Commercial lenders cross-collateralize loans to reduce risks. But accounting concerns and debt restructuring issues may emerge when using multiple properties to secure a loan associated with one property.
Placing loans on nonaccrual status
Generally, when interest payments on a loan are significantly overdue and collection of principal is deemed unlikely, the loan must be placed on “nonaccrual status.” If a bank experiences an increase in nonaccrual loans, it likely will be forced to bump up its reserves for loan losses, which may hurt its profits.
In some cases, cross-collateralization can cause multiple loans to be placed on nonaccrual status, even if some of the loans are still performing. The OCC, in its June 2012 Bank Accounting Advisory Series (BAAS), offers several examples that illustrate the potential impact of cross-collateralization on nonaccrual status.
One example involves a real estate developer that has two loans with a bank for two separate projects. Loan A is current and the bank expects full repayment of principal and interest. But loan B is placed on nonaccrual status.
According to the BAAS, placing one loan on nonaccrual status doesn’t automatically require the bank to give the other loan the same status. The guidance emphasizes that the obligors on the two loans are separate corporations wholly owned by the developer and there’s no cross-collateralization or personal guarantees.
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, by entering into a cross-collateralization agreement, the bank is merely taking steps to improve its position relative to the borrower. It need not 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.
In another example, loans A and B are related to separate real estate projects, 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 to meet a shortfall on loan B, which is past due.
According to the OCC, if the developer has the ability and intent to make the payments on both loans, the bank could maintain both loans on accrual status. If the developer lacks the ability and intent to make the payments, both loans should be placed on nonaccrual status.
Because the loans are cross-collateralized, collectibility should be evaluated on a combined basis. The developer, as guarantor, is the ultimate repayment source for both loans, so placing only loan B on nonaccrual status wouldn’t reflect that the collectibility of the entire debt is in doubt.
To find the June 2012 BAAS, go to http://www.occ.gov/publications/publications-by-type/other-publications-reports/baas.pdf.
Under current accounting standards, if restructured loans are considered troubled debt restructurings (TDRs), they may result in additional valuation allowances or losses on a bank’s financial statements. Generally, a restructuring is a TDR if a bank grants a concession to a borrower experiencing financial difficulties.
Some banks use cross-collateralization in an attempt to avoid TDR status on reworked loans. They might, for instance, defer loan payments or reduce the interest rate in exchange for additional collateral.
Seeking expert advice
If you have questions about the strategy of cross-collateralization, contact your CPA. He or she will be able to advise you on your financial moves.