Alert: Regulators Establish New Guidelines Regarding the Restructuring of Commercial Real Estate Mortgage Loans

Federal bank regulators have issued new guidelines designed to encourage financial institutions to renew or restructure troubled commercial mortgage loans to creditworthy customers, rather than foreclose on them.  Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 2009).  These guidelines, which were issued by various federal agencies including the Federal Deposit Insurance Corp. and the Federal Reserve on October 30, 2009, provide direction to lenders that have issued loans to commercial property owners who are “experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption periods.”  The number of troubled commercial real estate loans is increasing, and the regulators point out that commercial real estate loan workouts are often in the best interest of both the financial institutions and the borrowers. 

Risk Management Practices.  The guidelines provide that financial institutions should have risk management practices regarding the renewal and restructuring of commercial real estate loans.  Such practices should address issues including the documentation of the borrower’s financial conditions and collateral values, the identification and tracking of loan performance and risk, the financial institution’s regulatory reports, lending limits, loan collection procedures and ongoing credit reviews. 

Workout Arrangements.  Financial institutions will not be criticized, even if a restructured loan is eventually adversely classified, if management has followed appropriate loan workout arrangements with respect to the restructuring.  Workout arrangements should include prudent loan workout policies and plans, analyses of the borrower’s aggregate debt, the ability to monitor the borrower’s and/or guarantor’s performance, an internal loan grading system, and allowances for loan lease losses.  A financial institution should consider restructuring a commercial real estate loan after assessing the borrower’s repayment capacity, possible support from guarantors and the value of the underlying property.  

Loan Classification.  The guidelines also provide direction regarding whether restructured loans should be adversely classified.  Loans to reliable borrowers that are restructured in accordance with appropriate standards will not be adversely classified unless “well-defined weaknesses exist that jeopardize repayment.”  In addition, financial institutions may classify commercial real estate loans on their books as “performing” even if the value of the underlying property with respect to the loan has fallen below the loan balance if such loans are renewed or restructured with reasonable terms.  Further, financial institutions need not adversely classify loans merely because the loans are associated with an industry that is struggling financially. 

However, if a commercial real estate loan is entirely dependant on the sale of the underlying property for repayment, any portion of the loan balance in excess of the market value of the property should be classified as a “loss.”  If well-defined weaknesses exist with respect to a restructured loan and a partial charge-off has been taken, the remaining loan balance should be classified no more severely than “substandard” unless the loss exposure cannot be reasonably determined.  Even if renewed or restructured loans are not adversely classified, the regulators advise financial institutions to have an internal grading system and to monitor renewed and restructured loans very closely. 

Regulatory Reporting.  The guidelines stress that accurate regulatory reports are crucial.  Bank management is responsible for creating appropriate internal controls and governance with respect to preparing such reports and examiners are responsible for reviewing bank management’s processes with respect to accounting and reporting.  Bank management should ensure that staff members who work with borrowers to restructure loans are in communication with the staff members responsible for regulatory reports.

In short, federal regulators have set up these guidelines in order to encourage lenders to restructure or renew commercial real estate loans even if the underlying property value is less than the loan amount.  Banks will not be subject to federal criticism for commercial real estate loan workouts if such workouts are conducted in accordance with prudent practices and procedures and loans will not be adversely classified simply because the collateral securing the loan is valued below the loan amount.  Regulators hope that the guidelines will decrease the number of commercial real estate foreclosures and reduce bank losses on these loans in the long run.

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If you wish to discuss the potential impact this guidance may have on your organization, please contact the following Steptoe corporate and regulatory attorneys: Caroline Gaudet, cgaudet@steptoe.com; John Collins, jcollins@steptoe.com; Kevin Hunter, khunter@steptoe.com; Kevin Olson, kolson@steptoe.com; Nancy White, nwhite@steptoe.com; or Kami Galvani, kgalvani@steptoe.com.

Today’s troubled real estate market requires experienced and innovative lawyers. Steptoe's Distressed Real Estate Litigation & Restructuring group provides both. The Team handles litigation, workouts, insolvency matters, distressed asset sales, and all related tax issues arising from troubled real estate properties of all types, including office buildings, industrial, multi-family, retail, hospitality and resort properties, and undeveloped land. Our clients include investors, lenders, borrowers, owners, sellers, purchasers, commercial banks, investment banks, REITs, REMICs, hedge funds, private equity funds, special purpose entities, securitization trustees and servicers, developers, and construction companies.  

To learn more about the services offered by our Distressed Real Estate Team, please contact Frank Burke, fburke@steptoe.com in Los Angeles or Phoenix; Fil Agusti, fagusti@steptoe.com in Washington, DC; or Robbin Itkin, ritkin@steptoe.com in Los Angeles.

Steptoe's US offices are located in New York, Los Angeles, Washington, Chicago and Phoenix.