The suspension of accounting rules on modified loans is another dramatic measure that regulators and lawmakers have taken in the struggle to limit pandemic-related loan defaults.
The question of how — and increasingly, whether — to account for, report and reserve for modified loans has taken on increasing urgency for banks working to address borrowers’ unexpected hardship following the COVID-19 outbreak.
Regulators homed in on the treatment for troubled debt restructurings, or TDRs, in late March, as cities and states issued stay-at-home orders and the closure of nonessential businesses sparked mass layoffs. The intense focus on the accounting for these credits comes as a tsunami of once-performing loans made to borrowers and businesses across the country are suddenly at risk of souring.
“The statements from regulators and the CARES Act are trying to reduce the conversations that we have about TDRs by helping institutions minimize the amount of TDR challenges that they’re dealing with,” says Mandi Simpson, a partner in Crowe’s audit group.
TDRs materialize when a bank offers a concession on a credit that it wouldn’t have otherwise made to a borrower experiencing financial difficulties or hardship. Both of those prongs must exist for a loan to be classified as a TDR. Banks apply an individual discounted cash flow analysis to modified credits, which makes the accounting complicated and tedious, Simpson says.
“You can imagine, that could be pretty voluminous and cumbersome” as borrowers en mass apply for modifications or forbearance, she says.
Late last month, federal bank regulators provided guidance on TDRs to encourage banks to work with borrowers facing coronavirus-related hardship. Still, Congress intervened, broadening both the relief and the scope of eligible loans.
The Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, which went into effect on March 27, suspended the requirements under U.S. generally accepted accounting principles for coronavirus loan modifications that would have otherwise been categorized as TDRs. It also suspended the determination that a loan that has been modified because of the coronavirus would count as a TDR, “including impairment for accounting purposes.” This applies to any loan that receives a modification that was not more than 30 days past due as of Dec. 31, 2019.
The law encourages banks to record the volume of modified loans. It also specified that bank regulators can collect data about these loans for supervisory purposes.
Bank regulators issued their revised interagency statement on April 7 to align with Congress’ rule. Bankers should maintain appropriate allowances and reserves for all loan modifications. It adds that examiners will exercise judgment when reviewing modifications and “will not automatically adversely risk rate credits that are affected by COVID-19.”
Importantly, the U.S. Securities and Exchange Commission’s chief accountant issued an opinion accepting the CARES Act treatment of TDRs as GAAP on April 3. The statement reconciled U.S. accounting policy and federal law, and spared auditors from issuing modified opinions for institutions that adopt the TDR relief.
But the accounting relief could create longer-term issues for banks, says Graham Steele, staff director of the Corporations and Society Initiative at Stanford Graduate School of Business. He previously served as minority chief counsel for the Senate Committee on Banking, Housing and Urban Affairs and was a member of the staff of the Federal Reserve Bank of San Francisco.
He understands the imperative to provide forbearance and flexibility, but he says the modifications and concessions could lead to diminished cash flows that could erode a bank’s future lending capacity. He points out that it’s also unclear what would happen to balance sheets once the national emergency ends, and how fast those modifications would be reclassified.
“This seems like an ‘extend and pretend’ policy to me,” he says. “Congress and regulators have offered forbearance, but they’re changing mathematical and numerical conventions that you can’t just assume away.”
Simpson says that as part of the tracking of modified loans, institutions may want to consider those credits’ risk ratings and how their probability of default compares to performing loans. She is encouraging her clients to consider making appropriate and reasonable disclosures to share with investors, such as the amount and types of modifications. The disclosures could also give bank executives a chance to highlight how they’re working with borrowers and have a handle on their borrower’s problems and financial stress.
“I think proactively helping borrowers early on is a good move. I know banks are challenged to keep up with the information, just I am, and the timing is challenging,” Simpson says. “They’re needing to make very impactful decisions on their business, and you’d like to be able to do that with a little bit more proactivity than reactivity. Unfortunately, that’s just not the place that we find ourselves in these days.”