In March, the US Securities and Exchange Commission fired off a few letters asking a number of America’s regional banks to clarify their loan modification practices. In particular the SEC is reportedly looking into “troubled debt restructurings” (TDRs) which involve modifying existing loans’ terms.
Just to be clear, this particular form of ‘extend and pretend‘ is 100 per cent legal, though it’s governed by some fairly nebulous accounting rules and is meant to be reported. First though, look at those TDR growth rates. In a special report out on Thursday, Fitch Ratings says reported TDRs increased 48 per cent to $106bn in 2010. The mix, however, is the really interesting (and significant) thing.
TDRs have traditionally been the remit of residential loans, but they’re suddenly booming in the commercial real estate sector. So while residential loans still represented about 87 per cent of outstanding TDRs at the end of last year, commercial TDR’s grew at a whopping 85 per cent rate.
Something’s going on here.
Just a month after the SEC started scrutinising TDR practices, the US Financial Accounting Standards Board (FASB) finalised something called ASU 2011-2, or “A creditors determination of whether a restructuring is a troubled debt restructuring,” which will come into effect next month.
ASU 2011-2 is not much different to current accounting rules, where loans are meant to be classified as TDRs once a bank grants a concession to a borrower in financial difficulty that it wouldn’t normally consider. What ASU 2011-2 does is clarify what exactly counts as a “concession” and gives some additional guidance on when borrowers should be considered to be in “financial difficulty.”
The story of the original creation of TDRs under FAS-15 is an interesting one in itself. Tom Selling of the Accounting Onion points us in the direction of Stephen Zeff’s 2005 piece, “The evolution of U.S. GAAP: the political forces behind professional standards,” which recounts the creation of FAS-15.
In short it goes like this:
“In 1973, the City of New York was said to be bankrupt, and, with great difficulty, the banks that held the city’s debt instruments restructured the debt by modifying its terms. The principal payments were postponed, and the interest rate on the debt was lowered. The banks proposed not to reduce the balance on their books of the loan receivable from the city and therefore not to recognize any immediate accounting loss. FASB began to study the question, and the possibility of recognizing a loss in the event of such restructurings was put to a public hearing. At the hearing, Citicorp Chairman Walter B. Wriston said that if the banks had known that they might be required to recognize an immediate accounting loss from restructuring the city’s debt, “the restructuring just might not have happened.” Furthermore, the prospect of a required recognition of a loss in such cases led Wriston to doubt that such restructurings would be possible in the future. His bombshell testimony put considerable pressure on FASB. In the end, the board said in SFAS 15 that if, after a restructuring, the total cash flows to be received under the new terms were no lower than the balance in the receivable account, no writedown or loss recognition would be required. The standard was heavily criticized because it ignored the economic reality of the transaction altogether.”
And presto — four years later FAS-15 was born by a 5-2 vote of the FASB council.
In basic terms, Zeff says, it effectively allows financials that agree with debtors to modify the terms of their long-term loans to avoid recording a loss on the restructuring. TDRs as set out in FAS 15 (and later amended by SFAS 114) are just one component of the standard. Just to be clear, classifying loans as TDRs does usually shift the loan into non-performing status, which requires increased reserves.
Hence, perhaps, some banks’ apparent reluctance to correctly identify them as TDR.
Barclays Capital analysts wrote in late 2009, for instance:
“We remain concerned [non-performing assets] may be understated for some, particularly because several banks exclude and/or don’t report restructured loans, as well as TDRs, which we expect to have high redefault rates.”
Now back to the acronyms – ASU 2011-2 and the SEC
The amendment has four main provisions but for simplicity’s sake, we’re going to focus on just one. To use Fitch’s paraphrasing: “Payment default is not necessary to conclude that a borrower is experiencing financial difficulty.” In other words, it’s now up to the banks to figure out if the borrower’s in difficulty.
Fitch has a few thoughts on the whole thing:
“The FASB has cited “diversity in practice adversely affecting the comparability of information for users about restructurings of receivables” as its primary consideration for the update. Fitch interprets this to mean that the FASB does not believe all banks are appropriately identifying or disclosing all TDRs. This is consistent with increased regulatory scrutiny of loan accounting practices among banks, most notably from the SEC. For example, it is widely reported that numerous regional and community banks are being probed by the SEC regarding, among other things, TDR recognition and disclosure. Additionally, many financial institutions have received SEC comment letters regarding disclosures of TDRs (or lack thereof). Although Fitch does not believe that these changes substantially change current GAAP accounting, it is anticipated that this FASB action coupled with recent SEC scrutiny could result in more TDR recognition, with CRE portfolio’s being impacted significantly more than other loan types.“
As Fitch points out, residential loans are typically fully-amortising long-term loans. Banks don’t have to monitor them very much except to check that the payments are coming in. So banks are not very likely to determine a borrower is in financial difficulty until the loan actually defaults. That’s one of the reasons why most residential TDRs occur after a default. TDR recognition is pretty straight forward here.
By contrast, typical commercial loans are not fully-amortising and probably balloon in three- or five-years. Banks will be monitoring these and so the ‘determination’ idea becomes more important, and hence, we would guess, the ASU 2011-2 amendments seem much more focused on commercial loans.
As does the SEC inquiry, of course. Regional banks tend to have more commercial real estate exposure than their big-bank-brethren, which suggests the SEC’s focus is also squarely on commercial TDRs.
So, to the final (FASB) twist
If TDRs are one method of ‘extend and pretend’ which may not (at the moment) be fully accounted for in banks’ financial statements, it’s worth asking how prevalent the practice might be. Property & Portfolio Research reported last month that the number of commercial real estate loans scheduled to mature in 2011 doubled from the end of 2008 — in other words, banks were extending the loans.
Either way, the combination of ASU 2011-2 and the SEC investigation should help push up the reported numbers of TDRs — especially those commercial real estate ones — over the next few years.
But there’s a final twist to the FASB update. One that should strike fear into the hearts of any banks that might have been avoiding TDR classification or have particularly hefty redefault risk:
Mandatory disclosures will now be expanded to cover redefault rates, which were generally not being disclosed voluntarily. These disclosures will require financial institutions to disclose the amount of TDRs that entered payment default in the 12-month period since being classified as TDR. Thus, 3Q11 will be the first reporting period that investors get a good look at redefault rates at an institutional level and perhaps more importantly the first look at redefault rates on nonresidential mortgage loans.
From Hamp footnote to Hamp legacy – FT Alphaville
SEC probe examines bank-loan practices – Wall Street Journal
More transparency coming to hidden costs of ‘extend & pretend’ strategies – CoStar
CRE and the re-emergence of the troubled debt restructuring – Philadelphia Fed, 2008