In the current post-financial crisis lending environment, financial regulators are taking an especially close look at restructured small business loans. Most banks are working with at least some of their small business and commercial real estate borrowers to rehabilitate troubled loans by modifying loan terms and granting certain concessions.
Loan modification, however, may result in the creation of what’s known as a troubled debt restructure, or TDR. This distinction is important, because TDRs are subject to additional regulatory reporting, tracking and accounting requirements by the financial institution.
Concessions Are Key
Determining whether a loan modification constitutes a TDR is a two-step process: First, determine if the borrower is actually troubled. And second, determine if the modified terms you’re offering are more attractive than standard market terms.
Under GAAP, the modification of a loan’s terms constitutes a TDR if the lender grants any concession(s) to the borrower that it would not consider if it were not for the borrower’s current financial difficulties. These concessions may include things like lowering the interest rate, forgiving principal or previously accrued interest, allowing interest-only payments, and extending the loan’s maturity or amortization schedule.
Loan concessions may stem from an agreement between the bank and the borrower, or they could be imposed by a court. See the sidebar at left for specific TDR guidance.
It’s important to note that not all loan term modifications automatically constitute a TDR designation. For example, if the modified terms are consistent with market conditions and representative of terms the borrower could obtain in the open market, the restructured loan would not be categorized as a TDR.
Given the intricacies involved in TDR designations and the enhanced scrutiny regulators are placing on them, banks should establish policies and procedures to evaluate all loan modifications and concessions to determine whether they are TDRs or not. If a loan modification does meet the definition of a TDR, the bank must follow the accounting procedures set forth in ASC 310-40 (formerly FAS 114), including testing the loan for impairment.
Testing for Impairment
Banks must classify TDRs as “substandard” and, thus, test them for impairment. If found to be impaired, they must be written down to their current market value with the appropriate allowance for loan and lease losses (ALLL) adjustments under ASC 310-40, and the appropriate reserve provision must be made.
TDRs also must be segregated on financial statements and appear on the bank’s call report (not by name, but in the aggregate) through December 31 of the year that they are identified.
A loan is considered to be impaired when, based on current information and events, it is probable that an institution will not be able to collect all amounts due according to the original contractual terms of the loan agreement. Usually, a TDR that had been individually evaluated under ASC 310-40 would already have been identified as impaired because the borrower’s financial difficulties existed before the formal restructuring.
Banks should account for the modification of terms for a TDR in accordance with ASC 310-40. These require that impairment be measured based on the present value of the expected future cash flows, discounted at the effective interest rate of the original loan agreement. If the measure of the impaired loan is less than the recorded investment in the loan, the impairment is recognized through a valuation allowance.
Loan restructures and concessions can be an easy way to mask some problems, but regulators today are digging deeper in order to get a true picture of what’s going on in banks’ portfolios. They want to see TDRs for what they really are — not just glossed-over problem loans.
Therefore, it’s important that your bank have systems and processes in place to accurately assign problem loans as TDRs when they should be designated as such.
What Constitutes a TDR?
ASC 310-40 provides the following examples of loan modifications that may lead to a troubled debt restructure (TDR) designation:
• Absolute or contingent reduction of the stated interest rate for the remaining original term of the debt.
• Absolute or contingent reduction of the face amount or maturity amount of the debt as stated in the instrument or other agreement.
• Absolute or contingent reduction of accrued interest.
• Extension of the maturity date (or dates) at a stated interest rate that’s lower than the current market rate for new debt with similar risk.
• Conversion of a loan from one that amortizes principal and interest payments to an interest-only loan, even at a market rate.
In short: A loan modification is a TDR if the borrower could not qualify for a loan with similar modified terms from another lender.
Our firm can work with you to create internal systems that can help you with TDR designations. Please call us today to learn more.