Troubled Debt Restructurings Expected To Rise as New Accounting Rules Just Weeks Away
The number of loans that banks have to classify as troubled debt could increase dramatically in a few weeks as a result of new accounting rules issued last month. The new push to reclassify some loans is already hurting some lenders, and the reclassifications are expected to shine a spotlight on the commercial real estate lending practice that has come to be known as “extend and pretend.”
New accounting standards issued by the Financial Accounting Standards Board (FASB) just last month and taking effect for public companies first are expected to result in lenders re-examining their restructured debt and could compel them to reclassify some of it as troubled. Those adjustments will have to be made public in any quarterly and annual reports filed after June 15.
In addition to the accounting change, banking regulators have also started cracking down on lenders and requiring some to go back and reclassify some of their receivables as troubled debt restructurings (TDR).
The issue of TDRs sprung to life this month after FASB last month issued new guidance directing institutions to standardized what constitutes TDRs, and also report redefault rates on TDRs on a portfolio segment basis. Law and accounting firms have jumped into action with blogs and webinars for their clients explaining the change.
Wolf & Co., a leading regional certified public accounting and business consulting firm with headquarters in Boston, reported that in evaluating whether a restructuring constitutes a TDR, a lender must separately conclude that both: the borrower is experiencing financial difficulties and the restructuring constitutes a concession.
Those concessions could include:
- Transfer of assets from the debtor to the lender; or
- Granting of an equity interest to the lender by the borrower; or
- Modification of debt terms such as a reduction in the interest rate, payment deferrals, extension of the maturity date at a less than market rate (for similar risk), reduction of the face amount or maturity amount owed, or a reduction/write-off of accrued interest.
Some of the concessions described have been an oft-used tool by lenders to extend the maturity date on CRE loans to give borrowers and banks more time to ride out the economic recession and possibly recover some of the lost value of an asset – “extend and pretend.”
Tim Tiefenthaler, managing director in Las Vegas of McGladrey, an accounting, tax and consulting firm, posted to his firm’s clients that, according to the FDIC Quarterly Banking Profile, TDRs for all insured institutions have grown from $6.9 billion from year end 2007 to $87.5 billion at year end 2010.
“Federal banking regulators have noted that TDRs is an area of focus for examiners and the larger volume of modifications has resulted in significant concerns about the level of allowance for loan losses associated with these loans,” Tiefenthaler said. “Because of the magnitude of restructuring activities, regulators, investors, auditors and lending institutions have raised concerns about the diversity in practice in identifying loan modifications that constitute TDRs for a creditor.”
The new guidance issued to standardize how TDRs are accounted for is expected to increase the level of loan modifications that will be reported and accounted for as TDRs. It will be also be the first time that redefault rates on commercial real estate loans will become available on a broad basis, according to a new Fitch Ratings report on the topic.
Given the recent and forecasted shifts in TDR types away from residential loans, this information will be invaluable to asset quality analysis, especially as it relates to CRE-heavy loan portfolios, Fitch said.
First-lien residential mortgages continue to dominate the current mixture of TDRs, representing 87% of total outstanding TDRs, according to Fitch. These loans have experienced extremely high redefault and growth rates over the last two years.
The mixture has changed during the past year with nonresidential mortgage TDRs growing at a significantly faster rate than residential TDRs. Overall, total TDRs amongst U.S. banks grew at a 48% pace in 2010, with nonresidential TDRs growing by 85%.
Half of all CRE loans maturing in the next few years are anticipated to mature underwater and if extended without significant credit enhancement are at risk to be classified as TDR under new accounting guidance, Fitch estimated.
Fitch considers all TDRs nonperforming (regardless of accrual status) for the purposes of asset quality analysis. Fitch said that TDRs by their very nature have increased credit risk.
Fitch said it does not expect that these trends will materially affect ratings on an industry wide basis. However, the ratings of some financial institutions could be negatively affected to the extent that specific lenders experience disproportional growth in TDRs and report unusually high redefault rates.
The impact of reclassify receivables as TDRs was evident this week when NASB Financial Inc. in Grandview, MO, reported that it received a letter from the Office of Thrift Supervision directing its North American Savings Bank FSB to amend and restate its financial results for the quarter ended Dec. 31, 2010. OTS directed the $1.3 billion institution to reclassify certain residential development loans receivable, as TDR.
As a result of these restatements, NASB’s previously reported net income for the quarter ended Dec. 31, 2010, of $2 million will decrease to a net loss of $3 million.
NASB said the loans to be reclassified are paying as agreed and have not been restructured in the traditional sense by offering any concessions that discount the original terms. However, the original maturity dates were extended, the bank holding company said.