Beginning Q2-2020 Financial Institutions (FIs) will report High Volatility Commercial Real Estate (HVCRE) using recently eased and clarified rules. HVCRE loans are assigned a risk weight of 150% reflecting their construction and stabilization risk versus 100% for most commercial loans.
Key changes/clarifications are:
HVCRE is now defined more narrowly as HVCRE ADC:
New rules are now all-or-nothing and key terms and designations are linked to Call Report and Y-9 definitions. If 50% or more of the cash flow, loan funds or collateral are HVCRE ADC related then 100% of the loan is considered HVCRE. Exemptions now incorporate Supervisory LTV and borrower contributed capital. Analyses of collateral and borrower-contributed capital has to be properly documented.
A borrower can contribute capital in the form of cash, unencumbered marketable assets, related appraised value of real property, and development expenses paid out of pocket (to include legal fees, appraisals, development fees, and any other fees needed to complete the project). There is no restriction on distributing contributed capital in excess of the 15% requirement.
The new rules allow for declassification of HVCRE.
Project must be complete and the cash flow sufficient to meet debt service and operating expenses consistent with internal underwriting standards.
Currently, should a borrower wish to refinance a maturing HVCRE loan and reclassify the construction loan to a permanent loan (a normal 10-year fixed-rate loan), the lender would have to receive full payment and close out the loan entirely. Under these conditions, banks run the risk of losing that loan to a competitor. The clarified rule would allow banks to transition HVCRE loans to permanent loans once the project is stable, allowing banks to keep the loan on their books.
a. CRE lenders with existing HVCRE exposure should review each loan for declassification. Due to the technical requirements involved with classifying and declassifying HVCRE we recommend using an HVCRE checklist to assist UW and portfolio management personnel in determining the correct designation.
b. All banks should review internal controls and procedures to accurately reflect the information correctly in their loan monitoring reports and Call Reports.
c. Many community banks that choose to opt in to simplified CBLR (Community Banking Leverage ratio) framework after March 31, 2020 may not need to necessarily worry about HVCRE classifications for capital calculations. However, CBLR framework may not be the best option for banks in strong growth mode, or those that are contemplating a merger transaction – and thus they may still need to stay abreast with HVCRE developments.
d. Final designations should be documented highlighting the key HVCRE considerations
e. We also recommend periodic stress testing of AD&C loans to understand the range of capital at risk underlying this asset class.
Strategic Risk Associates
Senior Managing Director
Strategic Risk Associates
Twitter - @therisksteward