October 5, 2017
On September 27, 2017, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (Agencies) issued a proposal (Proposal) that would amend some of the current Basel III capital rules – foremost among them, the heightened capital charge for so-called “high volatility commercial real estate” (HVCRE).
The HVCRE capital charge has been controversial since the Agencies finalized the Basel III rules in 2013 (Final Basel Rule). For real estate loans that qualify as HVCRE, the current capital charge is 50 percent higher than for unsecured commercial loans and real estate loans that do not qualify as HVCRE. Moreover, the HVCRE capital charge is a form of U.S. “gold plating” of international capital standards – the HVCRE concept does not exist under the approach of the Basel Committee itself. And there have been a host of interpretive questions on what exactly constitutes HVCRE – with some of the public Agency answers containing unexpectedly conservative glosses on the Final Basel Rule.
The Proposal states that it is seeking to simplify HVCRE treatment. To that end, it introduces a new concept – “high volatility acquisition, development, and construction” loans (HVADC) – and imposes a lower, but still “gold plated,” capital charge that is 30 percent higher than the capital charge for unsecured commercial loans and non-HVADC real estate loans.
The Proposal is subject to a 60-day comment period beginning on publication in the Federal Register.
HVCRE treatment is most relevant under the Final Basel Rule’s so-called “standardized approach” to capital calculations. All U.S. banking organizations use the standardized approach to some degree: for most, it is the only relevant approach to calculating capital. But it is also relevant to the largest, most sophisticated institutions that use “advanced approaches” to capital treatment, which permit the use of internal models. This is because Dodd-Frank’s Collins Amendment requires such institutions to calculate capital under the standardized approach as well, and then use the approach that requires the most capital when reporting their capital ratios.
Under the Final Basel Rule, an HVCRE loan is “a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property,”[1] subject to certain exemptions. These exemptions, in addition to permanent financings, which are not HVCRE, include:
Loans that qualify for one of the exemptions are not subject to the heightened HVCRE capital charge.
HVCRE treatment has spawned interpretive questions, perhaps the most important of which relates to the borrower contributed capital requirement of the fourth exemption above:
Although the Final Rule seems very clear that only the 15 percent of “as completed” value contributed by the borrower as capital, “or” internally generated project earnings, is required to remain in the project until permanent financing is in place, the Agencies issued an FAQ answer that took a different position:
“15. The definition of HVCRE includes a provision that “the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.” What does “contractually required” mean in this context?
In order to meet this criterion in paragraph (4)(iii) of the HVCRE definition, the loan documentation must include terms requiring that all contributed or internally generated capital remain in the project throughout the life of the project. The borrower must not have the ability to withdraw either the capital contribution or the capital generated internally by the project prior to obtaining permanent financing, selling the project, or paying the loan in full.”[3]
The Proposal would replace the HVCRE definition in the standardized approach with the HVADC definition, which would apply to all credit facilities that “primarily” finance or refinance:
“Primarily” would mean credit facilities “where more than 50 percent of loan proceeds will be used for” such activities.[5] HVADC loans would carry a capital charge 30 percent higher than unsecured corporate loans and non-HVADC real estate loans.
With respect to the use of proceeds test, the Agencies stated that they expect “every [ADC] transaction to be supported by . . . documentation of sources and uses of funds tailored to the specific project” and expect “each banking organization to have a process in place to review the intended use of funds” for an ADC project, “consistent with prudent underwriting practices.”[6]
The Proposal would retain the exemptions for loans for one- to four-family residential properties, agricultural land acquisition loans, community development loans, and permanent financings. It would not, however, include any exemption similar to the current Rule’s minimum LTV/ borrower contributed capital exemption.
With respect to the one- to four-family residential property exemption, the Agencies stated that it would include “both loans to construct one- to four-family residential structures and loans that combine the land acquisition [and] development or construction of one- to four-family residential structures, either with or without a sales contract, including lot development loans.”[7] It is not a condition to the exemption that a specific buyer for a property be identified.
In addition, loans for the acquisition, development or construction of condominiums and cooperatives would not qualify for the exemption, unless the project contained fewer than five individual dwelling units. If each unit in a project is separated by a dividing wall that extends from ground to roof (rowhouses or townhouses), the unit would be considered a single residential property and qualify for the exemption. So would a loan to finance tract development – i.e., a project with multiple properties, each of which contained a one- to four-family dwelling unit. Loans used solely to acquire undeveloped land would not qualify.
Simplifying changes are proposed for the exemptions for community development loans and loans for the development of agricultural land, but the Agencies stated they were not intended to be substantive modifications of the current Rule. Agricultural land is intended to be broadly understood to encompass, for example, timberland and fish farms, but not related manufacturing or processing facilities, such as dairy processing plants.
The Proposal would provide more gloss on what constitutes a “permanent loan” than the current Rule. A “permanent loan” would be 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.”[8] However, current loan payments would not be required to be amortizing for a loan to be considered “permanent.” Bridge loans would generally not be considered permanent loans, and a permanent loan would “not include a loan that finances or refinances a stabilization period or unsold lots or units of for-sale projects.”[9] The Agencies did state that for certain owner-occupied projects, the owner “may have sufficient capacity at origination to repay the loan from ongoing operations, without relying on proceeds from the sale or lease of the property” – in which case the loan would be a permanent loan, and not an HVADC loan, at origination.[10]
The current HVCRE approach would continue until the Proposal was finalized, with the HVCRE status (or not) of loans existing at the time of a final rule being grandfathered. The Proposal would therefore have prospective application only.
The Proposal demonstrates that the Agencies continue to believe that ADC loans pose greater risk than permanent financing of development properties (and unsecured commercial loans). The Proposal, like the earlier Final Basel Rule itself, does not provide any empirical support for this belief, although it does state that “[i]n the preamble to the [Final Basel Rule], the agencies noted that their supervisory experience had demonstrated that [HVCRE] exposures . . . presented heightened risks.”[11]
If finalized, the Proposal seems likely to subject a larger number of loans to “gold plated” capital treatment. This result seems to reflect a determination by the Agencies that sorting out the full range of questions on the current Rule’s minimum LTV/borrower contributed capital exemption is too difficult an administrative task, although it is not clear why this should be the case.
In simplifying the HVCRE approach, moreover, the Proposal is highly likely to be over-inclusive as a risk matter, because the HVADC test turns on the use of a loan’s proceeds, and not on its characteristics. A loan that qualified for the minimum LTV/borrower contributed capital exemption under the current Rule, if made after the Proposal is finalized, could well be an HVADC exposure and thus require 30 percent more capital being held against it.
It is therefore appropriate to question the calibration of the 30 percent heightened capital charge and the degree to which “gold plating” of international standards is even necessary. It is also appropriate to question whether the Agencies should be providing more empirical support than asserted “supervisory experience” to justify more widespread gold plating.
[1] See, e.g., 12 C.F.R. § 3.2.
[3] Agencies, Frequently Asked Questions on the Regulatory Capital Rule (April 6, 2015).
[4] Proposed Rule, Regulatory Capital Rule: Simplification to the Capital Rule Pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of 1996. The HVADC revision does not apply to “advanced approaches” capital treatment.
Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or the following:
Financial Institutions Group:
Arthur S. Long – New York (+1 212-351-2426, [email protected])
Carl E. Kennedy – New York (+1 212-351-3951, [email protected])
Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, [email protected])
Real Estate Group:
Jesse Sharf – Los Angeles (+1 310-552-8512, [email protected])
Alan Samson – London (+44 (0) 20 7071 4222, [email protected])
Eric M. Feuerstein – New York (+1 212-351-2323, [email protected])
Erin Rothfuss – San Francisco (+1 415-393-8218, [email protected])
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