BC 255
Type: Banking Circular        
Subject: Troubled Loan Workouts and Loans to Borrowers in Troubled
         Industries 
Date: July 30, 1991

To: Chief Executive Officers of all National Banks, Deputy Comptrollers,
    District Administrators, Directors and all Examining Personnel

PURPOSE

This issuance provides a summary of supervisory and reporting guidance to
help banks deal with troubled borrowers or non- troubled borrowers
operating in troubled industries. The issuance addresses: 1) refinancing
medium-term commercial real estate loans; 2) loan concentrations; 3)
troubled debt restructurings; 4) returning a loan with a partial
charge-off to accrual status; 5) recognition of interest income on a cash
basis; and, 6) enhanced disclosure of nonaccrual loans. Some of these
matters were previously discussed in the joint agency supervisory release
of March 1, 1991, which was distributed as Banking Bulletin 91-07.

BACKGROUND

Many national bank customers are experiencing financial difficulties,
particularly those involved in industries such as real estate. Periods of
economic uncertainty for a major industry provide significant challenges
for banks. In commercial real estate markets, overcapacity, declines in
value of financed projects, and more cautious lending practices and less
availability of financing from traditional non-bank sources (such as
insurance companies, pension funds, etc.) have made bank loan portfolios
riskier.

In this environment, it is important that bankers understand supervisory
and reporting requirements when assessing the options available to them in
working with borrowers.  Understanding these requirements will help
institutions avoid unnecessarily restricting the availability of credit to
sound borrowers, especially in sectors of the economy that are
experiencing temporary problems. The OCC supports banks making loans on
sound terms to creditworthy borrowers. Similarly, the OCC supports
bankers' efforts to develop a strategy to minimize losses on troubled
loans -- which frequently means working with the borrower. It is important
that lack of understanding or misunderstandings about supervisory policies
not adversely affect the availability of credit to sound borrowers or the
prudent working out of loans to troubled borrowers.

Loan workouts can take a number of forms: simple renewal or extension of
the loan terms; extension of additional credit; formal restructuring of
the loan terms with or without concessions; or, in some cases, foreclosure
on underlying collateral. Banks should choose the alternative that will
maximize the recovery on each troubled loan.  This circular presents
supervisory considerations regarding these options.

Accurate reporting of troubled loans is also important. Banks' disclosures
of troubled loans should enable analysts and other readers of the
financial statements to understand fully the effects, both positive and
negative, that such loans have on the bank's financial condition and
results of operations. This issuance also clarifies certain reporting
policies regarding troubled loans.

LOAN WORKOUTS
 
Refinancing of medium-term commercial real estate loans

Many commercial banks aggressively participated in the 1980's real estate
boom by originating a large number of real estate construction and
development loans. In today's market, commercial real estate borrowers are
having difficulty obtaining planned post-construction refinancing and
purchase financing for real estate development projects. In many cases,
the usual sources for this financing, such as insurance companies and
institutional investors, are currently not available. In other cases,
projects that the bank financed are not performing in accordance with
original projections. Consequently, banks are frequently faced with the
choice of renewing a loan they had not planned to renew, restructuring the
loan, or foreclosing on the collateral.

This environment presents significant challenges to banks in maintaining
standards of asset quality and diversification. The OCC recognizes that,in
many cases, the most effective way for banks to minimize their losses on
existing loans may be to renew or extend loans beyond the original plan.
In other cases it may make sense to restructure the loan terms. As with
any commercial credit, these renewals, extensions, or restructurings must
be based on sound underwriting standards and must be subject to normal
loan classification rules. A bank will not be criticized for continuing to
carry such loans as long as the bank has a well conceived and effective
workout plan for the borrower, effective internal controls to manage the
levels of these loans, has classified the loan in cases where weaknesses
exist, and has properly considered these loans when determining the level
of the allowance for loan and lease losses.

Concentration of credit

Banks and the OCC have long recognized portfolio diversification as an
important element of an overall risk management strategy. Banks have been
criticized by the OCC for having excessive concentrations in certain
industries. In some cases, concentrations have been the subject of OCC
enforcement actions. In recent months, fear of regulatory criticism for
adding to, or not reducing, concentration levels has led some banks to
hesitate to extend credit to new creditworthy borrowers or to renew
existing sound loans.

However, concentration risk is only one consideration in managing the
risks associated with troubled borrowers and industries. The OCC
recognizes that it may be appropriate for a bank to make additional loans,
on prudent terms, in an industry where the bank has a concentration, if it
has effective internal systems and controls in place to manage
concentration risk. When management believes the renewal, extension, or
restructuring of credit is the best way to work out an existing troubled
relationship and avoid further losses, the level of loans to a particular
industry should not deter management from exercising its best judgment.
The OCC will criticize a bank for failing to recognize the reality of a
troubled loan but will not criticize a bank that manages a troubled loan
using a well conceived and effective workout strategy.

Troubled debt restructurings (TDRs)

Some banks feel that TDRs implemented in accordance with Statement of
Financial Accounting Standards No. 15, "Accounting by Debtors and
Creditors For Troubled Debt Restructurings" (FAS 15) will not work in
today's environment. Some of these banks believe that FAS 15 requires the
lender to grant the borrower a large concession. Others believe the lender
must wait a period of time after the restructuring before the loan can be
returned to accrual status. Neither belief is always the case.

The OCC believes TDRs can be useful in meeting sound business and
reporting objectives. Restructurings should be undertaken in a way that
improves the likelihood that the loan will be repaid in full. Regulatory
reporting policies and generally accepted accounting principles (GAAP) do
not require banks to grant excessive concessions, forgive principal, or
take other steps that are not commensurate with the borrower's ability to
repay. The only concessions required are those needed to restore the
expectation of full collectibility. The amount and size of those
concessions depends on the nature of the loan and the financial condition
of the borrower.

Regulatory reporting requirements and GAAP do not prevent banks from
including contingent payment provisions in the restructured terms. For
example, a bank may reduce the interest rate on a troubled loan but
require the borrower to pay the bank a percentage of any gain realized if
the collateral is sold. Or, the bank may require that the reduced rate
will automatically revert to a market rate if the borrower meets certain
profit levels. Thus, the bank can recover concessions granted during
periods of economic troubles if the borrower's financial condition
improves.

It is not always necessary for a bank to wait a period of time after the
restructuring before returning a restructured loan to accrual status.
Rather, in some situations, the loan can return to accrual status
immediately after the restructuring if the return is supported by a well
documented credit evaluation of the borrower's financial condition and the
prospects for full repayment. Examples include 1) payment performance
immediately prior to the restructuring or 2) other significant factors
that preclude the need for demonstrated performance.

Payment performance in accordance with the newly restructured terms is one
of the most important forms of evidence used to decide whether the
borrower can fully meet the restructured terms. The performance to be
assessed should not be limited to that occurring after the restructuring.
Performance immediately prior to the restructuring should also be
considered. Often the level of debt service on a restructured loan is less
than the payment the borrower was making before the restructuring. If this
is the case, and the borrower is expected to be able to continue this
level of performance and fully repay the new contractual amounts due, the
loan can immediately return to accrual status.

Other significant factors may constitute a preponderance of evidence that
the loan will be repaid in full. Those factors may be sufficient to allow
the loan to return immediately to accrual status without demonstrated
performance under the restructured terms. Such factors include substantial
and reliable new sales, lease or rental contracts, or other important
developments that significantly increase the borrower's net cash flow and
debt service capacity and strengthen the borrower's commitment to repay.
If such factors are not enough to eliminate entirely the need for
demonstrated performance, they may reduce the period of performance
otherwise considered necessary.

The instructions to the Consolidated Reports of Condition and Income (Call
Reports) were amended as of June 30, 1991, to permit the removal of
restructurings that are in compliance with their modified terms and
yielding a market rate of interest from restructured debt reporting after
the year in which the restructuring occurs. In situations where a partial
charge-off has been taken before the restructuring, an interest rate
concession may still achieve an effective yield that approximates a market
rate. This is because FAS 15 requires that the effective yield be computed
based on the recorded loan balance instead of the contractual balance.
This situation is even more frequent in today's environment given recent
declines in interest rates.

Because many banks have taken charge-offs on troubled loans, the TDR can,
in some cases, use a two-note structure to return one "good" note to
accrual status, with the troubled note accounted for separately. The
troubled note may represent the lender's contractual claim on the portion
of the loan that has been charged-off. For example:
 
*  Assume that a bank has a $10 million loan secured by real estate. The
loan is on nonaccrual status and $1 million has been charged off. Cash
flows are adequate to service only a $9 million loan at a market rate of
interest. The bank formally restructures the loan by dividing it into two
notes. The first is for $9 million and carries a market rate of interest.
The second is for $1 million (the charged-off portion of the note to which
the bank retains a claim) and carries a below market rate of interest. The
bank forgives no principal. This restructuring meets the requirements of
FAS 15, and assuming that full collection of the $9 million loan and the
borrower's continued performance under the modified terms are expected,
that loan can return to accrual status.

The return to accrual status must always be supported by well documented
evidence of the borrower's financial condition and the expectation of
complete repayment under the revised terms. The restructuring should
improve the collectibility of the loan in accordance with a reasonable
repayment schedule. The amount of charge-off must be based on a good faith
evaluation of collectibility and cannot be calculated simply to achieve a
specified rate of interest or avoid future troubled debt disclosures. In
every TDR, the bank must make a good faith evaluation of the
collectibility of the new contractual principal and interest, maintain the
allowance for loan and lease losses at an appropriate level and charge off
all identified losses in a timely manner.

REPORTING CONSIDERATIONS
 
Returning a loan with a partial charge-off to accrual status

On March 1, 1991, the four federal banking and thrift regulatory agencies
jointly issued a statement clarifying certain supervisory and reporting
policies. The release also announced the pending issuance of a request for
comment on a proposed reporting standard that would permit certain
partially charged-off nonaccrual loans to return to accrual status.

The proposal (sometimes called "loan splitting") was published for comment
on March 18, 1991, with a 45-day comment period that ended May 2. Most of
the comments received indicated concerns that the proposal was not in
conformity with GAAP. A number of commenters expressed concern that such
differences might diminish the integrity of bank financial reporting.
While noting these concerns, the agencies also observed that in some
respects where the proposal differed from GAAP, such as the areas of loss
recognition and disclosure, the proposal was more conservative than GAAP.
As a longstanding practice, however, the agencies have attempted to
minimize differences between regulatory reporting requirements and GAAP.

For that reason, the agencies recently announced in the Federal Register
that the proposal has been withdrawn. The agencies have agreed to
participate in projects underway by the American Institute of Certified
Public Accountants (AICPA) and the Financial Accounting Standards Board
(FASB) to attempt to resolve issues relating to recognizing income on
nonaccrual loans and estimating credit losses on certain loans.

The federal banking agencies have included guidance on certain aspects of
the March 1 policy statement in the instructions for the June 30, 1991
Call Report. This issuance reiterates those policies and is intended to
encourage depository institutions to continue to work with borrowers who
are experiencing difficulties and to avoid restricting the availability of
credit to sound borrowers, particularly in areas of the economy that may
be experiencing temporary problems.

Cash-basis interest recognition

For partially charged-off loans where the remaining recorded balance is
considered fully collectible, recognition of interest income on a cash
basis is an appropriate alternative to "loan splitting" when combined with
increased disclosure of the contribution to income that nonaccrual loans
provide.

While a loan is in nonaccrual status, some or all of the cash interest
payments received may be treated as interest income on a cash basis. This
can occur only if the remaining book balance of the loan (i.e., the
balance after charge-off of identified losses, if any) is deemed to be
fully collectible. The amount of interest income that should be recognized
is limited to that which would have been accrued on the asset's remaining
book balance at the contractual rate. Any excess over that amount should
be recorded as recoveries of amounts previously charged- off until the
charge-off is fully recovered.

A bank's determination of the ultimate collectibility of a loan's
remaining book balance must be supported by a current, well documented
credit evaluation of the borrower's financial condition. Prospects for
repayment must also be evaluated, including such factors as the borrower's
historical repayment performance and other relevant factors.

Suggested increased nonaccrual disclosure

Many financial statement readers use banks' current nonaccrual loan
disclosures as an important barometer of financial condition. Many
analysts place heavy emphasis on the levels of nonaccrual loans in
projecting future loan losses and earnings. Few banks take the opportunity
to show that there are varying degrees of problems in the reported total
of nonaccrual loans. Few indicate to the reader that many of these assets
provide a contribution to earnings through cash basis interest income and
loan loss recoveries.

In January 1991, the OCC suggested a format in Banking Bulletin 91-05 for
voluntary disclosures relating to nonaccrual loans. In addition to the
cash-basis interest income recorded on such loans, disclosure can include
charge-offs taken and cash payments applied as loan loss recoveries. Banks
may also segregate loans that are generating substantial cash flows
relative to other nonaccrual loans to help distinguish those loans that
are current but are in nonaccrual status due to concerns regarding the
borrower's financial condition. The OCC suggested that this increased
disclosure also might be extended to other real estate owned so that
analysts can see the contribution those assets make to operating income.

Accrual status of partially charged-off loans

There may be circumstances when a partially charged-off loan can return to
accrual status without first recovering the partial charge-off. In
accordance with the Call Report instructions, this is permitted when the
loan has been brought fully current with respect to principal and interest
and the bank expects that the full contractual balance of the loan
(including any amount charged-off) plus interest will be fully collected
under the terms of the loan. (These instructions also provide that certain
past due loans may return to accrual status if they are both well secured
and in the process of collection.)

Ordinarily, a partial charge-off would indicate that the bank does not
expect full repayment of the amounts contractually due and the loan would,
therefore, remain on nonaccrual status. If, however, facts have changed
since the charge-off was taken such that the full amounts contractually
due, including the amounts charged-off, are expected to be collected and
the loan is contractually current, the partially charged-off loan could
return to accrual status. This determination must be supported by a well
documented credit evaluation of the borrower's financial condition and the
prospects for full repayment.

OTHER RELATED OCC RELEASES

The following recent banking and examining issuances contain additional
guidance dealing with troubled loan situations and reporting troubled
assets:

Banking Bulletin 91-05 -- "Public Disclosure on Nonaccrual Loans"
Banking Bulletin 91-07 -- "Joint Agency Policy Statements"
Banking Bulletin 91-19 -- "Nonaccrual Loan Issues"
Examining Bulletin 91-02 -- "Joint Agency Statements Clarifying Certain
Regulatory Policies"

Questions about this Banking Circular, or any of the issuances listed
above, should be directed to the Office of the Chief Accountant at (202)
874-5180.

ORIGINATING OFFICE

Chief National Bank Examiner's Office
Office of the Chief Accountant

Susan F. Krause
Senior Deputy Comptroller for
Bank Supervision Policy

July 30, 1991