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.
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.
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
- The calculation of the loss will have to be updated each period.
- 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.
- The determination of whether to grant a credit concession should be made based on the financial merits, not on the accounting treatment.
- 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.
- The accounting treatment for TDRs is specified in Statement of Financial Accounting Standards #114.
- 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.