COVID-19 and Loan Modification

Issue/Inquiry

Due to the COVID-19 pandemic, the Bank is considering the following with respect to its loan customers:

• Deferring scheduled monthly payments for a period of time
• Allowing payments of interest only
• Allowing interest or payment reductions on a case-by-case basis

How should deferrals or modifications be documented? Can deferred principal and interest payments be capitalized or added to the back-­end of the loan?

Response Summary

Federal guidance regarding borrowers affected by the COVID-19 outbreak may allow the Bank to defer payments, interest, or principal upon the renewal or modification of a loan. The capitalization of interest may also be allowed, but this could potentially be problematic from the standpoint of the Bank’s federal regulator, the Federal Deposit Insurance Corporation (“FDIC”). Because such transactions may be considered troubled debt restructurings (“TDR”), this would prevent the loan from being carried onto the Bank’s books on an accrual basis. However, federal guidance regarding COVID-19 will protect the Bank from criticism by the FDIC if its actions are prudent, done in good faith, and are consistent with safety and soundness principals.

Response Detail

Lending Under the Revised Interagency Guidance:

On April 7, 2020, the Board of Governors of the Federal Reserve (“FRB”), the FDIC, the National Credit Union Administration (“NCUA”), the Office of the Comptroller of the Currency (“OCC”), and the Consumer Financial Protection Bureau (“CFPB”) (the “Federal Regulatory Agencies”), in consultation with the state financial regulators, issued a revision to the Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus issued on March 22, 2020 (the “Revised Interagency Guidance”). Revised Interagency Statement on Loan Modifications by Financial Institutions Working with Customers Affected by the Coronavirus, FIL-36-2020.

In particular, the Revised Interagency Guidance was intended to provide additional information regarding loan modifications as well as clarify the interaction between such modifications and the related relief provided by the Coronavirus Aid, Relief, and Economic Security Act(the “CARES Act”).

With respect to lending, the Revised Interagency Guidance states that financial institutions should work constructively with borrowers in communities and industries affected by COVID-19. It encourages institutions to engage in prudent and proactive actions that are in the best interests of the financial institutions, the borrowers, and the economy. When appropriate, an institution may modify or restructure a borrower’s debt obligations due to temporary hardships resulting from COVID-19 related issues.

As provided by the CARES Act, a financial institution may account for an eligible loan modification either under Section 4013 of the Act or in accordance with ASC Subtopic 310-40, Receivables – Troubled Debt Restructuring (“ASC Subtopic 310-40”).

In order to be an eligible loan under Section 4013, a loan modification must be:

• Related to COVID-19
• Executed on a loan that was not more than 30 days past due as of December 31, 2019
• Executed between March 1, 2020, and the earlier of:
  • 60 days after the date of termination of the National Emergency
  • December 31, 2020

If a loan modification is not eligible under Section 4013, or if the institution elects not to account for the loan modification under Section 4013, the institution should evaluate whether the modified loan is a TDR.

Modifications of loan terms will not automatically result in TDRs. According to ASC Subtopic 310-40, the restructuring of a debt is considered a TDR if the creditor, for economic reasons related to the debtor’s financial difficulties, grants a concession to the debtor that it would not otherwise grant. The Financial Accounting Standards Board has indicated to the Federal Regulatory Agencies that short-term modifications which are made on a good faith basis in response to COVID-19 for borrowers who were current prior to any relief are not considered TDRs under ASC Subtopic 310-40. This includes such short-term modifications (e.g., six months) such as:

• Payment deferrals
• Fee waivers
• Extensions of repayment terms
• Delays in payment that are insignificant.

Accordingly, the Revised Interagency Guidance states that working with borrowers who are current on existing loans, either individually or as part of a program for creditworthy borrowers who are experiencing short-term financial or operational problems as a result of COVID-19, would not generally be considered TDRs. No further TDR analysis would be required for such borrowers if the following are true:

• The modification is in response to the National Emergency.
• The borrower was current on payments at the time the modification program was implemented.
• The modification was short-term.

Prudent efforts to modify the terms on existing loans for affected customers will not be subject to examiner criticism, regardless of whether the loans are considered TDRs or Section 4013 loans, or are adversely classified. However, all loan modifications should comply with applicable laws and regulations, and be consistent with safe and sound practices. The Federal Regulatory Agencies will take into account the unique circumstances affecting borrowers and institutions as a result of the National Emergency, as well as the good faith efforts of the institution that demonstrably support consumers and comply with consumer protection laws.

FDIC Frequently Asked Questions (FAQs):

After the Revised Interagency Guidance was issued, the FDIC issued its Frequently Asked Questions for Financial Institutions Affected by the Coronavirus Disease 2019 (Referred to as COVID-19) – As of May 7, 2020 (“FDIC FAQs”).

In response to a question regarding whether it would be acceptable for a bank to offer borrowers affected by COVID-19 with payment accommodations, the FDIC FAQs states that the “FDIC encourages financial institutions to provide borrowers affected in a variety of ways by the COVID-19 outbreak with payment accommodations”, such as extending the maturity date or making skipped or deferred payments due in a balloon payment at the maturity date of the loan. The response further states that “when deferring or skipping payments, providing borrowers with accurate disclosures that are consistent with federal and state consumer protection laws will help to avoid any misunderstandings relative to the changes in terms”.

In addition, financial institutions should maintain appropriate documentation that considers the borrower’s payment status prior to being affected by COVID-19 as well as the borrower’s payment performance under the change in terms. Documentation could also include the borrowers’ recovery plans, sources of repayment, additional advances on existing or new loans, and the value of collateral.

Borrowers who were current in their payments before becoming affected by COVID-19 and are current in accordance with the revised terms of their loans would not be reported as past due. For loans subject to a payment deferral program on which payments were past due prior to the borrower becoming affected by COVID-19, the FDIC has taken the position that the delinquency status of the loan may be adjusted back to the status that existed at the date of the borrower becoming affected, which, in effect, would be frozen for the duration of the deferment period.

Other responses in the FDIC FAQs reiterate the Revised Interagency Guidance regarding TDRs or Section 4013 loans.

The Bank’s Next Action:

The Revised Interagency Guidance and FDIC FAQs indicate that the Bank will be granted a certain lee-way by the federal examiners if the Bank can demonstrate that its actions were reasonable and prudent in addressing the needs of borrowers who were adversely affected by the COVID-19 epidemic.

As stated above, payment deferrals or allowing interest-only payments is permitted by the Revised Interagency Guidance and FDIC FAQs. In fact, the FDIC has recognized such in the past as an appropriate step to take in certain circumstances. For example, it acknowledges that non-traditional mortgage products typically defer principal and even interest payments. The concern with respect to creditors providing such products is whether the creditors are taking proper steps to mitigate the risks associated with such products, such as implementing strong risk management standards, and having capital levels commensurate with the risk as well as an allowance for loan and lease losses that reflects the collectability of the portfolio. FDIC, Part 5000, Interagency Guidance on Nontraditional Mortgage Product Rate.

A practical question to ask is whether payment adjustment plans that require borrowers to pay accruing interest, but not principal, provides sufficient cash flow relief for the borrower. While this type of action may advance due dates and protect credit ratings, it may not be relief from the sudden loss or reduction in income. Likewise, there are no regulations prohibiting the renewal of loans without requiring accrued interest to be paid or adding unpaid interest to the principal balance of a loan (i.e., “capitalization of interest”). For acquisition, development, and construction financing, the creation of interest reserve accounts funded by the loan proceeds are common.

However, both the Safety and Soundness Examination Manual and the Risk Management Manual of Exam Policies of the FDIC require examiners to ask whether a financial institution has allowed payment adjustment plans requiring the payment of interest, but not principal, or renewed loans by capitalizing interest. On the surface, the renewal of loans without requiring the payment of accrued interest or the capitalization of interest may be considered an unsafe and unsound practice, especially when the loan in question is not sufficiently collateralized or the borrower is experiencing financial difficulty. It has been an element of many cease and desist orders issued by the FDIC.

In particular, the Interagency Retail Credit Classification and Account Management Policy indicates that the policies and controls of a financial institution should prohibit advances to finance unpaid interest and fees for closed-end consumer loans that are being extended, deferred, or re-written. Although this does not have the effect of a legal or regulatory requirement, the Interagency Guidance on Unsafe or Unsound Practices and Conditions indicates that it reflects the supervisory expectations and priorities of federal examiners.

The only time that it is acceptable to add accrued interest back to the principal is at the time of renewal or modification when the borrower has demonstrated a continued or renewed ability to pay the loan and the loan is sufficiently capitalized. Even in such case, it should be an exception and not a rule, since adding interest onto the principal for the sole fact of bringing the loan current would ordinarily be criticized by a financial institution’s federal examiner.

In order to evidence that the Bank has mitigated its credit risk through prudent actions that are consistent with safe and sound practices, the Bank should document the unique circumstances of each case that justify modifying loan repayment terms as well as how they are consistent with safe and sound banking practices.

Where interest or principal is forgiven, the Bank may demonstrate that such forgiveness mitigates the possibility of bankruptcy and a charge-off that would be of a greater amount than any amounts forgiven.

For any action that the Bank decides to take, it must first consider whether the renewal, modification, or deferment is considered a TDR and, if so, whether it can continue to carry the loan onto its books on an accrual basis.

This response is for informational purposes only and is not intended for legal guidance.

This entry was posted on Monday, May 18th, 2020 at 9:22 am.