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By: John Kleiman
Commercial lenders often cross-collateralize loans in order to reduce risks. But beware: Accounting concerns and debt restructuring issues may emerge when using multiple properties to secure a loan associated with one property.
Nonaccrual status for loans
Typically, when interest payments on a loan are significantly overdue and collecting any principal is unlikely, the loan must be placed on what’s known as “nonaccrual status.” For example, if your bank experiences an increase in nonaccrual loans, it will likely be forced to bump up its reserves for loan losses, which may hurt profits in the long run.
Cross-collateralization can cause multiple loans to be placed on nonaccrual status, even if some of the loans are still performing. In the OCC’s June 2012 Bank Accounting Advisory Series (BAAS), the agency offers several examples that show the potential impact of cross-collateralization on nonaccrual status.
For instance, one example involves a real estate developer that has two loans with a bank for two separate projects. Loan A is up to date and the bank expects full repayment of interest and principal. Loan B, on the other hand, is placed on nonaccrual status.
According to the BAAS, placing one loan on nonaccrual status won’t automatically require your bank to place the other loan on the same status. The guidance stresses that the responsible party on the two loans are separate corporations and are wholly owned by the developer and that there’s no cross-collateralization or personal guarantees.
So, if the bank subsequently negotiates a cross-collateralization agreement with the developer, must loan A also be placed on nonaccrual status? According to the BAAS, when entering into a cross-collateralization agreement, the bank is simply taking steps to improve its own position relative to the borrower. The bank does not need to place loan A on nonaccrual status if cross-collateralization doesn’t change the repayment pattern of the loans or endanger loan A’s full repayment.
Yet another example shows loans A and B are related to separate real estate projects. The loans are personally guaranteed by the developer and were initially cross-collateralized. Project A has the cash flows to repay loan A in full, but no excess in order to meet a shortfall on loan B, which is already past due.
According to the OCC, if the developer has the intent and the ability to make the payments on both loans, the bank could keep both loans on accrual status. If, on the other hand, the developer lacks the ability and intent to make the payments, both loans should then be placed on nonaccrual status.
Because, in the above example, the loans are cross-collateralized, make sure that collectability is evaluated on a combined basis. The developer, as the guarantor, is the ultimate repayment source for both loans, so placing only loan B on nonaccrual status wouldn’t indicate that the collectability of the entire debt is in doubt.
Troubled debt restructurings
Under current accounting standards, if restructured loans are regarded as troubled debt restructurings (TDRs), they may result in losses on the bank’s financial statements or additional valuation allowances. Typically, a restructuring is a TDR if a bank grants a concession to a borrower that’s experiencing financial difficulties.
Some institutions use cross-collateralization in hopes of avoiding TDR status on reworked loans. They might, for example, defer loan payments or reduce the interest rate in exchange for additional collateral.
Work with an expert
Should you have any questions about the cross-collateralization strategy, contact a Freed Maxick ABL advisor here or call us at 716-847-2651.