To: Chief Executive Officers of all National Banks, Deputy Comptrollers,
District Administrators, Directors and all Examining Personnel

PURPOSE

This issuance provides a summary of supervisory and reporting guidance
to help banks deal with troubled borrowers or non- troubled borrowers
operating in troubled industries. The issuance addresses: 1) refinancing
medium-term commercial real estate loans; 2) loan concentrations; 3)
troubled debt restructurings; 4) returning a loan with a partial
charge-off to accrual status; 5) recognition of interest income on a
cash basis; and, 6) enhanced disclosure of nonaccrual loans. Some of
these matters were previously discussed in the joint agency supervisory
release of March 1, 1991, which was distributed as Banking Bulletin
91-07.

BACKGROUND

Many national bank customers are experiencing financial difficulties,
particularly those involved in industries such as real estate. Periods
of economic uncertainty for a major industry provide significant
challenges for banks. In commercial real estate markets, overcapacity,
declines in value of financed projects, and more cautious lending
practices and less availability of financing from traditional non-bank
sources (such as insurance companies, pension funds, etc.) have made
bank loan portfolios riskier.

In this environment, it is important that bankers understand supervisory
and reporting requirements when assessing the options available to them
in working with borrowers. Understanding these requirements will help
institutions avoid unnecessarily restricting the availability of credit
to sound borrowers, especially in sectors of the economy that are
experiencing temporary problems. The OCC supports banks making loans on
sound terms to creditworthy borrowers. Similarly, the OCC supports
bankers\' efforts to develop a strategy to minimize losses on troubled
loans \-- which frequently means working with the borrower. It is
important that lack of understanding or misunderstandings about
supervisory policies not adversely affect the availability of credit to
sound borrowers or the prudent working out of loans to troubled
borrowers.

Loan workouts can take a number of forms: simple renewal or extension of
the loan terms; extension of additional credit; formal restructuring of
the loan terms with or without concessions; or, in some cases,
foreclosure on underlying collateral. Banks should choose the
alternative that will maximize the recovery on each troubled loan. This
circular presents supervisory considerations regarding these options.

Accurate reporting of troubled loans is also important. Banks\'
disclosures of troubled loans should enable analysts and other readers
of the financial statements to understand fully the effects, both
positive and negative, that such loans have on the bank\'s financial
condition and results of operations. This issuance also clarifies
certain reporting policies regarding troubled loans.

LOAN WORKOUTS

[Refinancing of medium-term commercial real estate loans]{.underline}

Many commercial banks aggressively participated in the 1980\'s real
estate boom by originating a large number of real estate construction
and development loans. In today\'s market, commercial real estate
borrowers are having difficulty obtaining planned post-construction
refinancing and purchase financing for real estate development projects.
In many cases, the usual sources for this financing, such as insurance
companies and institutional investors, are currently not available. In
other cases, projects that the bank financed are not performing in
accordance with original projections. Consequently, banks are frequently
faced with the choice of renewing a loan they had not planned to renew,
restructuring the loan, or foreclosing on the collateral.

This environment presents significant challenges to banks in maintaining
standards of asset quality and diversification. The OCC recognizes
that,in many cases, the most effective way for banks to minimize their
losses on existing loans may be to renew or extend loans beyond the
original plan. In other cases it may make sense to restructure the loan
terms. As with any commercial credit, these renewals, extensions, or
restructurings must be based on sound underwriting standards and must be
subject to normal loan classification rules. A bank will not be
criticized for continuing to carry such loans as long as the bank has a
well conceived and effective workout plan for the borrower, effective
internal controls to manage the levels of these loans, has classified
the loan in cases where weaknesses exist, and has properly considered
these loans when determining the level of the allowance for loan and
lease losses.

[Concentration of credit]{.underline}

Banks and the OCC have long recognized portfolio diversification as an
important element of an overall risk management strategy. Banks have
been criticized by the OCC for having excessive concentrations in
certain industries. In some cases, concentrations have been the subject
of OCC enforcement actions. In recent months, fear of regulatory
criticism for adding to, or not reducing, concentration levels has led
some banks to hesitate to extend credit to new creditworthy borrowers or
to renew existing sound loans.

However, concentration risk is only one consideration in managing the
risks associated with troubled borrowers and industries. The OCC
recognizes that it may be appropriate for a bank to make additional
loans, on prudent terms, in an industry where the bank has a
concentration, if it has effective internal systems and controls in
place to manage concentration risk. When management believes the
renewal, extension, or restructuring of credit is the best way to work
out an existing troubled relationship and avoid further losses, the
level of loans to a particular industry should not deter management from
exercising its best judgment. The OCC will criticize a bank for failing
to recognize the reality of a troubled loan but will not criticize a
bank that manages a troubled loan using a well conceived and effective
workout strategy.

[Troubled debt restructurings (TDRs)]{.underline}

Some banks feel that TDRs implemented in accordance with Statement of
Financial Accounting Standards No. 15, \"Accounting by Debtors and
Creditors For Troubled Debt Restructurings\" (FAS 15) will not work in
today\'s environment. Some of these banks believe that FAS 15 requires
the lender to grant the borrower a large concession. Others believe the
lender must wait a period of time after the restructuring before the
loan can be returned to accrual status. Neither belief is always the
case.

The OCC believes TDRs can be useful in meeting sound business and
reporting objectives. Restructurings should be undertaken in a way that
improves the likelihood that the loan will be repaid in full. Regulatory
reporting policies and generally accepted accounting principles (GAAP)
do not require banks to grant excessive concessions, forgive principal,
or take other steps that are not commensurate with the borrower\'s
ability to repay. The only concessions required are those needed to
restore the expectation of full collectibility. The amount and size of
those concessions depends on the nature of the loan and the financial
condition of the borrower.

Regulatory reporting requirements and GAAP do not prevent banks from
including contingent payment provisions in the restructured terms. For
example, a bank may reduce the interest rate on a troubled loan but
require the borrower to pay the bank a percentage of any gain realized
if the collateral is sold. Or, the bank may require that the reduced
rate will automatically revert to a market rate if the borrower meets
certain profit levels. Thus, the bank can recover concessions granted
during periods of economic troubles if the borrower\'s financial
condition improves.

It is not always necessary for a bank to wait a period of time after the
restructuring before returning a restructured loan to accrual status.
Rather, in some situations, the loan can return to accrual status
immediately after the restructuring if the return is supported by a well
documented credit evaluation of the borrower\'s financial condition and
the prospects for full repayment. Examples include 1) payment
performance immediately prior to the restructuring or 2) other
significant factors that preclude the need for demonstrated performance.

[Payment performance]{.underline} in accordance with the newly
restructured terms is one of the most important forms of evidence used
to decide whether the borrower can fully meet the restructured terms.
The performance to be assessed should not be limited to that occurring
after the restructuring. Performance immediately prior to the
restructuring should also be considered. Often the level of debt service
on a restructured loan is less than the payment the borrower was making
before the restructuring. If this is the case, and the borrower is
expected to be able to continue this level of performance and fully
repay the new contractual amounts due, the loan can immediately return
to accrual status.

[Other significant factors]{.underline} may constitute a preponderance
of evidence that the loan will be repaid in full. Those factors may be
sufficient to allow the loan to return immediately to accrual status
without demonstrated performance under the restructured terms. Such
factors include substantial and reliable new sales, lease or rental
contracts, or other important developments that significantly increase
the borrower\'s net cash flow and debt service capacity and strengthen
the borrower\'s commitment to repay. If such factors are not enough to
eliminate entirely the need for demonstrated performance, they may
reduce the period of performance otherwise considered necessary.

The instructions to the Consolidated Reports of Condition and Income
(Call Reports) were amended as of June 30, 1991, to permit the removal
of restructurings that are in compliance with their modified terms and
yielding a market rate of interest from restructured debt reporting
after the year in which the restructuring occurs. In situations where a
partial charge-off has been taken before the restructuring, an interest
rate concession may still achieve an effective yield that approximates a
market rate. This is because FAS 15 requires that the effective yield be
computed based on the [recorded]{.underline} loan balance instead of the
contractual balance. This situation is even more frequent in today\'s
environment given recent declines in interest rates.

Because many banks have taken charge-offs on troubled loans, the TDR
can, in some cases, use a two-note structure to return one \"good\" note
to accrual status, with the troubled note accounted for separately. The
troubled note may represent the lender\'s contractual claim on the
portion of the loan that has been charged-off. For example:

-   Assume that a bank has a \$10 million loan secured by real estate.
    The loan is on nonaccrual status and \$1 million has been charged
    off. Cash flows are adequate to service only a \$9 million loan at a
    market rate of interest. The bank formally restructures the loan by
    dividing it into two notes. The first is for \$9 million and carries
    a market rate of interest. The second is for \$1 million (the
    charged-off portion of the note to which the bank retains a claim)
    and carries a below market rate of interest. The bank forgives no
    principal. This restructuring meets the requirements of FAS 15, and
    assuming that full collection of the \$9 million loan and the
    borrower\'s continued performance under the modified terms are
    expected, that loan can return to accrual status.

The return to accrual status must always be supported by well documented
evidence of the borrower\'s financial condition and the expectation of
complete repayment under the revised terms. The restructuring should
improve the collectibility of the loan in accordance with a reasonable
repayment schedule. The amount of charge-off must be based on a good
faith evaluation of collectibility and cannot be calculated simply to
achieve a specified rate of interest or avoid future troubled debt
disclosures. In every TDR, the bank must make a good faith evaluation of
the collectibility of the new contractual principal and interest,
maintain the allowance for loan and lease losses at an appropriate level
and charge off all identified losses in a timely manner.

REPORTING CONSIDERATIONS

[Returning a loan with a partial charge-off to accrual
status]{.underline}

On March 1, 1991, the four federal banking and thrift regulatory
agencies jointly issued a statement clarifying certain supervisory and
reporting policies. The release also announced the pending issuance of a
request for comment on a proposed reporting standard that would permit
certain partially charged-off nonaccrual loans to return to accrual
status.

The proposal (sometimes called \"loan splitting\") was published for
comment on March 18, 1991, with a 45-day comment period that ended May
2. Most of the comments received indicated concerns that the proposal
was not in conformity with GAAP. A number of commenters expressed
concern that such differences might diminish the integrity of bank
financial reporting. While noting these concerns, the agencies also
observed that in some respects where the proposal differed from GAAP,
such as the areas of loss recognition and disclosure, the proposal was
more conservative than GAAP. As a longstanding practice, however, the
agencies have attempted to minimize differences between regulatory
reporting requirements and GAAP.

For that reason, the agencies recently announced in the [Federal
Register]{.underline} that the proposal has been withdrawn. The agencies
have agreed to participate in projects underway by the American
Institute of Certified Public Accountants (AICPA) and the Financial
Accounting Standards Board (FASB) to attempt to resolve issues relating
to recognizing income on nonaccrual loans and estimating credit losses
on certain loans.

The federal banking agencies have included guidance on certain aspects
of the March 1 policy statement in the instructions for the June 30,
1991 Call Report. This issuance reiterates those policies and is
intended to encourage depository institutions to continue to work with
borrowers who are experiencing difficulties and to avoid restricting the
availability of credit to sound borrowers, particularly in areas of the
economy that may be experiencing temporary problems.

[Cash-basis interest recognition]{.underline}

For partially charged-off loans where the remaining recorded balance is
considered fully collectible, recognition of interest income on a cash
basis is an appropriate alternative to \"loan splitting\" when combined
with increased disclosure of the contribution to income that nonaccrual
loans provide.

While a loan is in nonaccrual status, some or all of the cash interest
payments received may be treated as interest income on a cash basis.
This can occur only if the remaining book balance of the loan (i.e., the
balance after charge-off of identified losses, if any) is deemed to be
fully collectible. The amount of interest income that should be
recognized is limited to that which would have been accrued on the
asset\'s remaining book balance at the contractual rate. Any excess over
that amount should be recorded as recoveries of amounts previously
charged- off until the charge-off is fully recovered.

A bank\'s determination of the ultimate collectibility of a loan\'s
remaining book balance must be supported by a current, well documented
credit evaluation of the borrower\'s financial condition. Prospects for
repayment must also be evaluated, including such factors as the
borrower\'s historical repayment performance and other relevant factors.

[Suggested increased nonaccrual disclosure]{.underline}

Many financial statement readers use banks\' current nonaccrual loan
disclosures as an important barometer of financial condition. Many
analysts place heavy emphasis on the levels of nonaccrual loans in
projecting future loan losses and earnings. Few banks take the
opportunity to show that there are varying degrees of problems in the
reported total of nonaccrual loans. Few indicate to the reader that many
of these assets provide a contribution to earnings through cash basis
interest income and loan loss recoveries.

In January 1991, the OCC suggested a format in Banking Bulletin 91-05
for voluntary disclosures relating to nonaccrual loans. In addition to
the cash-basis interest income recorded on such loans, disclosure can
include charge-offs taken and cash payments applied as loan loss
recoveries. Banks may also segregate loans that are generating
substantial cash flows relative to other nonaccrual loans to help
distinguish those loans that are current but are in nonaccrual status
due to concerns regarding the borrower\'s financial condition. The OCC
suggested that this increased disclosure also might be extended to other
real estate owned so that analysts can see the contribution those assets
make to operating income.

[Accrual status of partially charged-off loans]{.underline}

There may be circumstances when a partially charged-off loan can return
to accrual status without first recovering the partial charge-off. In
accordance with the Call Report instructions, this is permitted when the
loan has been brought fully current with respect to principal and
interest and the bank expects that the full contractual balance of the
loan (including any amount charged-off) plus interest will be fully
collected under the terms of the loan. (These instructions also provide
that certain past due loans may return to accrual status if they are
both well secured and in the process of collection.)

Ordinarily, a partial charge-off would indicate that the bank does not
expect full repayment of the amounts contractually due and the loan
would, therefore, remain on nonaccrual status. If, however, facts have
changed since the charge-off was taken such that the full amounts
contractually due, including the amounts charged-off, are expected to be
collected and the loan is contractually current, the partially
charged-off loan could return to accrual status. This determination must
be supported by a well documented credit evaluation of the borrower\'s
financial condition and the prospects for full repayment.

OTHER RELATED OCC RELEASES

The following recent banking and examining issuances contain additional
guidance dealing with troubled loan situations and reporting troubled
assets:

Banking Bulletin 91-05 \-- \"Public Disclosure on Nonaccrual Loans\"

Banking Bulletin 91-07 \-- \"Joint Agency Policy Statements\"

Banking Bulletin 91-19 \-- \"Nonaccrual Loan Issues\"

Examining Bulletin 91-02 \-- \"Joint Agency Statements Clarifying
Certain Regulatory Policies\"

Questions about this Banking Circular, or any of the issuances listed
above, should be directed to the Office of the Chief Accountant at (202)
874-5180.

ORIGINATING OFFICE

Chief National Bank Examiner\'s Office

Office of the Chief Accountant

Susan F. Krause

Senior Deputy Comptroller for

Bank Supervision Policy