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Financial Services

THOUGHTWARE®

CECL’s Overlooked EffectImpact on Debt Securities & Off-Balance-Sheet Commitments

November 15, 2018

THOUGHTWARE®

Gordon Dobner, CPAPartnerHouston | 713.499.4605

John Griffin, CPAManaging DirectorDallas | 214.929.1846

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Five Key Takeaways

Impact of ASU 2016-13 on debt securities varies based on classification

Inclusion of HTM debt securities in CECL model represents a significant change in measurement & timing of recognition of credit losses

Standard makes targeted changes to AFS debt securities impairment model

New purchase credit deteriorated accounting applies to debt securities

Key decisions points for off-balance-sheet commitments include determination of unconditionally cancelable & likelihood funding will occur

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CECL Scope

INCLUDED

• Financing receivables (loans)• Held-to-maturity debt

securities• Loan commitments,

guarantees, standby L/C• Lease receivables as lessor

(ASC 842)• Reinsurance receivables• Receivables on repurchase &

securities lending agreements

EXCLUDED

• Financial assets at fair value• Available-for-sale debt

securities (updated model in ASU 2016-13)

• Participant loans defined contribution benefit plans

• Insurance policy loans• NFP pledges receivable• Loans & receivables between

entities under common control

ASU 2016-13’s Impact on Debt Securities

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• Must follow the CECL model of the ASUHeld-to-maturity (HTM) debt securities

• ASU provides separate impairment model• Modified version of today’s OTTI model

Available-for-sale (AFS) debt securities

• Debt securities purchased after original issuance must consider if PCD accounting applies

Purchased credit deteriorated (PCD)

Impact of ASU 2016-13 on Debt Securities

HTM Debt Securities

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Key CECL considerations potentially impacting estimating credit losses HTM debt securities

• Management’s determination of zero loss securities under ASC 326-20-30-10 • Pooling considerations• Determining CECL life • Due to lack of loss experience, most institutions source of historical

experience will be external• Can use both DCF & non-DCF methodologies• No fair value floor for estimating credit losses

HTM Debt Securities Under CECL

CECL Calculation Refresher

Historical lifetime

loss experience

Current conditions adjustment

Forecast adjustment

Current expected credit loss

Adjustments to historical lifetime loss experience

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• ASC 326-20-30-10 requires an entity to include a measure of expected credit losses even if that risk is remote

• However, an institution is not required to measure expected credit losses in which management’s expectation of nonpayment is zero at default (zero credit loss)

• The standard does not specify specific financial assets that would be zero loss & it is up to management’s judgment

Zero Credit Loss HTM Debt Securities

• Guidance on zero loss HTM debt securities• Example 8 in the implementation guidance illustrates the process to

document a conclusion of zero credit loss on HTM U.S. Treasury securities

• At the 2017 AICPA Banking Conference members of the AICPA DIEP & FASB’s TRG presented a process to document conclusion of zero credit loss on HTM U.S. Agency & GSE MBS (see following slide)

• AICPA FinRec recently issued a draft white paper on this issue

Zero Credit Loss HTM Debt Securities

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• 40+ years of history of no credit losses to investors• Payments are explicitly guaranteed by U.S.• Underlying mortgage loans are either insured by the FHA or guaranteed

by the VA, both U.S. agencies• U.S. can print currency to retire GNMA’s obligations

Securities issued by Ginnie Mae, a

U.S. agency

• P&I payments are guaranteed by the issuing agency• Explicit guarantee by the U.S. subject to a cap (part of the purchase

agreement when the agencies were taken into conservatorship in 2008• Widely believed to have an implied guarantee by the U.S.• Long history of no credit losses to investors

Fannie Mae & Freddie Mac MBS

Zero Credit Loss HTM Debt Securities

Source: As presented by members of AICPA DIEP & FASB’s TRG at the 2017 AICPA National Conference on Banks & Savings Institutions

• Institutions are responsible for the continual evaluation & monitoring (not a one-time decision)

• Determination should be focused on loss given default

• Should document positive & negative factors that may indicate that expectation of nonpayment is zero as well as may not be zero

• Provides example of positive & negative factors for U.S. Treasury, GNMA MBS & Agency MBS

Highlights from FinRec White Paper

Source: AICPA FinRec Zero Loss

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HTM Debt Securities Under CECL

• Three potential outcomes for HTM debt securities under CECL

• Management determines & documents zero loss (no CECL reserve)

• Management determines a CECL allowance is necessary (CECL reserve)

• Management determines CECL reserve is technically necessary but decides it is not material (no CECL reserve)

• Note: this would need to be considered for each different pool of (or individual) HTM debt securities

HTM Debt Securities Under CECL

Expectation is for most community financial institutions impact on HTM will be in munis & corporate bonds

• Unless there are additional credit enhancements can an institution get to an answer of zero, even if probability of default is remote?

• How do you calculate an estimate of credit loss where you have had no experience of loss?

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Using External Data for PD/LGD Model

• As institutions more than likely won’t have loss experience in HTM debt securities one solution may be to use external PD/LGD data from your bond accounting firm to create your CECL estimate or determination of materiality

• Probability of Default × Loss Given Default × Exposure at Default = Expected Loss (aka CECL allowance)

CECL allowance is the product of

all three components

PD: what is the probability of a bond defaulting over the

contractual life of the bond?

Exposure at default: what is the outstanding balance at default?

Book value of your bond

LGD: when the bond defaults, what percentage of the exposure at default is

charged off?

Probability of Default & Loss Given Default Concept

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• A default is assumed to take place on the earliest of the following

• The date their rating is revised down to ‘D’

• The date a debt payment was missed;

• The date a distressed exchange offer was announced; or

• The date the debtor filed for, or was forced into, bankruptcy

Source: S&P 2016 Annual Global Corporate Default Study and Ratings Transitions, provided by Baker Group

Defining a Bond Default

Municipal Expected Loss Model

• How do we model the expected loss of a municipal bond? Ratings Agencies such as S&P calculate the probability of a ratings move from one rating to another over a given time horizon.

• For example a AA credit may remain AA over its lifetime. Or it could migrate to A (1.46% annual probability), then to BBB (1.78%), and then default (0.00%).

Source: S&P 2016 Annual U.S. Public Finance Default Study and Ratings Transitions 

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• A municipal expected loss model must also consider recovery rates of municipal defaults

• Recovery rates: the value creditors actually receive at the resolution of the default relative to what they should have contractually received (par value)

• Average recoveries on individual Moody’s-rated municipal bonds since 1970 have been about 66% & are somewhat higher than the average 53% recovery rate for senior secured debt of global corporate issuers over a similar period

Loss Given Default Concept

• From 1986–2016, the occurrence of defaults in the municipal/public finance sector was very rare

• 15 U.S. rated bonds defaulted in 2016; 13 of the defaults were issues within Puerto Rico

• The data includes the following types of municipal bonds: general obligation, lease obligation, water & sewer revenue, public power, airports, ports, toll roads & bridges, etc.

Source: S&P 2016 Annual U.S. Public Finance Default Study and Ratings Transitions, provided by Baker Group

Municipal Defaults Are Rare

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Compare Municipal Bond Matrix vs. Corporate Matrix

Source: S&P 2016 Annual U.S. Public Finance Default Study and Ratings Transitions, provided by Baker Group

Municipal vs. Corporates

• Callable bonds: bonds that can be redeemed or paid off by the issuer prior to the bonds’ maturity date

• When an issuer calls its bonds, it pays investors the call price (usually the par value of the bond) together with accrued interest to date &, at that point, stops making interest payments

• Market rates down = more bonds called

• Market rates up = less bonds called

• What is the life of a callable bond?

Determining CECL Life of Munis

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• What about nonrated securities? Many municipalities choose not to get a bond issue rated

• Institutions are already likely using third-party municipal credit analysis as a part of their municipal credit program

• Nonrated securities need to be pooled together based on municipal credit metrics & related back to a Moody’s &/or S&P rating

• From there, the security will then go through the same probability of default & loss given default model as their rated counterparts

Nonrated Municipal Securities

AFS Debt Securities

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• Credit losses related to AFS debt securities should be recorded through an allowance for credit losses

• Amount of credit losses is limited to the amount by which fair value is below amortized cost. Time is no longer a factor in the determination

AFS Debt Securities

• Other factors to consider

• May aggregate similar CUSIP numbers that were purchased in separate trade lots by average cost basis if that corresponds to the basis used to measure realized & unrealized gains & losses for the debt securities

• If the entity intends to sell the debt security or more likely than not required to sell before recovery, then any allowance shall be written off & security written down to fair value

AFS Debt Securities

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• Other factors to consider

• To assess whether a credit loss exists, entity shall compare PV of cash flows expected to be collected with the security’s amortized cost

• Discount expected cash flows at the effective interest rate implicit in the security at the date of acquisition

• Prospective transition approach for debt securities for which an OTTI was recorded before the effective date

AFS Debt Securities

PCD Debt Securities

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• As an institution purchases debt securities from other institutions, it must consider if they meet the definition of PCD

• Per ASC 326 Glossary: “Acquired financial assets that as of the date of acquisition have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer’s assessment”

• “More-than-insignificant” is not defined & therefore institutions will need to apply judgment (see example 11 in illustrations guidance)

• Considerations in determining “more-than-insignificant” • Zero loss securities discussed previously

• Downgrade of ratings since issuance?

• Investment grade vs. subinvestment grade?

Accounting for PCD Debt Securities

What Is Considered More-than-Insignificant Deterioration in Credit Quality?

• Accounting Standards Update does not define what is considered a more-than-insignificant deterioration in credit quality

• Generally, the securities credit rating will be used

• Is a move from AAA to AA a significant deterioration in credit quality?

• Investment grade to noninvestment grade?

Moody’s S&P

Inve

stm

ent

Gra

de

Aaa AAA

Aa AA

A A

Baa BBB

Sub

inve

stm

ent

G

rade

Ba BB

B B

Caa CCC

Ca CC

C C

D D

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• If a purchase of a debt security meets the definition of PCD

• Initial recognition

• Initial allowance for credit losses will be added to the purchase price rather than being recorded as a credit loss expense in the income statement

• Noncredit discount or premium allocated to each individual asset

• Estimating initial amount of credit loss must follow applicable impairment model

• HTM follows CECL model

• AFS follows AFS impairment model (must use a DCF)

• Subsequent recognition would follow same approach (CECL or AFS impairment models) as any other non-PCD debt security

Accounting for PCD Debt Securities

Off-Balance-Sheet Commitments (OBSC)

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Common OBSC at Community Financial Institutions

• Commitments to extend credit

• Commitments to originate

• Unfunded lines of credit

• Standby letters of credit

• Commercial letters of credit (excluded from CECL)

OBSC Accounting Today vs. CECL

• Current accounting treatment (per

ASC 825)

• Follow ASC 450-20 which requires recognition if loss is both probable & reasonably estimable

• Report separately as a liability & noninterest expense (not provision for loan & lease losses)

• Excludes commitments recorded as derivatives under ASC 815 (mortgage loan commitments to be HFS)

• Accounting under CECL (ASC 326)

• Estimate expected losses over the contractual period obligated to extend credit following CECL model

• Should consider likelihood that funding will occur

• Not required to estimate losses if unconditionally cancelable by the issuer

• Report separately as liability & provision for credit losses

• Excludes commitments recorded as insurance & derivatives under ASC 815

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Unconditionally Cancelable by the Issuer

• For accounting purposes, institutions must be able to, at any time, with or without cause, refuse to extend credit**

• Best practice for implementation is to perform an inventory of OBSC & determine which may be unconditionally cancelable

• Credit cards – Yes

• HELOCs – No

**Source: OCC Bank Accounting and Advisory Series

Estimating CECL Reserve for OBSC

Key considerations

• Appropriate pooling

• Follow pooling for funded loans or change based on risk characteristics such as

• Commitment type, contractual period, likelihood funding will occur, etc.

• Likelihood funding will occur (funding rate)

• Leveraging methodology used in estimating credit losses on funded loans

• Materiality

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Five Key Takeaways

Impact of ASU 2016-13 on debt securities varies based on classification

Inclusion of HTM debt securities in CECL model represents a significant change in measurement & timing of recognition of credit losses

Standard makes targeted changes to AFS debt securities impairment model

New purchase credit deteriorated accounting applies to debt securities

Key decisions points for off-balance-sheet commitments include determination of unconditionally cancelable & likelihood funding will occur

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Continuing Professional Education (CPE) Credit

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The information contained in these slides is presented by professionals for your information only & is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered

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