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Ready for CECL?

By Rob Chrisman, Senior Advisor

Sure, we have the expiration of the QM Patch to worry about in January of 2021, unless Fannie Mae and Freddie Mac exit conservatorship. But here’s something else to be aware of: every originator knows that the demand for loans in the secondary market directly impacts their options in the primary market. Put another way, if no one wants to buy or own what you originate, it won’t be on your rate sheet. And, anything that impacts the demand for products in the secondary market also impacts rate sheets and borrowers. If you had to account for your future losses now, would that make a lender or bank think twice about funding a loan?

So it is with great interest that financial institutions are following CECL: the Current Expected Credit Loss standard. The new standard takes effect in 2020, 2021, or 2022, depending on an institution’s characteristics, but the soonest is December 15, 2019. It effectively requires life-of-loan loss estimates to be recorded at the point of origination. It is a big deal for banks and naturally has become the focal point of much consternation lately. Industry insiders believe that the implementation of Financial Accounting Standards Board’s (FASB) CECL accounting standard could have “drastic pro-cyclical” repercussions on the GSEs and credit unions.

While the new CECL model will indeed impact financial institutions more heavily, non-financial services entities are also included in the scope of this standard and worries are it will exacerbate many of the hurdles to extending credit that institutions are already facing in the wake of increased capital requirements. CECL is intended to be scalable for institutions of all shapes and sizes. Critics say it will result in a myriad of pricing algorithms that may negatively impact borrowers and result in a wide range of risk-based pricing based on what company is funding the loan and buying it.

Why even do it? According to an FDIC FAQ, “In the period leading up to the global economic crisis, institutions and financial statement users expressed concern that current U.S. GAAP restricts the ability to record credit losses that are expected, but that do not yet meet the “probable” threshold. After the crisis, interested parties requested that accounting standard-setters work to enhance standards on loan loss provisioning to incorporate forward-looking information. Standard-setters concluded that the existing approach for determining the impairment of financial assets, based on a ‘probable’ threshold and an ‘incurred’ notion, delayed the recognition of credit losses on loans and resulted in loan loss allowances that were ‘too little, too late.’”

The new accounting standard applies to all banks, savings associations, credit unions, and financial institution holding companies, regardless of size, that file regulatory reports for which the reporting requirements conform to U.S. generally accepted accounting principles (GAAP). Lenders should know that the new accounting standard does not apply to trading assets, loans held for sale, financial assets for which the fair value option has been elected.

Despite the new standard impacting companies’ accounting processes and the way credit impairments are assessed and recognized, many companies have not yet started an implementation plan. In early April, FASB rejected a request from mid-sized banks to tweak some sections of CECL that would help eliminate confusion for auditors, investors and banks. FASB stated it would force institutions and auditors to make complex judgments or decisions: the new CECL model measures impairment over the expected life of the asset.

Under CECL, the allowance for credit losses is an estimate of the expected credit losses on financial assets measured at amortized cost, which is measured using relevant information about past events, including historical credit loss experience on financial assets with similar risk characteristics, current conditions, and reasonable and supportable forecasts that affect the collectability of the remaining cash flows over the contractual term of the financial assets. In concept, an allowance will be created upon the origination or acquisition of a financial asset measured at amortized cost. The allowance will then be updated at subsequent reporting dates.

Specifically, this expected credit loss guidance applies to financial assets measured using amortized cost basis, trade receivables from revenue transactions in the ordinary course of operations, held-to-maturity debt securities, receivables, net investments in leases, and certain off-balance-sheet credit exposures such as standby letters of credit, and other similar instruments.

Implementation is no small feat. The CECL model doesn’t specify the methodology to be used; rather, it allows entities to select the methodology that management deems the most appropriate for the business and the nature of the company’s financial assets. Some methods for estimating expected credit losses include Probability of Default/Loss Given Default Method, Vintage Analysis Method, Discounted Cash Flow Method, and Loss Rate Method.

Without miring you down in accounting minutia, credit impairment will be recognized as an allowance for credit losses, rather than as a direct write-down of the amortized cost basis of a financial asset. The impairment allowance is a valuation account deducted from the amortized cost basis of financial assets to present the net amount expected to be collected on the financial asset. The allowance for credit losses must be adjusted for management’s current estimate at each reporting date. But the new guidance provides no threshold for recognition of impairment allowance so entities must measure expected credit losses on assets that have a low risk of loss.

What’s a lender to do? STRATMOR is recommending a series of actions to aid implementation. They include forming an implementation team, evaluating the types of financial assets that are subject to the new guidance, confirming your implementation deadline, and establishing an implementation project plan. Are you impacted? What does your CFO know about it? Might it impact your rate sheets?

Good news? At this point, with respect to BASEL III capital requirements, the implementation of CECL is expected to lower Common Equity Tier 1 capital ratios because the standard will increase loan loss provisions. Mortgage servicing rights final BASEL III capital rules remain a top priority for regulators, however they remain unpublished.  In addition, the Community Bank Leverage Ratio (“CBLR”) comment period expired in early April, and Community Banks remain hopeful they will be allowed to include up to 25 percent of their MSR in the CLBR ratio. Lenders who originate high quality loans will continue to receive better pricing from their investors than those lenders that don’t. Pricing and underwriting engines are analyzing CECL’s implications on pricing granularity, further “sharpening their pencils.”

The new credit impairment standard will be effective for fiscal years beginning after December 15, 2019, for public business entities (PBE) that are SEC registrants; after December 15, 2020, for other public business entities that are not SEC filers; and after December 15, 2021, for non-public business entities and nonprofit organizations. Early adoption is permitted.

Because CECL is new and different, your communication strategy will likely need to use qualitative and quantitative information to tell a complex story about an estimate with significant stakes for your market valuation. You’ll need to invest substantial time in developing a communication strategy, starting early to identify the questions that investors may ask and crafting intelligent, accurate answers. Start with a simple explanation of CECL terms and key ideas. Then, describe the methodology and any new judgments that management will need to make. Add a visual depiction of the economic assumptions that go into CECL compliance and a description of CECL’s effects on each lending portfolio, and you’ve started toward explaining what’s happening and what it means for your institution.

Other questions for residential lenders of all sizes to consider include: What’s the effect of CECL on a bank’s current and future capital plans? Will risk-based pricing be handled by our current rate sheet generating models? How does it affect a company’s capital (primarily at adoption and during the first post-adoption transition)? Will CECL mean that your company cancels or delays new products? There are plenty of others. Stay tuned for updates.

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