rate from a higher interest rate to the current market rate, and alteration of other terms without resorting to use of a below market interest rate. All other options should be considered before use of an interest rate that is below the current market rate in order to maximize the probability that the modification will be approved.

5)  Divide the loan into two notes: The guidelines cite with approval a workout plan that divides a single note into multiple notes. For example, the majority of the original loan amount may be placed in a primary note structured with a market rate of interest and other reasonable terms that can be serviced by the borrower under current market conditions and therefore be recorded as a “performing” loan. The remaining principal balance could be placed into a second loan – perhaps an interest-only loan, or something with more lenient terms – that could be classified as “doubtful” if necessary. This multiple loan structure enables the lender to recognize interest income and limit the amount reported as “Troubled Debt Restructuring” (TDR) in future reporting periods

The new FDIC guidelines provide a detailed analysis of the matters described above, as well as many other issues. Consequently, lenders and borrowers should consult with experienced legal counsel prior to entering into any loan modification transactions.

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Michael J. Zerman

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