What are the best ways to successfully bring loans with devalued collateral back into compliance with reasonable risk profiles while maintaining good borrower relationships?
By Amanda YoderIn an ever-changing marketplace, many banks and borrowers become plagued by the potential of collateral becoming devalued. For banks, there is the need to protect from loss on loans. For borrowers, it is the fear of substantial changes in loan structure that makes a loan no longer feasible. While the credit market has certainly kept banks attentive in the past few years, one area they have particularly been concerned about is altering real estate values and how to work through these changes at an individual borrower level.
Strategies at a global, bank-wide level may include:
- Profiling and categorizing loans based on risk exposure
- Overall portfolio diversification
- Stress testing
- Contingency plans for managing potential losses
- Continuous monitoring of market trends to help manage and adapt bank policies
- Incorporating borrower expertise of industries to understand challenges and future projections more specifically
While these are very important and should be evaluated, navigating an individual borrower’s collateral devaluation is a particularly important strategy for banks to look closely at.
As a first line of defense against loss, bankers will want to monitor collateral value closely. This is especially true for real estate. While real estate collateral is often considered high value due to its relatively stable value, easy marketability and readily ascertainable value, during the last few years, evolving workplace and retail patterns have left the stability of real estate values in question. Therefore, regular assessment of borrowers with substantial real estate collateral will be critical.
Often, loan documents will limit the number of times a borrower may be responsible for the cost of a formal appraisal or field exam. However, informal resources such as internal expertise, online valuation tools, portfolio comparisons of similar assets and public databases are common resources to effectively track collateral values.
In addition to monitoring collateral values for those borrowers with heavy real estate portfolios, a review of the applicable loan documents will also be critical. Bankers need to ensure that loan documents contain provisions that address collateral value fluctuations to provide the most excellent protection to the bank.
These provisions may include:
- Required loan-to-value and collateral maintenance. This confirms appropriate loan-to-value provisions and whether current loan-to-value ratios remain suitable for the existing risk profile of a borrower.
- Valuation of collateral. This confirms the bank has ample discretion to value collateral whether at borrower cost or otherwise.
- Additional collateral requirements. This ensures the bank has the right to require the borrower to provide other collateral in the case of declining collateral values. These provisions may also require varying types of collateral to diversify a borrower’s collateral pool to reduce the impact of future collateral value fluctuations.
Upon reviewing relevant loan documents, to the extent protective provisions are lacking, it is never too early to discuss amendments to the loan documents with a borrower.
After assessing a borrower’s collateral pool and relevant loan documents, if a particular borrower’s collateral has reduced in value below acceptable levels, here are a few steps to protect the bank further and address these collateral value fluctuations:
Renegotiation of terms. Bankers may first discuss the potential to restructure the transaction with the borrower. There are many options for restructuring a troubled loan. These options include:
- Paydown of the loan to maintain required loan-to-value ratios.
- Provide additional reserve accounts for debt service, capital improvements or other similar accounts tailored to the property type and risk factors.
- Provide additional collateral to restore acceptable collateral value levels.
- Explore the possibility of additional capital contributions or guarantors to strengthen the borrower’s financial strength and the loan.
Understanding legal options. To the extent a renegotiation of terms with the borrower is impossible, it is essential to understand the next steps for recourse. These options will be highly dependent on each borrower and whether the reduction in collateral values is a first step to an exit for the borrower or whether the relationship will be maintained with the bank.
Maintaining open communications. Regardless of the course taken with a borrower, keeping clear and open communications with a borrower will be vital to finding a win-win solution for collateral devaluations.
It is essential to seek advice from industry consultants, legal counsel and other specialists to assist in navigating these collateral issues. A combination of these strategies is likely necessary to successfully bring loans with devalued collateral back into compliance with policies and risk profiles while maintaining good borrower relationships.