On September 27, 2017, the Federal Reserve, FDIC and OCC released a Notice of Proposed Rulemaking (NPR) that they describe as simplifying compliance with certain aspects of the agencies’ risk based capital (RBC) rules to, among other things, replace the standardized approach’s (SA) treatment of HVCRE loans with a simpler treatment for most acquisition, development or construction (ADC) loans called high volatility acquisition, development or construction (HVADC). Spoiler alert: it just replaces vague and confusing rules with a slightly different set of vague and confusing rules.
On a going forward basis:
- HVADC would replace the HVCRE regime for the standardized approach (but not for banks using the advanced approach (AA)…(sort of) since most AA banks are required to follow the SA under certain circumstances, the AA banks will likely be subject to HVADC one way or another);
- Arguably, the HVADC regime applies to a wider range of loans (as it doesn’t have an exemption regarding borrower contributed capital BUT (and this is a big but) it does, therefore, remove the dividend blocker (i.e., the restriction on the distribution of internally generated capital)). To solve for the impact of this wider net, the agencies agreed to reduce the risk weight;
- HVADC loans would receive a 130% risk weight (rather than the 150% under the HVCRE regime);
- “Permanent loans” (or “prudently underwritten loans” that have a clearly identified ongoing source of repayment sufficient to service amortizing principal and interest payments aside from the sale of the property) would be exempt from HVADC; and
- HVADC would apply to loans originated after the effective date of the final rule (the loans made prior to that date would fall under HVCRE). Query how the grandfathering will work (e.g., what that means for signed term sheets prior to the effective date). More on that (and other issues later).
What? Exactly! Just when we were getting used to HVCRE and all of the issues posed by it and getting excited about the prospects of amending it (See Pittenger Bill), the government throws us for a loop. As part of the government’s efforts (the Economic Growth and Regulatory Paperwork Reduction Act of 1996 in which Congress agreed to meaningfully reduce regulatory burden, especially on community banking organizations) to reduce regulatory burdens, they established (well…to be fair, propose to establish) a new regulatory regime. As an aside – EGRPRA has been on the books for 20+ years but that probably won’t stop President Trump from taking credit (assuming everything goes well and everyone is happy).
It is possible that this new regime will come to simplify the issues surrounding the treatment of ADC loans for the standardized approach. Clearly – by deleting the infamous exemption #4 (click here), it does eliminate all of the questions, ambiguities and issues that plagued that exemption: issues about how to calculate the “cash” contribution of the borrower, how to deal with the prohibition on distribution of internally generated capital and others.
However, it raises all new issues: (1) there are new terms of art (like “primarily finances or refinances”) that the industry and regulators will need to digest and define, (2) banks and regulators will need to determine how to reconcile HVADC with HVCRE (as both may apply in certain circumstances), (3) the new rule still begs the question as to why acquisition loans (with no development or construction component) are even included, (4) does “permanent loan” mean self-amortizing? (the last fully amortizing commercial loan we remember was before the Mesozoic Age ended…), (5) if a previously HVADC loan can later become exempt by becoming a permanent loan, does that mean a previously exempt permanent loan can later fall into HVADC (presumably, you’d have a loan in default and requiring a higher risk weight anyway?), and (6) other issues around risk based capital rules, the advanced approach application and standardized approach application and on and on and on. If this all makes your head hurt, you’re not alone.
Over the course of the next month or so, we at Crunched Credit are going to wade through the issues, ambiguities and frustrations, digest the industry comments (the public will have 60 days from the date the rule is published in the Federal Register to comment) and hope to make sense of this. Hang in there and stay tuned.
In the meantime, see below for some helpful information:
- For background on HVCRE brought to you by us at Crunched Credit: click here, here, here and here.
- As a refresher and for a good summary of the comparisons/clarifications of the HVADC rule versus HVCRE: click here.
See below for some marginally helpful information:
The text of the HVADC rule is:
High volatility acquisition, development, or construction (HVADC) exposure means a credit facility that is originated on or after [effective date] and that:
(1) Primarily finances or refinances the:
(i) Acquisition of vacant or developed land;
(ii) Development of land to prepare to erect new structures including, but not limited to, the laying of sewers or water pipes and demolishing existing structures; or
(iii) Construction of buildings, dwellings, or other improvements including additions or alterations to existing structures; and
(2) Is not a credit facility that finances or refinances:
(i) One- to four-family residential properties;
(ii) Real property projects that would have the primary purpose of “community development” as defined under [12 CFR part 25 (national bank), 12 CFR part 195 (Federal savings association) (OCC); 12 CFR part 228 (Board); 12 CFR part 345 (FDIC)]; or
(iii) The purchase or development of agricultural land, including, but not limited to, all land used or usable for agricultural purposes (such as crop and livestock production), provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for commercial or residential development; and
(3) Is not a permanent loan. A permanent loan for purposes of this definition means a prudently underwritten loan that has a clearly identified ongoing source of repayment sufficient to service amortizing principal and interest payments aside from the sale of the property. For purposes of this section, a permanent loan does not include a loan that finances or refinances a stabilization period or unsold lots or units of for-sale projects.
Read the full NPR here.