COVID-19 Loan Modifications: Accommodations or Troubled Debt Restructuring?

  • 11/13/2020
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After nine months of COVID-19, and with the fiscal year-end pending, deferral due dates are approaching for many financial institutions. Review guidance on how to account for additional loan accommodations for borrowers.

Key insights

  • Consider providing additional loan accommodations to borrowers before December 31, 2020, if the modification qualifies under Section 4013 of the CARES Act.
  • Continue to monitor and manage credit risk in a prudent manner and in accordance with applicable laws and safety and soundness principles.
  • Even if the loan accommodations granted are not considered troubled debt restructuring, the allowance for loan and lease losses should still document your evaluation of these accommodations and the associated risk.

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At the onset of the COVID-19 pandemic, federal and state regulatory bodies moved into action and financial institutions responded to borrower challenges head-on with lightning-quick speed. Within 60 days, guidance addressed financial institutions’ accessibility to liquidity through several Federal Reserve liquidity facilities and lowered federal funds rates.

Financial institutions aimed to work with borrowers affected by COVID-19, but quickly asked an important question: How do we report these loans in the midst of a scenario for which no one could have planned? Many financial institutions needed to make loan modifications for impacted borrowers. Now, due dates for these deferrals are approaching and borrowers may need additional accommodations.

COVID-19 government response

Congress and the federal and state regulatory bodies responded quickly and released the following guidance:

  • On March 27, 2020, Congress signed into law the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Section 4013 temporarily suspended certain troubled debt restructurings (TDR) requirements under current U.S. generally accepted accounting principles (GAAP).
  • On April 7, 2020, the regulatory agencies issued “Interagency Statement on Loan Modifications and Reporting for Financial Institutions Working With Customers Affected by the Coronavirus (Revised)” (Revised Interagency Guidance). This statement clarified relief from the TDR requirements of current U.S. GAAP and encouraged financial institutions to work with their borrowers, using short-term (six-month) payment deferrals that were originally issued on March 22, 2020.

As the pandemic continued and the country faced a shutdown, financial institutions responded to calls from borrowers to grant loan deferments and abide by the guiding principles of safety, soundness, and prudence.

As we approach the end of the eighth month of the pandemic and a fiscal year-end for many financial institutions, due dates for these deferrals are approaching. There’s a realization from many financial institutions that borrowers may need additional accommodations.

In August 2020, the Federal Financial Institutions Examination Council (FFIEC) issued a joint statement to provide prudent risk management and consumer protection principles for financial institutions to consider as loans near the end of the initial loan accommodation period. In this statement, the FFIEC stated loan accommodations are viewed as positive actions, which can mitigate adverse effects on borrowers caused by COVID-19.

Comparison of the guidance available

If you’re already using Section 4013 of the CARES Act or the Revised Interagency Guidance, assess each future loan accommodation against the available guidance to determine which one applies. One of the primary differences between Section 4013 of the CARES Act and the Revised Interagency Guidance is timing. Under standard U.S. GAAP for TDRs, there is a six-month deferral cliff for when the financial institution should assess the loan. Under Section 4013, loan accommodations made during the applicable period have no such time limit.

In addition, if a loan was originally modified under the Revised Interagency Guidance, you can assess the next loan accommodation under Section 4013 of the CARES Act as long as it meets the stated criteria. If a loan is not eligible under Section 4013 (i.e., it was past due at December 31, 2019), it automatically falls under the Revised Interagency Guidance. As of the publication of this article, Section 4013 of the CARES Act is set to expire December 31, 2020.

Compare Section 4013 of the CARES Act with the Revised Interagency Guidance using this table:

Section 4013 of the CARES Act Revised Interagency

Modifications terms allowed (safety and soundness principles still apply)

Applies only to the following modifications: forbearance agreements, interest rate modifications, repayment plans, or other arrangements that defer/delay principal and interest payments Applies only to the following modifications made due to the COVID-19 pandemic: short-term modifications, such as payment deferrals, fee waivers, extensions of repayment terms, or delays in payment that are insignificant under ASC 310-40, government-mandated programs
Evaluation date of whether borrower was current (< 30 days past due) May apply to borrowers not more than 30 days past due at December 31, 2019 Applies on the date that a financial institution implemented a modification program for borrowers less than 30 days past due
Time period when the modification occurs Applicable period began on March 1, 2020, and ends on the earlier of December 31, 2020, or 60 days after the termination date of the presidential national emergency Applicable period not specified but is expected to be temporary
Duration of non-TDR designation Remaining life of the loan — subsequent modifications must be evaluated if they are not also eligible under the criteria Remaining life of the loan — subsequent modifications must be re-evaluated

Not all accommodations are the same

Specific aspects of your borrower’s situation will become more obvious as additional accommodations are made. For many financial institutions, large numbers of modified loans have already returned to normal payment practices or are performing under the modified terms. As the remaining loans reach the end of their accommodation period — and as we outlined above — communicating with your borrower is critical.

Let’s walk through an example:

Borrower A has a commercial loan with a financial institution, and the loan was current as of December 31, 2019. In April 2020, Borrower A’s business experienced a disruption of income due to COVID-19 and was granted a six-month payment deferral, starting May 1, 2020. Initially, the financial institution considered this loan modified under the Revised Interagency Guidance. On November 1, 2020, Borrower A approaches the financial institution again, noting the business has not fully recovered and needs an additional six-month deferral. The financial institution has two options from an internal reporting perspective:

  1. Assess the loan under the TDR guidance pursuant to U.S. GAAP and follow the guidance for valuation impairment; or
  2. Since the new accommodation is granted prior to December 31, 2020, report this loan under Section 4013 of the CARES Act.

Under either option, review the practices outlined above. Whether a loan is treated under the Revised Interagency Guidance or Section 4013 of the CARES Act, your institution’s policies may indicate risk rating or accrual status changes.

Allowance for loan and lease losses (ALLL)

Filter the above credit risk management notes into management’s periodic evaluation of the ALLL. While the accommodations granted to help borrowers are not considered TDRs, they can pose additional inherent risks to your financial institution’s loan portfolio.

In addition, if the loans are subject to risk rating, update the risk rating to reflect the revised financial status of the borrower. Consider these two ways to address the inherent risks of these accommodations:

  • Pool the loans currently under accommodation (in total or by loan segment) and apply an ALLL factor based on historic loss rates, your financial institution’s experience with similar accommodations, or other known qualitative external factors. Consider at what point the inherent risk declines, and adjust the applied factors accordingly.
  • Alternatively, loans currently under accommodation may remain in the homogenous loan pools, and a general qualitative and environmental factor can be assessed as part of a pandemic-specific qualitative factor. The 2006 Interagency Policy Statement on the Allowance for Loan and Lease Losses provides a list of qualitative and environmental factors, of which the last is deemed “other external factors.” Consider using this factor for loans under accommodation.

Coming into the pandemic, many financial institutions were experiencing record-low charge-off levels and even a decline in delinquencies. Keep in mind that the current loan modifications in place at your financial institution may be masking risk that has not yet been uncovered in conversations with borrowers. Document your institution’s qualitative and environmental factors to assess the effects of COVID-19 and the possibility of future charge-offs related to today’s economic environment. Review your institution’s consideration of the following:

  • Unemployment rates in the local area in which it operates
  • Real estate values, including both residential and commercial
  • Local government mandates, such as capacity limits for businesses or executive orders halting repossession or foreclosure
  • Ongoing shutdowns of certain businesses or reductions in capacity

Accrual status

Neither the CARES Act nor the Revised Interagency Guidance address the point at which a financial institution should cease the accrual of interest on a modified loan. The Financial Accounting Standards Board and regulatory guidance typically require financial institutions to place a loan on nonaccrual status when the loan is 90 days delinquent on contractual payments or when the financial institution has determined the outstanding principal and accrued interest will not be fully collectible.

While a loan is on a payment deferral, the loan will remain current for reporting purposes. However, as you gather updated financial information from borrowers, stay vigilant for any indications the collateral has deteriorated to a point where the entire principal and interest amounts are not expected to be collected. Additionally, remain proactive as you assess accrual status for loans coming out of a payment deferral period that may be showing signs of moving toward delinquency or nonpayment.

How we can help

The challenges brought by loan modifications in the midst of the pandemic, along with specific borrower situations, are here to stay as we move into 2021. Our financial institution professionals are here to help you evaluate your loan modifications and provide relevant guidance. Listen to our webinar to learn more and have your loan modifications questions answered by our team.

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