How the Proposed Current Expected Credit Loss (CECL) Rule Will Affect your Allowance for Loan and Lease Losses Presented by Wilary Winn Brenda Lidke, Director September 22, 2014 1
Topics Covered Proposed standard Data to start tracking Example of current ALLL model vs discounted cashflow example that meets CECL Non loan items affected by CECL 2
FASB Proposed Accounting Standards Update (ASU) Issued on December 20, 2012 Will significantly change the allowance for loan and lease losses and other approaches to impairment Newly created subtopic Financial Instruments: Credit Losses (Subtopic 825-15) Not just the ALLL, applies to all financial assets not classified at fair value e.g. AFS securities not included in scope 3
Instrument Type All financial assets - debt instruments, leases, and loan commitments The term debt instrument is defined in the proposal as a receivable or payable that represents a contractual right to receive cash (or other consideration) or a contractual obligation to pay cash (or other consideration) on fixed or determinable dates, whether or not there is any stated provision for interest. Covers loans, debt securities, trade receivables, reinsurance receivables, lease receivables, and loan commitments 4
Amortized cost should be based on the present value of the cash flows an entity expects to collect Contractual cash flows are adjusted for expected prepayments and defaults Cash flows should not be adjusted for extensions, renewals, or modifications unless a TDR is reasonably expected Cash flows expected to be collected are discounted at the effective interest rate Cash flows not expected to be collected are also discounted at the effective interest rate 5
Why the Change? GAAP did not properly reflect risk pre-financial crisis because of the delayed recognition of credit losses Financial Crisis Advisory Group 362 comment letters investors generally in favor of CECL and preparers generally not Departs from the incurred loss model which means the probable threshold is removed Removes the prohibition on recording day one losses 6
Not without controversy FASB FAQ Issued on March 25, 2013 Continued re-deliberations FASB not expected to re-expose ASU FASB states that a final ASU will be issued by the end of this year consensus is mid-2015 effective for 2017 or 2018 7
Measuring Expected Credit Losses Begin with historical loss rates for similar assets (grouped approach) Static pool for example Adjust for current conditions Adjust for reasonable and supportable forecasts Life of loan estimate - can assume economic conditions after the end of the reasonable forecast time period remain the same or can revert to historical loss rates Final guidance is expected to state that the entity should revert to historical loss experience 8
Final Guidance Final guidance will include implementation guidance describing the factors that an entity should consider to adjust historical loss experience for current conditions and reasonable and supportable forecasts 9
Technical Considerations Permits allowance calculation to be based on methods which implicitly include the time value of money DCF explicitly considers time value of money Loss-rate, roll-rates, probability of default methods, and provision matrices implicitly consider discount Contemplates use of mean and not mode if using statistical modeling 10
Economic Conditions to Start Tracking Now Unemployment national and local Current and expected interest rates Forward curves Monetary policy Inflation GDP (Gross Domestic Product) growth rates Expected housing appreciation/depreciation Credit union industry performance as a whole 11
Unemployment Rates 2007-2014 GA 7.9% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2007 2008 2009 2010 2011 2012 2013 12 MI 7.9% CA 7.3% OR 6.7% FL 6.2% MD 6.2% National 6.1% WI 6.0% MA 5.6% MN 4.6% MT 4.6% IA 4.5% NE 3.7%
Market Interest Rates - US Treasury Yield Curve at 6/30/14 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 13
Market Interest Rates - US Treasury Rates Forecast at 6/30/14 Rate Forecast Q3 14 Q4 14 Q1 15 Q2 15 Q3 15 US 10-Year 2.75 2.94 3.11 3.28 3.42 US 2-Year 0.60 0.76 0.96 1.21 1.48 Spread 2-10 2.15 2.18 2.15 2.07 1.94 14
Inflation and GDP Forecast Economic Indicator Q3 14 Q4 14 Q1 15 Q2 15 Q3 15 Fed Funds Target 0.25 0.25 0.25 0.38 0.63 Unemployment 6.10 5.90 5.80 5.70 5.60 Real GDP growth 2.95 3.00 2.90 2.95 2.95 CPI 2.10 2.20 2.20 2.05 2.10 15
FHFA Seasonally Adjusted House Price Index for USA Quarterly Appreciation Annualized Appreciation from Same Quarter 1 Year Earlier 15.00% 10.00% 5.00% 0.00% 5.00% 10.00% 15.00% 2014 Q2 2004 Q2 2004 Q4 2005 Q2 2005 Q4 2006 Q2 2006 Q4 2007 Q2 2007 Q4 2008 Q2 2008 Q4 2009 Q2 2009 Q4 2010 Q2 2010 Q4 2011 Q2 2011 Q4 2012 Q2 2012 Q4 2013 Q2 2013 Q4 16
4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Expected Home Price Long Term Average Data from Pulsenomics quarterly surveys 17
Expected Housing Appreciation by Region 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2014 2015 Data provided by Case-Shiller / CoreLogic via CNN Money 18
30+ Day Residential 1st Mortgage Loans By Region 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Northeast 7.10% North Central 6.06% South 6.90% West 4.31% National 6.04% Data from SNL Financial 19
Loan Data to Start Tracking Now Loan product type 30yr Fixed, HELOC, New Vehicles Loan Terms rate, amortization term, original balance Delinquency status Defaulted loan balance and date at the loan level Recovered amounts and date of recovery by loan Prepayments at the loan level date and balance Current CLTV (Combined Loan to Value) Current FICO 20
How Should the Loan Data be Tracked? Easily accessible database of loans Depends on loan volume Could use Excel or Access Alternatively, there are companies that specialize in data storage Save pertinent information each quarter-end 21
What Else Should My Credit Union be Doing Now? Use the data to explore forecasting Look at using the different economic factors and how these will adjust prepay and default assumptions Run a parallel ALLL model Credit unions that create the proposed model now will have a better chance of a successful implementation later To have a better understanding of the magnitude of reserve change that will be required 22
Discounted Cashflow Analysis Key Valuation Inputs: Conditional Repayment Rate (CRR) Conditional Default Rate (CDR) Conditional Prepayment Rate (CPR = CRR + CDR) Loss Severity Discount Rate depends on accounting context. For CECL it is original yield 23
Loan Example - 620 FICO group Discounted Annual Annual Annual Sched. P&I payment $ 30,686.07 Losses CRR% CDR% Severity% $ 196,507 5.0% 3.5% 20% Loan Remaining Repo Total Total Repo Valuation Payment Loan Actual Voluntary Prin Prin P&I DQ Repo Prin Monthly Monthly Monthly Month Month Balance Amort Prepays Recoveries Collected Interest Collected Balance Balance Liquidations Losses CRR% CDR% Severity% 0 23 5,000,000-1 24 4,973,028 5,669 21,302-26,972 24,926 51,897 14,823 - - - 0.43% 0.30% 20% 2 25 4,946,248 5,656 21,124-26,781 24,718 51,498 29,521 - - - 0.43% 0.30% 20% 3 26 4,919,657 5,644 20,947-26,591 24,511 51,102 44,097 - - - 0.43% 0.30% 20% 4 27 4,893,255 5,631 20,772-26,402 24,306 50,708 58,551 - - - 0.43% 0.30% 20% 5 28 4,867,039 5,618 20,598-26,216 24,102 50,317 72,884 - - - 0.43% 0.30% 20% 6 29 4,841,009 5,605 20,425-26,030 23,900 49,930 87,096 - - - 0.43% 0.30% 20% 7 30 4,815,164 5,593 20,253-25,846 23,699 49,545 86,366 14,823 - - 0.43% 0.30% 20% 8 31 4,789,501 5,580 20,083-25,663 23,500 49,163 85,642 29,521 - - 0.43% 0.30% 20% 9 32 4,764,020 5,567 19,914-25,481 23,302 48,783 84,924 44,097 - - 0.43% 0.30% 20% 10 33 4,738,719 5,555 19,746-25,301 23,106 48,407 84,211 58,551 - - 0.43% 0.30% 20% 11 34 4,713,598 5,542 19,580-25,122 22,912 48,033 83,503 72,884 - - 0.43% 0.30% 20% 12 35 4,688,654 5,529 19,414-24,944 22,719 47,662 82,800 87,096 - - 0.43% 0.30% 20% 13 36 4,663,887 5,517 19,250-24,767 22,527 47,294 82,103 101,189 - - 0.43% 0.30% 20% 14 37 4,639,295 5,504 19,088-24,592 22,337 46,929 81,411 115,164 - - 0.43% 0.30% 20% 15 38 4,614,876 5,492 18,926-24,418 22,148 46,566 80,725 129,021 - - 0.43% 0.30% 20% 16 39 4,590,631 5,480 18,766-24,245 21,960 46,206 80,043 142,762 - - 0.43% 0.30% 20% 17 40 4,566,557 5,467 18,607-24,074 21,774 45,848 79,367 156,386 - - 0.43% 0.30% 20% 18 41 4,542,654 5,455 18,449-23,904 21,590 45,493 78,696 169,896 - - 0.43% 0.30% 20% 18-338 42-360 0 1,239,624 1,799,821 1,205,709 4,245,154 2,109,775 6,354,928 - - 1,503,209 297,500 0.43% 0.30% 20% Total 1,339,728 2,157,063 1,205,709 4,702,500 2,527,810 7,230,310 1,503,209 297,500 0.43% 0.29% 20% 24
Risk Layering Real Estate Loans Key Loan Attributes Interest rate fixed or variable Contract term balloons, hybrids, etc. Lien position Closed or open ended Source retail vs. wholesale Loan purpose primary, second home, investor Debt to income ratios Credit score Combined Loan-to-Value ratio 25
Average 12 month CDR% by LTV% and FICO 15.0% CDR% 12.5% 10.0% 7.5% 5.0% > 125% 105% - 125% 95% - 105% 80% - 95% < 80% 2.5% 0.0% >775 725-774 700-724 650-699 600-649 FICO 26
Example of Current ALLL Calculation Historical Historical TDR Known Total Loan Ending Average C/O Loss Loss Loss Q & E Required Type Balance Balance Ratio Allowance Allowance Allowance Change Allowance All Mortgages 125,000,000 112,500,000 0.50% 562,500 250,000 500,000 200,000 1,512,500 27
Example of Proposed ALLL Calculation - DCF Analysis Discounted Discounted Annual Annual Gross Discount Discounted Lifetime Annual Loan Payment Credit LTV Ending Prepay % Default % Loss Avg Future Rate Future Future Future Type Status Score Status Balance (CRR) (CDR) Severity % Life Losses (WAC) Losses Losses % Losses % Fixed 30 yr Current 720+ Under 50% 25,000,000 10% 0.0% 0% 6.0 4.0% 0.0% 0.0% Current 720+ 50% 75% 15,000,000 9% 0.1% 10% 6.5 9,750 4.0% 7,556 0.1% 0.0% Current 720+ 75% 100% 10,000,000 8% 0.1% 15% 7.0 10,500 4.0% 7,979 0.1% 0.0% Current 720+ 100% 120% 5,000,000 7% 0.4% 17% 7.5 24,750 4.0% 18,443 0.4% 0.0% Current 720+ 120% 150% 5,000,000 4% 1.3% 23% 9.0 132,210 4.0% 92,889 1.9% 0.2% Current 720+ Over 150% 5,000,000 4% 1.8% 42% 9.5 359,955 4.0% 247,988 5.0% 0.5% Repeat for FICO Buckets Current 660 719 by LTV bucket 5,000,000 6% 0.7% 20% 8.5 55,250 4.5% 38,005 0.8% 0.1% Current 620 659 by LTV bucket 5,000,000 5% 3.5% 20% 8.5 297,500 5.0% 196,507 3.9% 0.5% Current 500 619 by LTV bucket 5,000,000 4% 13.0% 20% 5.5 715,000 5.5% 532,620 10.7% 1.9% Current Under 500 by LTV bucket 5,000,000 4% 20.0% 20% 4.5 900,000 5.5% 707,305 14.1% 3.1% Delinquent 30+ days 500,000 4% 30.0% 20% 4.5 135,000 4.0% 113,158 22.6% 5.0% Delinquent 60 89 days 500,000 2% 50.0% 20% 3.0 150,000 4.0% 133,349 26.7% 8.9% Delinquent 90+ days 500,000 2% 75.0% 20% 2.5 187,500 4.0% 169,988 34.0% 13.6% ARM 10/1 repeat all FICO & LTV buckets above 38,500,000 8% 2.0% 20% 6.0 924,000 3.5% 751,675 2.0% 0.3% Total Mortgages 125,000,000 8% 2.9% 15% 6.5 3,901,415 4.0% 3,017,462 2.4% 0.4% 28
Difference in Methodology Much more detail is required loans are grouped by like characteristics LTV, FICO, amortization term, etc. Prepay (CRR) and default (CDR) assumptions are built from historical losses by group and adjusted for economic environment Loan terms, interest rates, and scheduled amortization are used in the calculation Results under new methodology are 2x higher than current results 29
What is the expected change in your organization s provision under the proposed rules? Decrease Increase by 25% Increase by 25% to 50% Increase more than 50% 30
For Purchased Credit-Impaired (PCI) financial assets Amortized cost would be the purchase price plus the associated expected credit loss at acquisition. The difference between amortized cost and the par amount (noncredit discount or premium) is amortized or accreted into income The credit discount is not accreted - establish a day one allowance instead Permits increases in expected cash flows to be recognized immediately significant shift from current GAAP Final rule is expected to state that non-credit related discount/premium should be allocated to the individual assets purchased 31
TDR Guidance Use the modified contractual cash flows, discounted at the original effective interest rate Initial rule stated that the difference would be recorded by a basis adjustment rather than an allowance However, the final rule will clarify that an entity is required to increase the cost basis of the restructured asset through a corresponding increase in the entity s allowance for expected credit losses in certain TDRs. The effect is that the write-down is not permanent and the reserve is recoverable. 32
No more other than temporary impairment (OTTI) model for debt securities Change from individual security evaluation to include pool evaluations Record an allowance instead of direct write-off (allows the opportunity for reversal) For assets carried at FV/OCI, there is a practical expedient available. Credit losses do not have to be recognized if both: Fair value equals or exceeds the amortized cost (which is the first step in the existing OTTI model); and Expected credit losses on the asset are insignificant 33
Miscellaneous Items Redefines collateral-dependent in the glossary 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. Clarifies that operation is by the lender and removes the word solely Final rule is expected to state that on collateral-dependent assets, the reserve is measured as the difference between the collateral s fair value (less selling costs) and the amortized cost basis of the asset. 34
Miscellaneous Items - Continued Defines nonaccrual, cost-recovery and cash-basis methods, write-off (charge-off) Final guidance is expected to clarify that an entity is not required to recognize a loss on a financial asset for which the risk of nonpayment is greater than zero, yet the amount of the loss would be zero - Example have a CDR, but have a zero loss severity 35
36
Contact Information Wilary Winn LLC First National Bank Building 332 Minnesota Street, Suite 1750W Saint Paul, MN 55101 651-224-1200 www.wilwinn.com 37
Services and Contact Information Private Label MBS/CMOs and Asset Liability Management: Frank Wilary fwilary@wilwinn.com Mergers and Acquisitions, Fair Value Footnotes, ASC 310-30, and TDRs: Brenda Lidke blidke@wilwinn.com Mortgage Servicing Rights and Mortgage Banking Derivatives: Eric Nokken enokken@wilwinn.com 38