Comments on some recent posts dealing with loan modifications suggest some people believe lenders can avoid recognizing losses by modifying loans (see Naked Capitalism "Cramdown and Future Mortgage Credit Costs", Mr. Mortgage "WAMU's New $1 Million 5-Year 1% Balloon Loan Mod", Credit Slips "Cramdown and Future Mortgage Credit Costs: Evidence and Theory") .
This is not the case.
The operative question is whether or not the modification constitutes a Troubled Debt Restructure (“TDR”). From a Center for Audit Quality guidance on the Application of FASB Statement 114:
3) How should an entity determine if a modification of the terms of a residential mortgage loan would be considered a troubled debt restructuring under Statement 15?
In accordance with paragraph 2 of Statement 15, “a restructuring of a debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.”
This covers virtually all material modifications (certainly substantial interest rate reductions or bankruptcy cramdown modifications).
If a loan is a TDR:
Statement 114 provides guidance on how an entity should measure impairment. Specifically, paragraph 13 of Statement 114 states: “…a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical
expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. … The creditor may choose a measurement method on a loan-by-loan basis. A creditor shall consider estimated costs to sell, on a discounted basis, in the measure of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan.”
All of which is to say the loan needs to be marked to market. So, while a modification may postpone the actual cash loss on a deal, on the financial statements the loss needs to be recognized at the time of the modification.
Is it possible a lender could use overly optimistic cash flow assumptions to defer and/or minimize losses? Absolutely, but examiners are sensitive to this possibility, and TDRs get a lot of scrutiny during exams.
Crowe Horwath provides a good general overview of TDRs here.
|