Modifying A Construction Loan on a Single Family Residence

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 construction loan on a single family residence.

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: The lender originated a $400,000 construction loan on a single family “spec” residence with a 15-month maturity to allow for completion and sale of the property. The loan required monthly interest-only payments at a market rate and was based on a LTV of 70 percent at origination. During the original loan construction phase, the borrower made all interest payments from personal funds. At maturity, the home had not sold and the borrower was unable to find another lender willing to finance this property under similar terms.

SCENARIO 1: At maturity, the lender restructured the loan for one year on an interest-only basis at a below market rate to give the borrower more time to sell the “spec” home. Current financial information indicates the borrower has limited ability to continue to pay interest from personal funds. If the residence does not sell by the revised maturity date, the borrower plans to rent the home. In this event, the lender will consider modifying the debt into an amortizing loan with a 20-year maturity, which would be consistent with this type of income-producing investment property. Any shortfall between the net rental income and loan payments would be paid by the borrower. Due to declining home values, the LTV at the renewal date was 90 percent.

*
Classification: The lender internally graded the loan substandard and is monitoring the credit. The examiner agreed with the lender’s treatment due to the borrower’s diminished ongoing ability to make payments and the reduced collateral position.
* Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the borrower demonstrated an ability to make interest payments during the construction phase. The examiner did not concur with this treatment because the loan was not restructured on reasonable repayment terms, the borrower has limited capacity to service a below market rate on an interest-only basis, and the reduced collateral margin indicates that full repayment of principal and interest is questionable.
* TDR Treatment: The lender reported the restructured loan as a TDR. The borrower is experiencing financial difficulties as indicated by depleted cash reserves, inability to refinance this debt from other sources with similar terms, and the inability to repay the loan at maturity in a manner consistent with the original exit strategy. A concession was provided by renewing the loan with a deferral of principal payments, at a below market rate (compared to the rate charged on an investment property) for an additional year when the loan was no longer in the construction phase. The examiner concurred with the lender’s TDR treatment.

SCENARIO 2: At maturity of the original loan, the lender restructured the debt for one year on an interest-only basis at a below market rate to give the borrower more time to sell the “spec” home. Eight months later, the borrower rented the property. At that time, the borrower and the lender agreed to restructure the loan again with monthly payments that amortize the debt over 20 years at a market rate for a residential investment property. Since the date of the second restructuring, the borrower has made all payments for over six consecutive months.

*
Classification: The lender internally graded the restructured loan substandard. The examiner agreed with the lender’s initial substandard grade at the time of the restructuring, but now considered the loan as a pass due to the borrower’s demonstrated ability to make payments according to the modified terms for over six consecutive months.
*
Nonaccrual Treatment: The lender initially maintained the loan on nonaccrual, but returned it to an accruing status after the borrower made six consecutive monthly payments. The lender expects full repayment of principal and interest from the rental income. The examiner concurred with the lender’s accrual treatment.
*
TDR Treatment: The lender reported the first restructuring as a TDR. However, the second restructuring would not be reported as a TDR. The lender determined that the borrower is experiencing financial difficulties as indicated by depleted cash resources and a weak financial condition; however, the lender did not grant a concession on the second restructuring as the loan is at market rate and terms. The examiner concurred with the lender.

SCENARIO 3: The lender restructured the loan for one year on an interest-only basis at a below market rate to give the borrower more time to sell the “spec” home. The restructured loan has become 90+ days past due and the borrower has not been able to rent the property. Based on current financial information, the borrower does not have the capacity to service the debt. The lender considers repayment to be contingent upon the sale of the property. Current market data reflects few sales and similar new homes in this property’s neighborhood are selling within a range of $250,000 to $300,000 with selling costs equaling 10 percent, resulting in anticipated net sales proceeds between $225,000 and $270,000.

*
Classification: The lender graded $130,000 loss ($400,000 loan balance less estimated net sales proceeds of $270,000), $45,000 doubtful based on the range in the anticipated net sales proceeds, and the remaining balance of $225,000 substandard. The examiner agreed, as this classification treatment results in the recognition of the credit risk in the collateral dependent loan based on the property’s value less costs to sell. The examiner instructed management to obtain a current valuation on the property.
*
Nonaccrual Treatment: The lender placed the loan on nonaccrual when it became 60 days past due (reversing all accrued but unpaid interest) because the lender determined that full repayment of principal and interest was not reasonably assured. The examiner concurred with the lender’s nonaccrual treatment.
*
TDR Treatment: The lender plans to continue reporting this loan as a TDR until the lender forecloses on the property, and transfers the asset to the other real estate owned category. The lender determined that the borrower was continuing to experience financial difficulties as indicated by depleted cash resources, inability to refinance this debt from other sources with similar terms, and the inability to repay the loan at maturity in a manner consistent with the original exit strategy. In addition, the lender granted a concession by reducing the interest rate to a below market level. The examiner concurred with the lender’s TDR treatment.

SCENARIO 4: The lender committed an additional $16,000 for an interest reserve and extended the $400,000 loan for 12 months at a below market rate of interest with monthly interest-only payments. At the time of the examination, $6,000 of the interest reserve had been added to the loan balance. Current financial information that the lender obtained at examiner request reflects the borrower has no other repayment sources and has not been able to sell or rent the property. An updated appraisal supports an “as is” value of $317,650. Selling costs are estimated at 15 percent, resulting in anticipated net sales proceeds of $270,000.

*
Classification: The lender internally graded the loan as pass and is monitoring the credit. The examiner disagreed with the internal grade and instructed the lender to reverse the $6,000 interest capitalized out of the loan balance and interest income, and adversely classified the loan. The examiner concluded that the loan was not restructured on reasonable repayment terms because the borrower has limited capacity to service the debt and the reduced collateral margin indicated that full repayment of principal and interest is not assured. The examiner classified $130,000 loss based on the adjusted $400,000 loan balance less estimated net sales proceeds of $270,000, which was classified substandard. This classification treatment recognizes the credit risk in the collateral dependent loan based on the property’s market value less costs to sell. The examiner also criticized management for the inappropriate use of interest reserves. The remaining interest reserve of $10,000 is not subject to adverse classification because the loan should be placed on nonaccrual.
*
Nonaccrual Treatment: The lender maintained the loan on accrual status. The examiner did not concur with this treatment. The loan was not restructured on reasonable repayment terms, the borrower has limited capacity to service a below market rate on an interest-only basis, and the reduced collateral margin indicates that full repayment of principal and interest is not assured. The examiner advised the lender that the loan should be placed on nonaccrual. The lender’s decision to advance a $16,000 interest reserve was inappropriate given the borrower’s inability to repay it. The lender should reverse the capitalized interest in a manner consistent with regulatory reporting instructions and should not recognize any further interest income from the interest reserve.
* TDR Treatment: The lender reported the restructured loan as a TDR. The borrower is experiencing financial difficulties as indicated by depleted cash reserves, inability to refinance this debt from other sources with similar terms, and the inability to repay the loan at maturity in a manner consistent with the original exit strategy. A concession was provided by renewing the loan with a deferral of principal payments, at a below market rate (compared to investment property) for an additional year when the loan was no longer in the construction phase. The examiner concurred with the lender’s TDR treatment.

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