Mike Thronson and Gabe Nachand | Partners, Moss Adams, LLP
Moss Adams’ Mike Thronson and colleague Gabe Nachand conducted a workshop following their conference-wide
presentation to involve a smaller group in an interactive discussion of the practical aspects of CECL, including CECL-compliant allowance methodologies.
- Whatever new model you choose, you want it to be more quantitative; it will be easier to meet documentation and reasonable and supportable standards.
- FAS 114 goes away under CECL, but it will look a lot like it.
- You won’t be, able to get away from historical losses. You are anchored to historical to some degree.
Initial thoughts: We’re pushing more to the quantitative and driving that up – getting qualitative to zero is the idea. Whichever new model you choose, you want it to be more quantitative; it will be easier to meet documentation and reasonable and supportable standards. Part of what CECL is all about is allowing you to be flexible to put more reserves on the books for when you need them. If you think you can get your allowance to under 4 percent, you probably have a substantial qualitative portion of your allowance?
Wouldn’t individual loan information be more accurate than loading all up to a pool? FAS 114 goes away under CECL, but it will look a lot like it. You end up with pooled loans with similar characteristics and when risk characteristics change you pull those loans out of the pool. Risk rating doesn’t tell me anything about loan-to-value. Risk rating is not as valuable as some other things.
How can you get away with changing your methodology to something more quantitative? This is your opportunity. A new standard has inherent change. There will be qualitative adjustments but keep qualitative and unallocated to a minimum. Don’t transition too early or you could get hit with industry wide increases on top of your increases. Can’t get away from historical losses; whether you use them or not, they’re for perspective. You’re going to be anchored in historical to some degree.
Example #1 – Loss Rate Approach (collective valuation)
- Assume a bank originates 10 year amortizing loans with similar risk characteristics for a total pool of $3 million.
- The banks cumulative historical credit loss rate for the last 10 years was—-1.5%.
- Significant factors that could effect collectability of the pool of loans are RE values and unemployment rates.
- Reasonable and supportable forecasting period is 2 years.
Note: Be careful about the difference between annualize losses and life of loan losses. We’re seeing multipliers because of analysis rooted in annualized.
Example #2 – Loss Rate Approach (individual valuation)
- Assume a bank started a program to originate commercial loans during a reporting period.
- At the end of the first reporting period it has originated one loan with an amortized cost of $1 million.
- Significant factors that could effect collectability of the loan are borrower specific operating results and local unemployment rates.
- Reasonable and supportable forecasting period is 1 year.
Note: PCAOB will have a say in what will be considered reasonable for SEC institutions, most likely two years or less for most. The most frequently seen LEP is 18 months.
Example #4 – Combined Approach (collective and individual)
- Assume a bank provides unsecured commercial loans of up to $75K; considers credit losses collectively as a pool.
- Loss estimates for loans with credit deterioration is based on borrower-specific facts and circumstances.
- Therefore the bank estimates expected credit losses on an individual basis.
Example #6 – Collateral Dependent Financial Assets “An entity may, as a practical expedient, use the fair value of the collateral at the reporting date when developing its estimate of the allowance for credit losses for a financial asset for which the repayment is expected to be provided substantially through the operation or sale of the collateral when the borrower is experiencing financial difficulty based on the entity’s assessment as of the reporting date (collateral-dependent financial asset).” (326-20-35-4 – partial)
Note: There are not many changes to how to estimate for collateralized loans, although the new standard does eliminate discounted cash flow.
Example #7 – Assets Secured by Collateral Maintenance Provisions “For certain financial assets, the borrower may be required to continually adjust the amount of the collateral securing the financial asset(s) as a result of fair value changes in the collateral. In those situations, an entity may use, as a practical expedient, a method that compares the amortized cost basis with the fair value of collateral at the reporting date to measure the estimate of expected credit losses.” (326-20-35-5 – partial)
Example #12 – Purchased Financial Assets with Credit Deterioration “An entity shall record the allowance for credit losses for purchased financial assets with credit deterioration over the remaining contractual term of the financial asset(s), in accordance with paragraphs 326-20-30-2 through 30-10 and 326-20-30-12.” (326-20-30-13 – partial)
Note: The difference between amortized cost basis and par is the allowance.