In the current banking environment, risk management is critical, particularly when it comes to a bank’s lending activities. One potential strategy for reducing risk associated with commercial loans is cross-collateralization — that is, using multiple properties to secure a loan associated with one property.
Cross-collateralization can provide significant benefits, but the strategy raises several issues banks must consider before adopting it. It also may raise issues in a nonlending context. (See the sidebar “Watch out for IRA cross-collateralization.”)
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 will likely be forced to increase 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 March 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 place the other loan on 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.
Another example indicates that the outcome might be different if loan A has “a consistent dedicated source of repayment” and the bank can support the assertion that cross-collateralization won’t affect loan A’s timely repayment.
Considerations when restructuring debt
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.
To avoid TDR status, however, the bank must ensure that the additional collateral is sufficient to compensate the bank for the other terms of the restructuring. Accounting standards provide guidance but don’t give examples of every possible set of facts to make this determination. So, when in doubt, have your accounting advisor evaluate the terms of a proposed restructuring.
Weigh the risks
Cross-collateralization can be an effective way to reduce risk, but it also can introduce new risks into the equation. Community banks should carefully weigh the benefits of cross-collateralization against its potential pitfalls.
Watch out for IRA cross-collateralization
Banks and brokerage firms sometimes require IRA owners to sign cross-collateralization agreements. Typically, these agreements provide that the owner’s non-IRA accounts may be used to cover a shortfall in the IRA — for example, if the IRA experiences investment-related losses, or incurs fees that exceed the amount in the IRA. Similarly, the IRA may be used to cover shortfalls in non-IRA accounts.
Recently, the U.S. Department of Labor issued two advisory opinions stating that these arrangements are prohibited transactions that endanger an IRA’s tax-exempt status. The DOL is considering further action on this issue.
In response, the IRS has provided temporary relief to IRA owners who’ve entered into cross-collateralization agreements. The Service won’t treat these agreements as a taxable event provided there’s been no execution or other enforcement against the IRA assets.