Allowance for Loan Losses-Preparing for CECL

CUNA CFO Council Annual Meeting

May 2015

New Orleans, La.

Presented By:

Mike Sacher, Sacher Consulting

Presentation Objectives

• Provide overview of CECL

– How different from incurred loss model?

• Summarize key provisions of proposed standard

• Review example provided in proposed standard and

discuss go-forward strategies

• Note: Not possible in one hour presentation to get too

micro. Goal of presentation is to provide overview and

“food for thought.”

2

What is CECL?

• Acronym for Current Expected Credit Losses

• CECL based on an estimate of “lifetime contractual cash flows not

expected to be collected.”

• Current GAAP based on “Incurred” Loss Model”

– Event giving rise to the loss must have already occurred or

loss expectation must rise to level of probable

• CECL will likely result in significant increase to the balance of the

Allowance for Expected Credit Losses

– No longer referred to as Allowance for Loan Losses

• “Day 1” losses will be recognized under CECL

3

Is CECL Based on Fair Value?

• No!

• No consideration of interest rate vs. market

• When impaired, uses contractual rate for DCF purposes,

which is not a FV indicator

• FV may be either higher or lower than ACL analytics

reflect

4

Why CECL?

• Incurred loss model viewed as flawed due to:

– “Delayed recognition” of losses

– Reflective of “incurred current credit events”

• CECL

– Recognizes “expected credit risks”

– Requires consideration of a broader range of reasonable &

supportable information to inform credit loss estimates

5

Basis for Conclusion #16

• “The Board believes that it is potentially misleading to

investors to allow the balance sheet to reflect an amount

greater than the present value of cash flows expected to

be collected for instruments measured using amortized

cost, which would be the result of an approach that

recognizes only some of the contractual cash flows not

expected to be collected (that is, only those expected to

occur in the next 12 months).”

• I recommend you read the “Basis for Conclusions”

section of the Proposed ASU-very interesting!6

When CECL?

• Proposed ASU was issued for comment in 2012, and comment period ended

4/30/13

• According to FASB website (as of 4/28/15):

– Last update was on 3/18/15

– Identified Next Steps

The FASB will continue redeliberations on the CECL model, considering

feedback received through comment letters and outreach activities.

• Once finalized, transition period?

• Initial adoption will be recognized by a cumulative effect adjustment

• Don’t panic-there will be time to prepare

7

What does CECL apply to?

• Applies to financial instruments measured at amortized cost

– Loans “held for investment” (vast majority of all CU loans)

– Debt securities classified as HTM (other guidance for AFS)

– US Treasury securities

– MBS

– Other HTM

• New ACL method for HTM provides opportunity to “recover” previously

recognized write downs as conditions improve

• Includes guidance for Purchased Credit Impaired (PCI) assets

• Loan commitments not measured at F/V through Net Income

8

$ Impact of CECL?

• My sense is ACL (Allowance for Credit Losses) could

end up 150% to 200% of today’s balance (assuming

today’s balance is not overstated).

• Why?

• What about new loans originated?

– When do you assess ACL requirements?

9

Thoughts About Complexity

• Overall, the concepts of this proposed ASU are pretty

straight forward and logical…

• The challenge may be in data collection by appropriate

“pools” of loans.

– Plenty of lead time to get this right, but need to start thinking

about this now

• Disclosure requirements may be one of most difficult

aspects-ensure you review this area of the proposed

ASU!

10

Main Provisions (Pg. 2 of PASU)

1. Impairment based on current estimate of contractual cash flows

not expected to be collected at reporting date

2. Removes existing “probable” threshold

3. Broadens the range of information that must be considered in

measuring the ALL

– Historical loss information on similar assets (past events)

– Current conditions

– Reasonable and supportable forecasts that affect the

expected collectibility of remaining cash flow

11

Main Provisions (Pg. 2 of PASU)

4. Estimated losses would always reflect both:

– Possibility that a credit loss results AND

– Possibility that no credit loss results

5. “Accordingly, the proposed amendment would prohibit an entity

from estimating expected credit losses solely on the basis of the

most likely outcome (that is, the statistical mode)”

– More later…

6. Must consider prepayments in estimating future contractual cash

flows

12

1. Information on past events (historical experience of

similar assets)

2. Current conditions

3. Reasonable & supportable forecasts and their

implications for expected credit losses

4. Include quantitative & qualitative factors specific to

borrowers

– Borrower’s creditworthiness

– Current point and forecasted direction of economic cycle

13

Consider both internally and externally

available data

Consider both internally and externally

available data

5. Adjust historical experience metrics for current available

information

6. As forecast horizon increases, degree of judgment

increases

7. Consider available information without undue cost

and effort that is relevant to estimating contractual

cash flows.

– “Use estimation techniques that are “practical and

relevant”

14

Forecasting Extended Future Periods

See FAQ 13. Both of following okay

• “Revert to unadjusted historical averages for future periods

beyond which an entity is able to obtain reasonable and

supportable forecasts”

• “Assuming that economic conditions will remain stable for future

periods beyond which an entity is able to make or obtain

reasonable and supportable forecasts (that is, freezing the furthest

reasonable and supportable forecast and utilizing that forecast for

the remaining future periods”

15

Pooling of Loans

• Pool financial assets with similar risk characteristics. Be

careful not to broaden categories of dis-similar

characteristics

– 1st TD vs. 2nd TD

– New vs. Used auto

– Indirect vs. Direct

– Subprime vs. Prime

– Etc.

16

Forecasted Losses Might be Lower than

Historical Averages

• FASB Q&A #14

All things equal, when the current and expected economic

conditions facing the entity are more favorable than the economic

conditions that existed for the period over which historical

statistics were developed, the Board expects that the current

expected credit loss estimate would be lower than the historical

average.

17

Time Value of Money

1. Estimated losses shall reflect the time value of money.

2. DCF is one way of capturing time value concept.

3. If estimating losses using DCF model, use effective interest rate

for discount rate

4. Loss ratio method commonly used by credit unions is okay (see

par. 825-15-55-3)

18

Neither Worst-Case or Best-Case Scenario

1. Reflect both possibility that a credit loss results and the

possibility that no credit loss results

2. Probability weighted calculation that considers

likelihood of more than two outcomes not required

3. Prohibited from estimating credit losses based solely on

the most likely outcome (the statistical mode)

4. No ACL required if no loss would be recognized upon

default (adequately collateralized loans)

19

FASB Q&A #11:

“That is, even when the most likely outcome (which is a

common way to determine estimated cash flows) is zero

credit loss, an entity would be required to establish an

allowance for expected credit losses based on the risk of

credit loss for similar assets with a similar credit rating.

That risk of credit loss exists equally in portfolios and

individual assets.”

– In other words, still have to consider less likely outcomes and

provide some estimate in the event that a less likely outcome

might occur20

FASB Q&A #11:

“…In practice, however, the Board does not believe that the

prohibition against the statistical mode will conflict with many

commonly used approaches to estimating credit losses. Specifically,

many measurement methods (such as a loss-rate method, a roll-rate

method, a probability-of-default method, and a provision matrix using

loss factors) rely on an extensive population of actual loss data as an

input when estimating credit losses. Those methods already typically

rely on a statistical mean (that is, the average outcome) as opposed

to the statistical mode when estimating credit losses.

21

Accrual of Income (825-15-25-10)

1. “…An entity shall cease its accrual of interest income

when it is not probable that the entity will receive

substantially all of the principal or substantially all of the

interest.”

2. Beware of NCUA guidance on 90 days past due

cessation of accrual

22

Timing of Charge-Off (825-15-35-1)

• An entity shall directly reduce the cost basis in a financial asset (or portion of a

financial asset) within the scope of this Subtopic in the period in which the entity

determines that it has no reasonable expectation of future recovery.

– This is an important point and addresses a broad diversity in practice in

credit unions.

• Recovery of a financial asset previously written off shall be recognized by

recording an adjustment to the allowance for expected credit losses only when

consideration is received. In this context, a recovery means that an entity has

received consideration in satisfaction of some or all contractually required

payments following a write-off of the financial asset.

23

Disclosure Issues

• Voluminous Allowance disclosures still applicable

• Disclosure requirements will increase with finalization of

this ASU

• See next slide

24

• The Board decided to require that the credit quality indicators for all classes of financing

receivables (excluding revolving lines of credit such as credit cards) that are disclosed

under current GAAP be disaggregated by year of the asset’s origination (that is,

vintage year).

• The Board decided to limit the disaggregation by vintage year to no more than five

annual reporting periods, with the balance for financing receivables originated before the

fifth annual reporting period shown in aggregate.

• Other guidance for interim reporting (n/a for credit unions)

• The Board directed the staff to perform outreach to understand the usefulness, costs,

and operability issues with preparers, users, auditors, and financial institution regulators

for this disclosure requirement, and on the basis of the feedback received, the Board

may reconsider the alternatives to the roll-forward disclosure requirements at a

future meeting.

• Above as per 2/11/2015 FASB Action Alert

25

Implementation Guidance

1. Because of the subjective nature of the estimate of expected credit losses, this

Subtopic does not require specific approaches or specific policy elections in

this regard.

2. Rather, an entity has latitude to develop estimation techniques that are applied

consistently over time and aim to faithfully estimate expected credit losses by

using the key principles in this Subtopic.

3. An entity is not required to utilize a probability-weighted discounted cash flow

model to estimate expected credit losses.

4. Similarly, an entity is not required to reconcile the estimation technique it uses

with a probability-weighted discounted cash flow model.

26

Implementation Guidance

• Collateral Dependent Financial Asset

– A financial asset for which the repayment is expected to be

provided primarily or substantially through the operation (by

the lender) or sale of the collateral, based on an entity’s

assessment as of the reporting date

• Are the following Collateral Dependent Financial Assets?

– Residential real estate loan?

– Auto loan?

– Member business loan?

– Real estate loan in foreclosure?27

Implementation Guidance

• Expected losses on loan commitments must be included

in calculation.

• Can’t simply use one-year loss rate adjusted for

remaining contractual term since loss occurrence is not

linear!

• Think about “probability of default” separately from “loss

given default.”

28

Sacher Thoughts

1. Loss ratio approach used by most CU’s is a STARTING

POINT.

– Often not adequately disaggregated

– Only a snapshot of past xx months (often 12-24 months)

– Does not measure losses over remaining life of portfolio

– Often does not consider current how current conditions

impact historical loss measures (even though supposed to

consider Q&E)

– Does not quantify forecasts of future conditions

29

Sacher Thoughts

Loss Ratio Not the Answer!

825-15-55-24

“It typically would be inappropriate to estimate the expected credit losses for a long-

term asset by multiplying an annual loss rate (that is, the net amount written off in a

12-month period divided by the average amortized cost) by the remaining years of

the asset’s contractual term because loss experience is often not linear.”

“That is, for certain types of lending, credit losses are low shortly after origination,

rise rapidly in the early years of a loan, and then taper to a lower rate until maturity.

When estimating expected credit losses under this Subtopic, the loss rate should be

commensurate with the current credit risk of the financial asset.”

30

Sacher Thoughts

2. CU’s should consider the need for static pool analysis

a. Proper identification of unique pools, such as

Used vs new auto

Direct vs. indirect

1st mortgage vs. 2nd

Condo vs. house

b. Cumulative loss data for each pool by vintage year

c. See par. 825-15-55-19 for discussion of this issue

31

Sacher Thoughts

3. CU’s need to think thru the types of loan portfolio

metrics that meet the requirements of the ASU:

– Updated FICO & FICO migration

– Updated LTV/CLTV

4. What about FICO odds charts for consumer loans?

– If we can quantify probability of default, and combine with

loss given default (the magnitude of loss upon default), then

we have the basis for complying with key ASU requirements

32

Sacher Thoughts

5. CU’s need to identify appropriate general economic

indicators that might need to be impounded into the

CECL equation:

– National & local unemployment trends and forecasts

– Unique field of membership impacts (strikes, layoffs, etc.)

6. Do we need outside analytics provider to manage this

process?

– Probably not for straight forward portfolios

– Maybe yes for larger, more sophisticated portfolios

33

What About Auto Loans?

• See Example 3 from Proposed ASU

• Entity B is a lending institution that provides retail financing to consumers

purchasing new or used farm equipment throughout the country.

• The four-year amortizing loans it originates are secured by the farm equipment

purchased by the borrowers with proceeds from the loan using a relatively

consistent range of loan-to-collateral-value ratios at origination.

• The underlying farm equipment collateral is repossessed and sold at auction by

Entity B when the borrower becomes 90 days past due

• Entity B tracks these loans on the basis of the calendar-year of origination. The

following pattern of credit loss experience has been developed based on the

ratio of the amortized cost basis in each vintage that was written off because of

credit loss and the original amortized cost basis, shown as a percentage

34

What About Auto Loans?

35

• In estimating expected credit losses on the remaining outstanding loans at December 31,

20X9, Entity B evaluates its historical loss experience. It notes that the majority of losses

historically emerge in the second and third year of the loans.

• It notes that historical loss experience has worsened since 20X3 and that loss

experience for loans originated in 20X6 has already equalled the loss experience for

loans originated in 20X5 despite the fact that the 20X6 loans will be outstanding for one

additional year as compared with those originated in 20X5.

• In considering current conditions and reasonable and supportable forecasts, Entity B

notes that there is an oversupply of used farm equipment in the resale market that is

expected to continue, thereby putting downward pressure on the resulting value of

equipment. It also notes that severe weather in recent years has increased the cost of

crop insurance and that this trend is expected to continue.

36

What About Auto Loans?

What About Auto Loans?

• On the basis of these factors, it estimates that cumulative

loss experience on the remaining vintages outstanding

will be 4.6 percent, 4.8 percent, 5.0 percent, and 5.1

percent for loans originated in 20X6, 20X7, 20X8, and

20X9, respectively.

• These rates would be applied to the amortized cost in

each category, and the effects of those changes would

be recognized currently in net income as an adjustment

to the allowance for expected credit losses

37

What About Unsecured Loans?

• See Example 4 in PASU-homogenous unsecured loans

• Past due loans evaluated individually

• Current loans evaluated on a pool basis using “loss rate” approach

based on loans with similar risk characteristics

• Loss rate reflects cash flows the entity does not expect to collect

over the life of the loans in the pool

• Can’t simply be an annual loss ratio

• What about loss indicators (odd charts data) provided by credit

agencies?

38

What About Mortgage Secured Loans?

• No examples provided in literature

• If this were 2006-2007 timeframe, what impacts to prior

loss estimates?

• Impacts at end of “great recession?”

• See slide # 15 re: forecasting beyond reasonable

timelines

39

What About MBL’s?

• See Example 1 in PASU

– Uses historical loss rates by credit grade assigned to loans,

updated for current conditions.

– Assumed no change in current conditions nor any changes to

future losses (based on a 5-year loan term)

• See Example 2 in PASU

– Baseline historical loss rates similar to Example 1

– Add additional credit risk factors that reflect current conditions

(mgt. evaluation of current point in economic cycle, collateral

values, underwriting standards, etc.)

– Also 5-year loan terms, so less emphasis on future indicators 40

Reference Material

• FASB Project Update: Accounting for Financial

Instruments-Credit Impairment– http://www.fasb.org/jsp/FASB/FASBContent_C/ProjectUpdatePage&cid=1176159268094

• See also Basis for Conclusion Section of Proposed ASU

• FASB FAQ on Proposed ASU– http://www.fasb.org/cs/ContentServer?c=Document_C&pagename=FASB%2FDocument_C%2FDocumentP

age&cid=1176162305167

• FASB’s CECL Model: Navigating the Changes, Crowe

Horwath– http://www.crowehorwath.com/folio-pdf/FASBCECLModel-NavigatingChanges_FIA15904.pdf

41

42

Contact Information

Michael J. Sacher, CPA

mike@sacherconsulting.com

Office: 310.459-9313

Cell: 310.880-5323

Fax: 310.454-7160

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