Allowance for Loan Losses - Understanding CECL and Current Trends

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1 2014 CliftonLarsonAllen LLP Presentation for the National Association of Federal Credit Unions Allowance for Loan Losses - Understanding CECL and Current Trends September 2, 2015 CLAconnect.com

2 Today s presenters Todd Sprang Todd is a principal with CliftonLarsonAllen s financial institutions group. He has more than 20 years of audit and consulting experience and serves as an engagement partner on financial institutions throughout the United States. Todd has served multiple terms as a member of the AICPA Depository Institutions Expert Panel and is a frequent speaker at national financial institutions industry conferences. 2

3 Today s presenters Chuck Kelly Chuck is a Senior Manager with CliftonLarsonAllen s financial institutions group, with over 13 years of experience working primarily with credit unions. His most recent presentations and articles include: Presentation: TDR s... And the Saga Continues Presentation: What Should You Know About Call Reports Article: New Guidance May Simplify Goodwill Accounting for Credit Union Mergers Article: Latest Changes to the Call Report for Credit Unions

4 Background Weaknesses identified in current practice following the recent global economic crisis: Many financial statement users noted that the incurred loss model may have prevented institutions from recognizing credit losses that were imminent in 2007 and 2008 (due to the probability threshold ) Complexity of multiple credit impairment models

5 Incurred Loss Model (Existing Method) The incurred loss model currently used by credit unions to estimate the Allowance for Loan and Lease Losses (ALLL) utilizes several different components including: Reserves for homogeneous loan pools based on historical loss data Reserves for non-homogeneous impaired loans Reserves for Troubled Debt Restructurings (TDRs) based on discounted cash flow calculations or FV of collateral less costs to sell Reserves for Qualitative and Environmental (Q&E) factors identified

6 Incurred Loss Model (Existing Method) The existing method generally: Delays recognition of credit losses until the loss is considered probable. FASB now believes that entities should record their expectation of loss. Considers losses that have been incurred and will most likely be reflected as charge-offs during the next operating cycle (12 months after the reporting date). However, practice tends to vary with regards to the amount of time for which incurred losses are being captured.

7 Exposure Draft Proposed Accounting Standards Update Financial Instruments-Credit Losses, issued December 20, 2012 Financial assets not accounted for at fair value with changes in fair value reflected in net income with exposure to potential credit risk Todays discussion will focus on the following examples applicable to financial institutions Loans Loan commitments 7

(loan life vs next 12 months) Exposure draft stated the estimate is neither a worst-case scenario nor a

8 Expected Loss Model (Proposed Method) This method will generally reflect management s estimate of all credit losses expected to be realized over the life of their existing loan portfolio. (loan life vs next 12 months) Exposure draft stated the estimate is neither a worst-case scenario nor a best-case scenario, but rather should be based on assessment of current conditions and reasonable and supportable forecasts about the future.

9 Expected Loss Model (Proposed Method) When a credit union originates a loan, it has increased its exposure to credit losses. Likewise, when a contractual payment is received in full from the borrower, that exposure has decreased. FASB believes that financial statement users desire transparency with regard to management s full estimate of all expected credit losses, and the proposed model would provide users with a consistent balance sheet objective.

10 Probability Threshold 2014 CliftonLarsonAllen LLP 10

Expected Loss Model (Proposed Method) Expected credit loss is an estimate of the present value of future cash flows not expected to be collected based on quantitative and qualitative information such

11 Expected Loss Model (Proposed Method) Expected credit loss is an estimate of the present value of future cash flows not expected to be collected based on quantitative and qualitative information such as: Past events Historical loss experience Current conditions Borrower credit worthiness -and- Forecasts of expected credit losses Current point and forecast direction of economic cycle Not a big fan of the last two 11

12 Expected Loss Model (Proposed Method) FASB expects that a credit union s estimate of expected credit losses largely will be informed by historical loss information for financial assets of a similar type and credit risk. The expected credit loss estimate represents a life of loan estimate and considers: Prepayments Collateral value Current and expected economic conditions (compared to loss history)

13 Expected Loss Model (Proposed Method) Reflects time value of money either explicitly or implicitly: Explicit Discounted cash flow model calculating present value of future cash flows discounted at the instrument s effective interest rate Implicit Loss statistics based on a ratio of amortized cost written off due to credit losses to the amortized cost of the asset at the reporting date FASB believes that entities should be permitted to utilize estimation techniques that are based on historical write-off experience

Expected Loss Model (Proposed Method) Selection from possible scenarios Probability weighted calculation not required, but population of loss data should include items that

14 Expected Loss Model (Proposed Method) Selection from possible scenarios Probability weighted calculation not required, but population of loss data should include items that resulted in a loss and those that resulted in no loss. Prohibited from using: Worst-case scenario Best-case scenario or based solely on the most likely outcome (statistical outcome)

15 Expected Loss Model (Proposed Method) The prohibition against estimating expected credit losses based solely on the most likely outcome was not intended to prohibit a credit union from developing its adjustment to historical loss experience for current and future economic conditions on the basis of the most likely outcome.

16 Expected Loss Model (Proposed Method) A practical expedient is available for collateral dependent financial assets A collateral dependent asset is a financial asset for which repayment is expected primarily or substantially through: 1. Operation by the lender 2. Sale of the collateral

17 Expected Loss Model (Proposed Method) Collateral dependent instrument calculation depends on reason for collateral dependence Operation by lender Compare the amortized cost to the discounted fair value of the collateral Sale of collateral Compare the amortized cost to the discounted fair value of the collateral, less expected selling costs

18 Expected Loss Model (Proposed Method) Credit unions would adopt CECL by posting a cumulative-effect adjustment to their statement of financial condition (undivided earnings) as of the beginning of the first reporting period in which the guidance is effective. Suggestion: Estimate the impact of this adjustment well ahead of effective date for capital planning purposes.

19 2014 CliftonLarsonAllen LLP Comments on the CECL Exposure Draft CLAconnect.com

20 Overall Comment Letter Themes to FASB Clear distinction between supporters of the proposed model and opponents Proposed model will not fully correct the problem of too little too late Interaction with the Recognition and Measurement proposal and Risk-Based Capital is uncertain

21 Comments from Large Institutions to FASB Significant implementation time is required Modify the proposed forecast loss period Remove the concept of time value of money Modify or exclude application to debt securities Eliminate TDR designation Reconcile with IASB

22 Comments from Smaller Institutions to FASB Inability to accurately predict losses and lack of available data Requires significant implementation cost Regulators will likely utilize this as a tool to increase ALLL and decrease capital Violates matching principle Exclude smaller or non-public institutions

23 Comments from Auditors of Smaller Institutions to FASB Proposed model will be more challenging to support and audit Life of loan losses aren t reasonable and supportable Modify or exclude application to debt securities Costs of additional disclosure requirements outweigh benefits Eliminate TDR designation

24 Comments from Regulators to FASB Addresses the problem of too little, too late Encourage convergence with IASB Suggest practical expedients and transition periods for smaller institutions Support application of nonaccrual and write-off provisions to non-regulated entities Alternatives to TDR recognition and disclosure

25 Additional Impact of Comments Alternatives to CECL have been discussed Alternatives to lessen impact on equity have been discussed FASB considered Alternative models Alternative threshold for incurred model 25

26 Survey Question #1 True or False The Current Expected Credit Loss model will require credit unions to reserve for expected losses that have yet to be incurred in their allowance for loan losses.

27 2014 CliftonLarsonAllen LLP Clarifications and Changes to the CECL Exposure Draft CLAconnect.com

28 Exposure Draft Clarifications and Changes Revert to unadjusted historical loss experience when the remaining life of the asset exceeds the institution s supportable forecast period Over estimated life on a straight-line basis OR Over a period and in a pattern that reflects assumptions about expected losses over that period NOTE: You should disclose, in your financial statement footnotes, the reversion method applied. 28

29 Exposure Draft Clarifications and Changes Consider all contractual cash flows over the life of the asset Estimate credit losses over the contractual term of the loan Adjust for expected prepayments Do not adjust for expected extension, renewals and modifications Unless you expect to execute a troubled debt restructuring 29

30 Exposure Draft Clarifications and Changes Expected losses should always reflect risk of loss, even if remote but doesn t require recognition of loss when risk of nonpayment is greater than zero but estimated loss is zero. The final standard will not, however, specify circumstances when a zero allowance may be appropriate An entity would not be prohibited from developing an estimate of loss based upon: Loss rate methods Probability of default methods Provision matrix using loss factors 30

31 Exposure Draft Clarifications and Changes Illustrative methodology calculations In our opinion these will be of limited use to preparers and supplemental guidance from regulatory agencies will be much more important. Nonaccrual guidance and write off/recovery guidance to be excluded from the final standards For loans where the borrower must continually adjust the collateral, the ALLL would be limited to the difference between FV of collateral (less costs to sell, as applicable) and the amortized cost of the loan. 31

32 2014 CliftonLarsonAllen LLP Definitions CLAconnect.com

33 Interest Income Non-Accrual Status Cease accrual of interest when it is not probable that substantially all principal or substantially all interest will be received EXPECT THIS GUIDANCE TO BE EXCLUDED FROM FINAL STANDARD.

34 Interest Income Return to accrual status If collection of substantially all principal and all interest is again probable, resume interest income recognition using method applied before loan was placed on nonaccrual EXPECT THIS GUIDANCE TO BE EXCLUDED FROM FINAL STANDARD.

35 Write Offs and Recoveries Write offs are to be taken by reducing cost basis when there is no reasonable expectation of future recovery. Recovery of previous write offs recognized via an adjustment to the allowance when consideration is received. EXPECT THIS GUIDANCE TO BE EXCLUDED FROM FINAL STANDARD.

36 2014 CliftonLarsonAllen LLP Troubled Debt Restructurings (TDR) under CECL CLAconnect.com

37 Initial Assessment of a Modification Modifications were assessed for both of the following: 1. Financial difficulty of the borrower/member 2. Concession granted to the member by the credit union

38 Expected Loss Model - TDR The concept of a TDR continues to exist under the proposed standard as the Board concluded that the TDR designation remains relevant under the CECL model. In addition, the model will require that, in certain TDRs, an entity may be required to increase the cost basis of the restructured loan through a corresponding increase in the ALLL. 38

39 The Evolution of a TDR Subsequent assessment of a TDR 1. Accrual versus Nonaccrual 2. Financial reporting 3. Impairment calculation 39

40 Interagency Guidance Issued October 24, 2013 and addresses: 1. Accrual treatment 2. Loan classification for TDRs 3. Classifying TDRs as collateral dependent or not collateral dependent 4. Proper measurement of TDRs for regulatory reporting purposes

41 Collateral Dependent Loans Repayment of the loan is expected to be provided solely by the sale, or continued operation, of the underlying collateral. Cash flows from other sources can be no more than nominal. Impairment/reserves to be based on fair value of the collateral less estimated costs to sell regardless of whether foreclosure is probable

42 Collateral Dependent Loans Many Credit Unions defaulted to using the collateral method for estimating TDR reserves, but was this appropriate? What about now???

43 Example Reserve Estimates (THEN) Loan A New Loan Origination $5 mil CRE Loan 100% LTV Market Rate Strong Guarantor Historic loss reserve pool 1% Reserve $50,000 Loan B Existing Loan $5 mil CRE Loan 100% LTV Member distress Concession granted Classified as TDR Collateral based reserve 15% Reserve $750,000

44 Example Reserve Estimates (NOW) Loan A New Loan Origination $5 mil CRE Loan 80% LTV Market Rate Strong Guarantor Historic loss reserve pool 1% Reserve $50,000 Loan B Existing Loan $5 mil CRE Loan TDR 80% LTV Collateral based reserve 0% Reserve $0

45 NCUA Accounting Bulletin 14-1 Issued September 30, 2014 Allows, under certain circumstances, an acceptable practice to NOT account for a subsequently restructured loan to be reported as a TDR Once a TDR, always a TDR?

46 Required Conditions 1. Must be a subsequent restructuring 2. Member at time of new restructuring must: a. Not deemed to have any financial difficulties and b. No concession is granted 3. New agreement must specify market terms 4. From concession standpoint, if any principal forgiveness on a cumulative basis a. This is a concession so would not qualify

47 The Evolution of a TDR Developments Multiple shorter renewal periods Retained close relationship with borrower Improved economic environment Improved collateral value Loan no longer collateral dependent 47

48 The Potential Alternative Current variances in practice as to whether or not there is an alternative 1. Once a TDR, always a TDR = specific reserve calculation 2. New loan = Return to the FAS 5 portion of calculation 48

49 The Potential Alternative FAS 91 Refinancing Guidance ( ) If the terms of the new loan resulting from a loan refinancing or restructuring other than a troubled debt restructuring are at least as favorable to the lender as the terms for comparable loans to other customers with similar collection risks who are not refinancing or restructuring a loan with the lender, the refinanced loan shall be accounted for as a new loan. 49

50 The Potential Alternative FAS 91 Refinancing Guidance ( ) Conditions to consider: 1. The new loan's effective yield is at least equal to the effective yield for similar loans and 2. Modifications of the original debt instrument are more than minor 50

51 Policy and Procedures Loan types and circumstances Commercial Multiple renewals/modifications Processes and approvals Documentation Verification 51

52 Regulatory Guidance Agencies will not object to treating a subsequently restructured TDR as a new loan if, at the time of the restructuring: 1. Rate not less than rate for similar credit risk 2. Other terms no less favorable than similar new debt 3. Borrower not experiencing financial difficulties 4. No concessions granted with principal forgiveness deemed to be an ongoing concession 52

53 Survey Question #2 True or False Under the guidance provided by NCUA s Accounting Bulletin No. 14-1, a TDR that is modified to reduce the interest rate for the next six payments is eligible to be removed from TDR status once the interest rate reverts back to the original rate, beginning with the seventh payment following this modification.

54 2014 CliftonLarsonAllen LLP Presentation and Disclosure Guidance for CECL CLAconnect.com

55 Presentation and Disclosure Requirements are similar to current disclosure requirements for loans, with some additions. For example: 1. Disclosures apply to all instruments within the scope of the proposed standard 2. Description of economic circumstances that caused changes to the allowance during the period 3. Reasons for significant changes in write offs

56 Presentation and Disclosure Information about reasonable and supportable forecasts, but not explicitly required to disclose the time period covered by reasonable and supportable forecasts.

57 Presentation and Disclosure - Changes Credit quality indicators for all classes of loans (except LOCs and credit cards) that are disclosed under current GAAP, be disaggregated by year of origination (vintage year) for the past 5 annual reporting periods, with the balance of the originations before the 5 th annual reporting period shown in the aggregate. Note: Outreach is currently being conducted on this matter.

58 2014 CliftonLarsonAllen LLP Considerations and Challenges - CECL CLAconnect.com

Effective Date By the end of 2014 with an effective date of 2016 or 2017 Q1 2015 with an effective date of 2017 or 2018 Q2 2015

59 Effective Date By the end of 2014 with an effective date of 2016 or 2017 Q with an effective date of 2017 or 2018 Q with an effective date of 2017 or 2018 A final standard to be issued by the end of 2015 with an expected effective date of

60 In the Meantime.. Challenges Regulatory and auditor unknowns Reasonable and supportable forecasts Where we are in the economic cycle Disagreement with loan pools due to difference of opinions over similar risk characteristics Which loans should be evaluated individually Future modifications of practice through this issuance of regulatory guidance Bigger institutions want more latitude while smaller institutions want more guidance. 60

61 In the Meantime Considerations Will you simply modify existing methods? Increased ALLL for life of loan estimates Determine life of loan estimates Change loan terms for future loans to mitigate impact? Add qualitative adjustment for where we are in the economic cycle What is the impact on ALLL, earnings, and capital? Doesn t take loss curve into account 61

In the Meantime Learn about acceptable methods Historical loss rates Probability of default times loss severity Risk rating categories (static pool analysis) Determine data availability

62 In the Meantime Learn about acceptable methods Historical loss rates Probability of default times loss severity Risk rating categories (static pool analysis) Determine data availability Determine quantity of data Can use different methods for different loan types Cannot choose a method only because it gives you the lowest amount of ALLL Investigate sources of industry data 62

63 Survey Question #3 True or False The use of the Current Expected Credit Loss model will require credit unions to gain an understanding of the economic life cycle of their loan types by vintage, and apply a qualitative adjustment to reserves if the credit union believes the loan is at a point in the economic life cycle where more or less losses are expected over the remaining life of the loan than historical experience would suggest.

64 2014 CliftonLarsonAllen LLP Questions? CLAconnect.com

2014 CliftonLarsonAllen LLP Todd Sprang, CPA Principal Oak

410-308-8076 Cell 410-908-5078 Chuck.Kelly@claconnect.

65 2014 CliftonLarsonAllen LLP Todd Sprang, CPA Principal Oak Brook, Illinois Direct Mobile Chuck Kelly, CPA Senior Manager Baltimore, Maryland Direct Cell CLAconnect.com twitter.com/ CLAconnect facebook.com/ cliftonlarsonallen linkedin.com/company/ cliftonlarsonallen 65

Recent Developments in Accounting and M&A for Banks

2014 CliftonLarsonAllen LLP Recent Developments in Accounting and M&A for Banks Community Bankers of Washington Annual Convention September 11, 2014 CLAconnect.com Today s presenter Todd Sprang Todd is