Understand Troubled-Debt Restructures (TDRs)

Understanding the difference between a restructure versus a troubled-debt restructure is critical in an era of rising real estate delinquencies and foreclosures.

 
 

The combination of depressed real estate values and the cooperative spirit of credit unions often result in real estate loan restructuring. Although commonplace today, these restructures were rarely done in the past because it was unusual for a real estate loan to become delinquent.

As noted in the following chart from Peer-to-Peer, credit unions are experiencing a rising trend in delinquent real estate loans reflective of the current economic cycle. Management and those charged with corporate governance must understand the necessary accounting requirements for the restructure of a delinquent real estate loan.

Delinquency & C.O. since Year-End 2009

Source: Callahan & Associates' Peer-to-Peer

When Is a Restructure a Troubled-Debt Restructure?
Understanding the difference between a restructure versus a troubled-debt restructure (TDR) is critical. A TDR is one in which the creditor, for economic or legal reasons related to the debtor's financial difficulties, grants a concession to the debtor that it would not otherwise consider. A TDR is the result of an agreement between parties or terms imposed by a court of law.

Is it possible to have a restructure that does not meet the definition of a TDR? Yes. For example, assume a borrower with good credit and adequate collateral value wants to restructure their real estate loan to take advantage of lower market rates. This concession in rates is NOT the result of the borrower’s financial difficulties and would not be considered a TDR. Conversely, assume a borrower with deteriorating credit and a high LTV needs to reduce their monthly payment in order to avoid foreclosure. The credit union grants a temporary, or permanent, rate reduction. This would be considered a TDR, which then would require specialized accounting treatment as summarized below.

TDR Accounting
Let’s assume a real estate loan has a balance of $200,000 with an interest rate of 6% and a remaining term of 28 years. The borrower is in trouble, and the best estimate of property value is $150,000. The borrower requests a rate modification for two years at 2% to enable their continued payments on the loan. Let’s also assume the credit union believes the borrower will make the reduced payments in good faith and will be able to return to full payments at the end of the concession period.

The first point to recognize is if the credit union simply recognizes the reduced rate of interest over the course of the next two years, earnings will be prospectively reduced by the amount of the rate concession (6% versus 2%). Accounting standards don’t generally allow for delayed loss recognition and specifically require immediate loss recognition in the context of TDRs.

So how do we calculate the loss in interest income which results from the rate concession? In this simple example, the amount of loss recognition would be the present value, discounted at the loans original interest rate of 6%, of the difference in cash flows that result from the rate concession. Assume the present value in the difference in payments, discounted at 6%, amounts to $10,000. This amount would need to be specifically provided for in the Allowance for Loan Losses for the loan in question. To reiterate, if this entry is not made at the time of restructure, this amount of loss would be deferred over the next two years, which is NOT in accordance with GAAP.

The longer the period of the rate concession or the greater the amount of the rate reduction, the greater the TDR loss to recognize. TDRs can also result from the forgiveness of part of the outstanding loan balance.

Other Critical Points

  1. The calculation of the loss will have to be updated each period.
  2. This simple example assumes that payments at the original interest rate of 6% will resume in month 25. Management will need to document its rationale for this critical assumption.
  3. The determination of whether to grant a credit concession should be made based on the financial merits, not on the accounting treatment.
  4. It is critical for the lending staff, who is typically involved in negotiating the rate concession, to be communicating these decisions with the accounting staff to ensure the proper accounting results.
  5. The accounting treatment for TDRs is specified in Statement of Financial Accounting Standards #114.
  6. NCUA requires a TDR be classified in its original delinquent category until 6 consecutive payments are made in accordance with the revised loan terms.

As noted in the above example, the TDR charge for even a short-term rate concession on a real estate loan can be significant. Failure to ensure the proper accounting and the appropriate communication between lending and accounting is in place can result in overstatement of earnings and call into question the competency of management. Now is the time to ensure your management team is familiar with the specialized accounting required for TDRs.

 

 

 

March 23, 2009


Comments

 
 
 
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  • The article is not detailed enough to allow a clear understanding of the specialized accounting for a TDR. Is it assumed that the borrower is delinquent or just "in trouble." The allowance for loan losses is just that - an allowance for loss of PRINCIPLE not interest too. Interest is not accrued on a loan until the day has passed. There is no loss of interest income that could occur until the interest is accrued but expected not to be paid. Are you explaining that the credit union has to push into the allowance the interest that never accrued and was negotiated out of the agreement? It sounds rediculous to me. Maybe I just don't understand the methodology that you have presented or your article is not clear enough for general understanding. At no point is the interest lossed before it is accrued. Unaccrued interest income and the difference in "Expected" interest income (going out 24 months in your example) are not balance sheet items.
    Anonymous
     
     
     
  • Allow me to clarify the questions raised by response #2. The example provided in the article noted that a loan was restructured from a rate of 6% to a revised rate of 2% for a 2-year period. While it is true that at the time of restructure, there was no accrual for future income, one must recognize that an event has occurred which resulted in the earnings power of the asset being seriously diminished. In other words, a financial event has occurred which requires measurement. It is the loss in future earnings that GAAP requires be immediately recognized thru a charge to earnings. Is this logical? In my opinion, yes it is. Imagine if a significant portion of the loan portfolio reflected the same characteristics of this one restructured loan. Unless you record the loss as noted above, the result would be to load the balance sheet up with under-performing or non-performing assets without any income statement or balance sheet recognition. Under the requirements imposed by GAAP, a loss has been recognized AND the balance sheet has been appropriately impacted vis-à-vis the establishment of a credit to the Allowance for Loan Losses for the loan in question. GAAP got this one right. The requirement is logical, measureable and provides the best disclosure to the users of financial statements.
    Mike Sacher
     
     
     
  • In light of the Making Home Affordable Modification program-that credit unions are eligible to participate in-where a credit union would receive federal dollars for upfront incentives to make a loan modification, contributions based on future payment performance, and contributions to offset reductions in lowering payments (interest rate reductions); what would be your recommendation on the associated accounting issues as these would be considered TDRs?
    Steve VanSickler
     
     
     
  • What if the modified loan was modified due to pending financial hardship and was not delinquent at the time of modification - thus not having an original delinquency category - what would it be catagorized as under the ALLL guidelines, and would the 6 consecutive payments still apply?
    Steve VanSickler
     
     
     
  • Re Comment 6...NCUA requires a TDR be classified in its original delinquent category until 6 consecutive payments are made in accordance with the revised loan terms.

    Q - is this reporting requirement different for banks? And are there any other differences between CUs and banks in the TDR space, for example do credit unions enjoy a level of flexibility re accrual vs non accrual status that banks do not?

    Mike DeFors
     
     
     
  • Steve-give me a call on Monday and we can discuss further... 310.880-5323
    Mike Sacher
     
     
     
  • RE: Question #4 Response - What impact on your impairment assessment would the federal funds make?
    Steve VanSickler
     
     
     
  • Steve-Re: Making Home Affordable Modification program... If you will be accepting lower payments, lower rates, etc. due to the financial condition of the borrower, I think theory requires you to perform a present value calculation of the revised cash flows discounted at the loans original rate to determine the amount of impairment. Remeber you always should consider materiality since these calculations can be labor intensive. The point here is not to create a bookkeeping nightmare. Rather, we need to understand the potential impact and ensure the accounting folks and lending folks are communication so the data can be captured and assessed for materiality.
    Mke Sacher
     
     
     
  • Steve: Re: Comment #5: First, you should check with regulator to get ultimate answer on this question. My sense if loan was not Dq. at time of restructure then probably no need to report as dq. subsequent to restructure. However, be careful not to confuse this issue with whether the restructure is a TDR. A loan could be "current" when contractual changes are made that would constitute a TDR. The dq. status at time of restructure is not the main issue. Rather, you must look at the reason for the restrucure. If the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider, then you have a TDR... Thanks for the questions... Mike
    Anonymous
     
     
     
  • Good information. Let's assume the loan returns to the regular interest rate of 6% after 2 years. Any changes to how this is accounted for in the ALL? Also, clarify that this is also for consumer loans.
    Paul Kirkbride
     
     
     
  • I'm being told that all TDRs must be placed in non-accrual status regardless of delinquency, collateral support, or the other tests performed for setting non-accrual status. Is this truly the case as it seems to me these are two independent decisions.
    Roger Kelso
     
     
     
  • Mike, we spoke about question #5 at a conference you gave in December.

    The facts are the same: Current loan with the member making payments. They have had reduced hours or other hardship such as loss of income (but one spouse still employed). We provide them with a modification (temporary rate reduction and re-amortization). Loan is still paying current even after modification but 6 months have not passed.

    Must we report as delinquent on call report?

    In December, your thought was that we could continue to report as current consistent with your critical point bullet #6 above (report in same category as before modification).

    Now, the DFI is in here and they say that we must show as delinquent until we receive 6 payments under the modified terms. I find this ridiculous as the loan was current before and it is current now. They say this must happen because we will not collect all principal and interest as scheduled in the ORIGINAL contract terms.
    Dave
     
     
     
  • In your example, I would assume that the loan is impaired as the cu is not going to collect all amounts due per the original loan agreement - not going to collect all of the original interest. Given the fact that this is a real estate loan, why wouldn't this be considered a collateral-dependent loan, and therefore under FAS 114 be restricted to only use the fair value of the collateral, less costs to sell for valuing the loan and not the pv of expected future cash flows as in the example.
    Mike D
     
     
     
  • What about reporting delinquency based on original contract terms? Will this be the original disbursement, rate, and terms? What about adjustable rate loans - what defines original after the rate is adjusted?
    Mary Anderson
     
     
     
  • The credit union has some HELOCs in 1st lien position with a LTV over 100%. These are performing loans. The original interest rate is variable and the credit union is contemplating on lowering the interest rate to 3% for five years. Will this loan modification will be classified as a TDR, TDR with allowance or just a modification? We are not lowering the monthly payment or the payment amount, the members are not in financial distress, we will be lowering the interest rate to 3% fixed for 5 years.
    William Darias
     
     
     
  • FAS 114 makes note that provisions of the Statement need not be applied to immatieral items. What would your definition be of immaterial on a portoflio of loans totaling $1B?
    Anonymous
     
     
     
  • Loan restructured and amortizing at below market rate. After 6 mo, cash flow is substantiated at the below market rate and pay performance is established. The loan will remain TDR because of rate. Will the loan continue to be impaired and substandard even though it cash flows (at below market rate) and has established payment performance? i.e. are terms TDR and Pass mutually exclusive?
    Betty
     
     
     
  • DOES THIS ONLY PERTAIN TO REAL ESTATE LOANS:

    6.NCUA requires a TDR be classified in its original delinquent category until 6 consecutive payments are made in accordance with the revised loan terms.

    LORIE GARCIA
     
     
     
  • Very helpful in understanding what constitutes a TDR, and how to properly account for and report a TDR.
    Anonymous
     
     
     
  • very timely well written
    Anonymous