At the point in time when the economic structure of loan becomes financially unsupportable for the borrower, a lender is faced with a few options. The lender could simply default the loan and begin collection activity. Alternatively, the lender could seek to re-work the deal in some way to provide some breathing room for the borrower. No good deed goes un-punished, so it’s good to understand the impact of the two most common types of borrower accommodations – the loan modification and the forbearance agreement.
First; the basics. The core purpose of a loan modification is to adjust the terms of a loan because the borrower would have been in default under the prior terms. The notion being that the loan relationship is going to continue. The core purpose of a forbearance agreement is to prevail over the prior loan terms and legal rights for a period of time because the borrower needs relief from those rights in order to accomplish something of value to the lender. The notion being that forbearance is not a long term fix.
That is not to say that there isn’t significant cross over for both types. A loan modification may reduce payments and shorten maturity with the expectation of a re-fi. Alternatively, a forbearance agreement may contemplate installment payments and an extended payout after maturity. In between the two types of agreements there are a lot of different ways to structure the deals and choosing the right one is as much strategy as tactics.
Below is a breakdown of how different deal specifics typically are reflected in a loan modification vs. a forbearance agreement.
|While a default may have existed just prior to the modification, after a modification the prior default is withdrawn.||The prior default will typically still exist.||With an existing and recognized default, the lender will not need to re-default the loan at a later time. This will reduce the time to collection activity in relation to the loan document terms.|
|Regardless of whether the loan was previously accelerated, the modification will withdraw the acceleration.||The loan will typically remain accelerated.||Acceleration permits the lender to collect the whole debt immediately. This and the default may be an issue if the borrower files bankruptcy. In most jurisdictions, a bankruptcy court will require a lender to obtain relief from the automatic stay in order to accelerate the loan after the borrower files bankruptcy.|
|Maturity may be modified as part of the loan modification. Although a loan modification can effect any terms of the original loan document, such as covenants, or economic / payment terms also.||Maturity will have already occurred because of the default and acceleration. A new maturity will not usually be provided because the loan typically remains in default under forbearance and throughout the forbearance period.||Lack of a new maturity date under a forbearance provides the lender with a quicker reaction time for collection work. On the other hand, modifying the maturity gives a borrower more flexibility under the loan terms to attempt to pay back the loan.|
Statute of Limitations
|As long as the maturity (and acceleration) remains in the future, most direct collection causes of action will not have their statute of limitations start running.||Once the loan is mature and accelerated the statute of limitations for collections begins to run.||It’s important to stay on top of your statute of limitations after acceleration and maturity. If those deadlines are not extended, time will be on the side of the borrower (and guarantors).|
Rights of Lender
|A loan modification typically has similar terms to the original loan documents, but not always. This is a good time to clean up any outstanding items.||After default, the collection options are all open to the lender. However, forbearance agreements will usually curb those to some extent during the forbearance period.||Because loan modifications usually track closing with what a bank rep is used to dealing with, it takes less oversight to monitor. On the other hand, forbearance is a whole new deal which might not integrate into the lender’s system or process well.|
Notices of Future Default
|Lender will need to comply with the terms of the modification.||Lender will need to comply with the terms of the forbearance. The difference is that the default under the loan agreement has already occurred and a forbearance agreement usually has a much tighter default provision; often with no cure period.||With the notice periods in a loan modification applicable, the time to declare a default will cause a delay in moving forward. Any cure time will add to this. On the other hand, a forbearance will not require a default under the loan (and its provisions), but rather whatever the lender requires under the forbearance agreement.|
|Bank accounting is beyond the scope here, but a modification may be shown as a differently from a non-performing loan.||Bank accounting is beyond the scope here, but forbearance is likely still a non-performing loan.||Consult your compliance folks on this.|
|A modification will usually avoid a default for a borrower, which will have a significantly more positive impact on the borrower vs a forbearance.||A forbearance will have a significantly more negative impact of the borrower because the default and acceleration will be subsisting. Additionally, even in simple capital structures, loans by other lenders will often “cross default” resulting in a domino effect when the first of several loans to various lenders is put into formal default.||
If the borrower has a chance of a refi at a different institution or program a default may preclude the refi. So, a lender should consider its gain vs. its collateral.
Also, if the borrower is under several different loan agreements with different lenders, the defaulting lender should be aware of the potential domino effect and resulting spiral downward.
The decision to enter into a loan modification or a forbearance is both a strategic and tactical one. I have outlined just a few considerations for making a determination. In practice the process is extremely deal specific and, frankly, a risk opportunity.
Beyond the scope of this article is the impact each can have in bankruptcy, collection litigation and lender liability. All of which should be considered.
As always, remember – no good deed goes unpunished.