On Compliance: Proposed Capitalization of Interest Rule

The National Credit Union Administration Board approved a proposed rule in November 2020 that, if finalized as proposed, would give federally insured credit unions a new loan workout option to help accommodate members during the COVID-19 Pandemic and beyond.

Currently, federally insured credit unions have several loan workout options allowed under Appendix B to Part 741 of NCUA rules including “re-agings, extensions, deferrals, renewals, or rewrites.”  

Appendix B, however, also says that a federally insured credit union’s loan workout policy “must provide that in no event may the credit union authorize additional advances to finance unpaid interest and credit union fees,” which prohibits federally insured credit unions from capitalizing the loan’s past-due interest—i.e. adding it to the loan balance and charging interest on it—as part of a loan modification or other workout.  

The proposed rule would amend Appendix B to remove the prohibition on federally insured credit unions restructuring troubled loans by capitalizing unpaid interest in a loan workout.

If finalized, the option to capitalize interest would be especially useful for credit union loans that have been subject to forbearance during the pandemic. As the proposed rule notes, “Fannie Mae and Freddie Mac have had a long-standing policy supporting the ability of servicers to capitalize interest and fees as part of a prudent modification program.” Government-sponsored enterprise-related mortgages have been subject to a foreclosure and eviction moratorium for months that is currently scheduled to expire on March 31, 2021, but could be extended further.  

Some GSE-related mortgage borrowers affected by COVID-19 may be able to resume regular loan payments as part of a workout when this moratorium expires but not be able to pay the arrearage, the amount of money owed that showed have been paid sooner, that has accrued during the moratorium in full at that time. Similar considerations apply to non-mortgage loans that are also in forbearance. Federally insured credit unions being able to roll this arrearage, including unpaid interest, into the loan’s balance would be a straightforward and convenient way to modify these loans that would help preserve their value on an accounting basis.

The preamble to the 2012 final rule focused on requiring federally insured credit unions to discontinue accruing interest on loans that are past due by 90 days or more and also clarified “that when accrued interest is reversed, the reversed interest cannot be subsequently restored but can only be recognized as income if it is collected in cash or cash equivalents, and that there is no additional accrual until restoral to accrual conditions are met.”  

The 2012 final rule, however, did not provide a specific justification for prohibiting capitalizing unpaid interest as part of a loan modification or other workout that makes the past-due interest likely collectable. Federal banking regulations do not prohibit banks from capitalizing unpaid interest as part of a loan workout.

Six Conditions

Under the proposal, federally insured credit unions could adopt a loan workout policy that permits capitalization of unpaid interest in a modification if the policy meets six conditions:

1. The modification complies with all applicable federal and state consumer protection laws and regulations.
2. The modification’s documentation reflects the borrower’s ability to repay, the borrower’s source(s) of repayment and, when appropriate, compliance with the credit union’s valuation policies at the time the modification is approved.
3. The borrowers receive written disclosures that are clear, conspicuous, and consistent with federal and state consumer protection laws.
4. The federally insured credit union appropriately reports the loan status for the modified loans in accordance with applicable law and accounting practices, including that the credit union “shall not report a modified loan as past due if the loan was current prior to modification and the borrower is complying with the terms of the modification.”
5. The credit union’s loan workout policy appropriately balances helping borrowers versus minimizing losses to the credit union by considering:
   1. “Whether the loan modifications are well-designed, consistently applied and provide a favorable outcome to borrowers”; and
   2. “The available options for borrowers to repay any missed payments at the end of their modifications to avoid delinquencies or other adverse consequences.”
6. The credit union’s policy includes appropriate safety and soundness safeguards designed to prevent the following:
   1. “Masking deteriorations in loan portfolio quality and understating charge-off levels;”
   2. “Delaying loss recognition resulting in an understated allowance for loan and lease losses account or inaccurate loan valuations;”
   3. “Overstating net income and net worth (regulatory capital) levels”; and
   4. “Circumventing internal controls.”

Commenters uniformly supported the proposed rule, including the Credit Union National Association, the Cooperative Credit Union Association, the CrossState Credit Union Association, the Indiana Credit Union League, the Minnesota Credit Union Network, the National Association of Federally-Insured Credit Unions, the National Association of State Credit Union Supervisors and the Wisconsin Credit Union League. Several credit unions that filed comments said that they had used the capitalization of unpaid interest solution for modifications before 2012 and would welcome the return of that option, especially during the COVID-19 pandemic.  

While it will be up to new NCUA Chairman Todd Harper to decide whether the NCUA Board will vote on a final version of the rule, this proposal appears to have broad industry support and, if finalized as proposed, would likely help both credit unions and their members. NCUA’s proposed safeguards seem reasonably designed to limit consumer protection and safety and soundness concerns related to capitalization of interest in a workout.

Giving federally insured credit unions a new capitalization of unpaid interest loan workout option would also be apropos because Fannie’s and Freddie’s mortgage workout policies allow this practice, because it would create a more level regulatory playing field with banks, and because it would help many credit union members of recently reduced means during the COVID-19 pandemic be better able to pay off their loans affordably.

Michael S. Edwards is an attorney-at-law with extensive experience representing credit unions, community banks and credit union organizations in the United States and around the world on a wide range of regulatory, compliance and other legal matters. Now with his own law firm based in the Washington, D.C., area, Edwards previously served as SVP/advocacy and general counsel of the World Council of Credit Unions and was senior assistant general counsel in the regulatory advocacy section of the Credit Union National Association.