Modifying a Commercial Operating Line of Credit in Connection with Owner-Occupied Real Estate

9 Feb

Timothy McCandless Esq. and Associates
Offices Statewide

(909)890-9192
(925)957-9797
FAX (909) 382-9956
tim@Prodefenders.com

http://www.timothymccandless.com

(Adapted from the October 30, 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts)

Introduction

In response to the residential mortgage crisis, and in anticipation of the looming commercial mortgage crisis of much greater potential magnitude, the federal banking regulators got together and issued a policy statement to encourage lenders to modify commercial mortgages and other loans secured by commercial real estate. Attachment 1 to the Policy Statement featured six example scenarios to help lenders to understand that the question isn’t whether you modify a loan, but rather how you modify a loan, that may result in regulatory penalization.

From the statement: “[t]he regulators have found that prudent CRE loan workouts are often in the best interest of the financial institution and the borrower. Examiners are expected to take a balanced approach in assessing the adequacy of an institution’s risk management practices for loan workout activity. Financial institutions that implement prudent CRE loan workout arrangements after performing a comprehensive review of a borrower’s financial condition will not be subject to criticism for engaging in these efforts even if the restructured loans have weaknesses that result in adverse credit classification. In addition, 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 solely because the value of the underlying collateral has declined to an amount that is less than the loan balance. ”

What follows is the regulator’s example of modifying a C.O.L.O.C.

Note:

* The financial regulators consist of the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee (collectively, the regulators).

BASE CASE: Two years ago, the lender originated a CRE loan at a market rate to a borrower whose business occupies the property. The loan was based on a 20-year amortization period with a balloon payment due in three years. The LTV equaled 70 percent at origination. A year ago, the lender financed a $5 million interest-only operating line of credit for seasonal business operations at a market rate. The operating line of credit had a one-year maturity and was secured with a blanket lien on all the business assets. To better monitor the ongoing overall collateral position, the lender established a borrowing base reporting system, which included monthly accounts receivable aging reports. At maturity of the operating line of credit, the borrower’s accounts receivable aging report reflects a growing trend of delinquency, which is causing the borrower some temporary cash flow difficulties. The borrower has recently initiated more aggressive collection efforts.

SCENARIO 1: The lender renewed the $5 million operating line of credit for another year, requiring monthly interest payments at a market rate of interest. The borrower’s liquidity position has tightened but remains satisfactory, cash flow to service all debt is 1.2x, and both loans have been paid according to the contractual terms. The primary repayment source is from business operations, which remain satisfactory and an updated appraisal is not considered necessary.

Classification: The lender internally graded both loans as pass and is monitoring the credits. The examiner agreed with the lender’s analysis and the internal grades with the understanding that the lender is monitoring the trend in the accounts receivables aging report, and the borrower’s ongoing collection efforts.

Nonaccrual Treatment: The lender determined that both the real estate loan and the renewed operating line of credit may remain on accrual status as the borrower has demonstrated an ongoing ability to perform, has the financial capacity to pay a market rate of interest, and full repayment of principal and interest is reasonably assured. The examiner concurred with the lender’s accrual treatment.

TDR Treatment: The lender concluded that while the borrower has been affected by declining economic conditions, the renewal of the operating line of credit did not result in a TDR because the borrower is not experiencing financial difficulties and has the ability to repay both loans (which represent most of its outstanding obligations) at a market rate of interest. The lender expects full collection of principal and interest from the borrower’s operating income. The examiner concurred with the lender’s rationale and TDR treatment.

SCENARIO 2: The lender reduced the operating line of credit to $4 million and restructured the terms onto monthly interest-only payments at a below market rate. This action is expected to alleviate the business’ cash flow problem. The borrower’s company is still considered to be a going concern even though the borrower’s financial performance has continued to deteriorate and sales and profitability are declining. The trend in delinquencies in accounts receivable is worsening and has resulted in reduced liquidity for the borrower.

Cash flow problems have resulted in sporadic delinquencies on the operating line of credit. The borrower’s net operating income has declined, but reflects the capacity to generate a 1.08x debt service coverage ratio for both loans, based on the reduced rate of interest for the operating line of credit. The terms on the real estate loan remained unchanged. The lender internally updated the assumptions in the original appraisal and estimated the LTV on the real estate loan was 90 percent. The operating line of credit has an LTV of 80 percent with an overall LTV for the relationship of 85 percent for the relationship.

Classification: The lender internally graded both loans substandard due to deterioration in the borrower’s business operations and insufficient cash flow to repay all debt. The examiner agreed with the lender’s analysis and the internal grades with the understanding that the lender will monitor the trend in the business operations profitability and cash flow. The lender may need to order a new appraisal if the debt service coverage ratio continues to fall and the overall collateral margin further declines.

Nonaccrual Treatment: The lender reported both the restructured operating line of credit and the real estate loan on a nonaccrual basis. The operating line of credit was not renewed on market rate repayment terms, the borrower has an increasingly limited capacity to service the below market rate on an interest-only basis and there is insufficient support to demonstrate an ability to meet the new payment requirements. Since debt service for both loans is dependent on business operations, the borrower’s ability to continue to perform on the real estate loan is not assured. In addition, the collateral margin indicates that full repayment of all of the borrower’s indebtedness is questionable, particularly if the company fails to continue being a going concern. The examiner concurred with the lender’s nonaccrual treatment.

TDR Treatment: The lender reported the restructured operating line of credit as a TDR because (a) the borrower is experiencing financial difficulties (as evidenced by the borrower’s sporadic payment history, an increasing trend in accounts receivable delinquencies, and uncertain ability to repay the loans); and (b) the lender granted a concession on the line of credit through a below market interest rate. The lender concluded that the real estate loan should not be reported as TDR since that loan had not been restructured. The examiner concurred with the lender’s TDR treatment.

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