BANK EXAMINATION REFORM

Speaker: Frank Barefield

January 27, 2010

What has Happened to the Multifamily Industry Today?

• Vacancy has increased• Concessions have increased• Credit of our residents decreased• Income has decreased• Turnover has increased• Expenses have increased• NOI has decreased• Capitalization rates have increased• Property values have decreased• Number of lenders decreased• Loan to Value decreased

What has Happened to the Multifamily Industry Today?

ExamplePrior Years This Year

NOI 1,000,000 900,000Cap Rate 6% 7.5%Value 16,666,666 12,000,000

Loan to Value .80 .75Maximum Loan 13,333,332 9,000,000Net after 10 yrs amort. .84Loan balance today 11,200,000

What has Happened to the Multifamily Industry Today?•Many banks have failed because of negative capital due to asset write downs

•Many bank shareholders have lost money due to the failures

•Many property owners have had their loans called, property foreclosed and sold, and been sued

Interagency Policy Statement on Prudent Commercial Real Estate

Loan Workouts

Issued October 30, 2009

Adopted by:

Board of Governors of the Federal Reserve System (FRB)

Federal Deposit Insurance Corporation (FDIC)

National Credit Union Administration (NCUA)

Office of the Comptroller of the Currency (OCC)

Office of Thrift Supervision (OTS)

Federal Financial Institutions Examination Council (FFIEC)

State Liaison Committee

I. Purpose• To replace the interoffice policy statements on the review

and classification of commercial real estate loans issued November 1991 and June 1993

• Intended to promote supervisory consistency

• Ensure that supervisory policies do not curtail the availability of credit to sound borrowers.

• To ensure that 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.

II. Loan Workout Arrangements

The institution will not be criticized for engaging in loan work out arrangements so long as it has

A. A prudent workout policy that permits the institution to modify the workout plan if continued repayment performance is not met or if collateral values do not stabilize.

B. A prudent workout plan for an individual credit that supports the ultimate collection of principal and interest.

The institution will not be criticized for engaging in loan work out arrangements so long as it has

C. An analysis of the borrowers global debt service and a realistic projection of

borrower’s and guarantor’s expenses

D. The ability to monitor the ongoing performance of the borrower and guarantor

a. Analyzing repayment capability of the borrower• The character, overall financial

condition, resources and payment record of the borrower

The ability to monitor the ongoing performance

of the borrower and guarantor

• The degree of protection provided by the cash flow from the business operations or the collateral on a global basis considering the borrowers total debt obligations.

• Market conditions that may influence repayment prospects

• The prospects for repayment from any guarantors

b. Evaluating Guarantees• Does Guarantor have financial

capacity and willingness to pay

• Guarantee is adequate to provide support for repayment of the debt, in whole or in part

• Guarantee is written and legally enforceable

The ability to monitor the ongoing performance

of the borrower and guarantor

The ability to monitor the ongoing performance of the borrower and guarantor

c. Assessing Collateral Values• New or updated appraisal or

evaluation as needed to support the plan

• New appraisal may not be necessary where an internal evaluation by the institution updates original appraisal assumptions to reflect current market conditions and provide an estimate of the collateral’s fair value

III. Classification of LoansGoals:• Loans that are adequately protected by the

current sound worth and debt service capacity of the borrower, guarantor, or the collateral generally are not adversely classified.

• Loans to sound borrowers that are renewed or restructured in accordance with prudent underwriting standards should not be adversely classified unless well defined weaknesses exist that jeopardize repayment.

III. Classification of LoansA. Nonmaturing Loan Performance Assessment

For Classification Purposes• Consider past record of performance

• Examiner should not adversely classify or require the recognition of a partial charge off on a performing loan solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.

• However, it is appropriate to adversely classify a performing loan when well defined weaknesses exist that will jeopardize repayment

III. Classification of LoansB. Classification of Renewals or Restructurings of

Maturing Loans• Many borrowers whose loans mature in the

midst of an economic crisis have difficulty obtaining credit due to deterioration in collateral values despite their current ability to service the debt

• In such cases the most appropriate and prudent course is to restructure or renew loans to borrowers who have demonstrated an ability to pay their debts but cannot currently obtain long term financing

III. Classification of Loans

• Prudent loan workouts or restructurings are generally in the best interests of both the institution and the borrower

• Renewals or restructuring of maturing loans to borrowers who have the ability to repay on reasonable terms will not be subject to adverse classification

• Adverse classification of a restructured loan is appropriate if well defined weaknesses exist that jeopardize repayment of the loan

III. Classification of Loans• Restructuring may involve a multiple note structure

where a troubled loan is restructured into two notes. Lenders may separate a portion of the current debt into a new legally enforceable note that is reasonably assured of repayment. This note may be placed back on accrual status in certain situations.

• The portion of the debt that is not reasonably assured of payment (the second note) should be adversely classified and charged off as appropriate.

• In contrast, the loan should remain or be placed on non-accrual status if the lender does not split the loan into separate notes, but internally recognizes a partial charge off.

Loan Categories

Pass

Special Mention (holding classification waiting on further information)

Substandard

Doubtful

Loss

Example of a CRELoan Workout

BASE CASE:Office Building

• $15,000,000 original loan

• 20 year amortization

• $13,600,000 Balloon at end of yr 3

• 75% LTV

• Stabilized appraisal of $20,000,000

• D/S coverage of 1.35x

• Market interest rate

• Lender expected to renew loan at end of yr 3

• Project cash flow has declined

• Rental concessions being given to compete and retain tenants

Scenario 1:

• Lender renewed $13,600,000 Loan

• Market rate of interest

• 17 year amortization

• Borrower not delinquent on any payments

• Borrower has cash flow

• 1.12x D/S coverage

• Review of leases – stable tenants, long term leases

• Recent appraisal @ $13,100,000 (104% LTV)

• Lender graded the loan as pass – borrower has capability to continue to make payments on reasonable terms. Kept loan on accrual status.

• Examiner agreed – full repayment of loan reasonably expected

Scenario 2: • Lender renewed the

$13,600,000 loan• Market rate of interest• 17 year amortization• Borrower not delinquent on

any payments• NOI declined and D/S

coverage ratio is 1.12x• Leases coming up for

renewal and additional concessions will be necessary

• D/S coverage not expected to drop below 1.05x

• Current appraisal not ordered

• Lender estimates current FMV is $14,500,000 (94% LTV)

• Lender did not ask for current borrower financials to assess the ability of the borrower to pay from other sources

• Lender graded loan as pass

• Examiner disagreed and listed the loans special mention – Although borrower has the ability to make payments now, there has been a declining trend in income stream, more potential concessions, and reduced collateral margin. Also lender’s failure to request current financial info and get updated collateral valuation represents administrative deficiencies.

• Lender maintained loan in accrual status. Examiner agreed because cash flow sufficient at this time and full repayment is expected.

Scenario 3:• Lender restructured the

$13,600,000 loan

• 12 month interest only at below market rate of interest

• Borrower been late on some payments

• D/S projected @1.12x based on new terms

• Short term leases at the property – some behind on rental payments

• Recent appraisal at $14,500,000 (94% LTV)

• Lender graded loan pass

• Examiner disagreed - borrower has limited capability to service the debt at a below market rate, interest only, has been sporadically delinquent, with reduced collateral position.

• Examiner classified loan as substandard

• Lender maintained loan on accrual status due to cash flow and collateral margin.

• Examiner disagreed – full payment of principal and interest not reasonably assured.

Summary

•Banks will be contacting borrowers to get detailed information

•Although collateral value is important, it is secondary to ability to pay

•Make sure the borrower/guarantor provides whatever information is necessary to support their ability to pay.