Understanding TDRs and Automation in the Time of COVID-19
As the COVID-19 health crisis continues to batter the economy, a troubled debt restructuring (TDR) will consume a significant portion of getting businesses up and running as unprecedented financial difficulties have grappled every industry in the world.
A TDR takes place only when unusual circumstances present themselves, such as a worldwide pandemic forcing global closures of businesses deemed “non-essential.” So then, a creditor may offer a debtor a concession also under one of the conditions below:
- The debtor files for bankruptcy.
- The debt is in default.
- The debtor’s securities have been delisted.
- Other sources of funds are no longer an option.
- The debt cannot be met under current circumstances.
There are several options for concessions, and restructuring, such as a maturity date extension, acceptance of varying types of payments besides cash, a decrease in the principal or even the interest rate. If the debtor can get funds from other sources, at market rates, then a TDR may not be the right solution.
Invariably, the large-scale economic impact will have many financial organizations searching for new ways to manage their debtors and their loans. When the recovery process begins, and it will, the financial institutions who can design more manageable terms and attractive loan offers will set themselves apart from their competition and gain more customers over the long-term.
Since there are significant financial problems to deal with in the current, and near future, it’s crucial to ensure your systems and processes are optimized to handle the deluge. This isn’t a time to mask problems, but instead, it is the time to discover the bottlenecks and determine how to address them now.
With a TDR, financial institutions can sometimes disagree how and where to label concessions and modifications. Unquestionably, TDRs will be prominent and what’s most important is whether bankers can offer reasonable terms to ensure steady economic recovery, which will then be beneficial for all. Keep reading to learn more.
How the CARES Act Addresses TDRs
According to Section 4013 of the CARES Act, a financial organization can “suspend any determination of loans modified as a result of COVID-19 as being troubled debt restructurings. Federal banking agencies and the National Credit Union Administration must defer to a financial institution to make a suspension. Such elections may begin on March 1, 2020 and last no later than the earlier of (i) 60 days after the lifting of the COVID-19 national health emergency and (ii) December 31, 2020 (the “Applicable Period”).
“Pursuant to Section 4013, such suspensions will be applicable for the term of the loan modification, but solely with respect to any modification (including forbearance agreements, interest rate modifications, repayment plans and any other similar arrangement that defers or delays the payment of principal or interest) that occurs during the Applicable Period for a loan that was not more than 30 days past due as of December 31, 2019.”
In short, if coronavirus-related changes are made, they should not be described as a TDR. Further, any modified loans under the CARES Act will not affect any of the associated bank’s risk-based capital requirements. Credit unions won’t have to worry about this until 2021 when they are then required to work with risk-based capital rules.
Re-evaluate your accounting procedures
On March 19, the FDIC issued a letter to all FDIC-supervised organizations and it contained information on TDRs:
Financial institutions should determine whether loans with payment accommodations made to borrowers affected by COVID-19 should separately be reported as TDRs in separate memoranda items for such loans in regulatory reports. A TDR is a loan restructuring in which an institution, for economic or legal reasons related to a borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. However, a loan deferred, extended, or renewed at a stated interest rate equal to the current interest rate for new debt with similar risk is not reported as a TDR. Financial institutions may refer to Accounting Standards Code (ASC) 310-40 (formerly Financial Accounting Standards Board (FASB) Statement No. 15) for additional guidance on determining whether a loan with renegotiated terms should be accounted for as a TDR. ASC 310-10-35 (formerly FASB Statement No. 114) also provides guidance on accounting for impairment losses on TDRs.
The agencies are encouraging financial institutions to work with borrowers and said they won’t criticize institutions for doing so in a “safe and sound manner.” The agencies added they won’t direct supervised institutions to automatically categorize loan modifications as troubled debt restructurings, or TDRs. They reiterated that not all modifications of loan terms result in a TDR. “Short-term modifications made on a good faith basis in response to COVID-19 to borrowers who were current prior to any relief are not TDRs. This includes short-term — for example, six months — modifications such as payment deferrals, fee waivers, extensions of repayment terms, or other delays in payment that are insignificant.”
The main source of guidance around TDRs can be found under accounting practices ASC 310-40, referring to receivables. Yet, if short-term changes are made in response to coronavirus-related financial difficulties, then they will not be designated as TDRs. This can include the following:
- Six-month modifications
- Waivers of fees
- Repayment term extensions
- Deferrals on payments
- Other related delays
But, borrowers must be current with their debt repayments.
The Financial Accounting Standards Board (FASB) also issued this statement:
“For modification programs designed to provide temporary relief for current borrowers affected by COVID-19, financial institutions may presume that borrowers that are current on payments are not experiencing financial difficulties at the time of the modification for purposes of determining TDR status, and thus no further TDR analysis is required for each loan modification in the program. Modification or deferral programs mandated by the federal or a state government related to COVID-19 would not be in the scope of ASC 310-40, e.g., a state program that requires all institutions within that state to suspend mortgage payments for a specified period.”
Some expect that a suspension of current expected credit loss standards, or the Current Expected Credit Loss (CECL) model, should be extended for the next two years since there will be a massive impact on difficulties surrounding bank funding. Just like the great recession of 2008, financial models were not specifically optimized for scenarios of volatile and rapid change.
While all financial institutions must be CECL compliant, the oncoming credit deterioration of most debtors will significantly change the landscape – and, this will need to be measured and considered.
The great recession happened over a decade ago, and that’s about how long financial institutions have had to deal with TDRs at this level – but, the economic effects related to the COVID-19 pandemic will be unlike anything ever experienced in the 21st century. Bankers will be dealing with novel cash needs, closings, and how to reopen businesses with new health guidelines. As a result, efficient TDR processes need to be put in place now.
COVID-19 and TDRs
During this time, financial institutions will need to work closely with banking regulators and the SEC. So then, the measurement of the necessary reserves needed for determining a TDR is often an inefficient manual process that can produce extraordinary bottlenecks and challenges to a speedy recovery.
Knowing that this is coming, there is no time like the present to start automating your processes. The allowance should be automated, as well. In addition, it’s imperative to include how modifications may be made and how it will affect CECL models. Thinking outside the box will be necessary.
Establishing good will is imperative as there will be many businesses that will not have the ability to recover from the economic pummeling. In fact, many will need more than just a TDR. The good news is regulators will not penalize financial institutions for using sound practices in offering various risk mitigation solutions to their clients.
Also, if a payment deferral is agreed upon – and it is not reported yet as past due – then, it won’t be considered past due even during the deferral. Plus, TDRs following the guidance can still be considered collateral based on the Fed’s discount window.
Increase defensibility of risk management processes through documentation for examiners, auditors, and others.
Since risk management is even more important now, automation can help to increase defensibility with auditors, regulators, and examiners. It can also help to reduce user error around siloes and manual entry when the onslaught of TDRs are requested and determined.
Look for new ways to improve the way you assist your customers. Consider implementing a COVID-19 recovery assistance program to use practices deemed “safe and sound” for mitigating credit risk. Involve key stakeholders in designing and implementing this type of program. Think of how this program will impact both liquidity and capital.
Payment status evaluation can then be made once the program is deployed. And, compliance should be addressed. Then, use automation for lease and loan modifications. It is critical to streamline, and simplify, your processes. For example, you might decide to design your automated processes so that they maintain the yield while ensuring compliance with current guidelines.
There isn’t any question that TDRs will come to the forefront once again. So then, the sooner you automate your TDR processes, the sooner you can help the influx of customers seeking assistance from your financial institution.