Pub. 10 2020-2021 Issue 5

Many corners of the banking industry are concerned that low rates, slower loan origination, and excess liquidity trends are here to stay for the foreseeable future and have begun searching for loan surrogates.

CECL Can Convert Purchase Credit Impaired and Impaired Loans

Since CECL was issued by FASB, most of the attention has been paid to data needs, modeling and forecasting in adopting CECL. However, for many institutions, the conversion of Purchased Credit Impaired (PCI) to Purchase Credit Deteriorated (PCD) and adjusting Impaired Loans to one of three CECL methods is equally important. The conversion to CECL requires the following significant steps once the historical dataset has been loaded, reconciled and validated.

  • Perform risk assessment and documentation for segment/class structure.
  • Structure pool loans to determine loss rates, prepayment rates, probability of default, loss given default and other historical pool statistics.
  • Determine loan commitments that need to have CECL allowances applied by segment/class structure.
  • Either statistically or by another method, determine which external market factors such as unemployment rate correlate with pool statistics for forecasting purposes.
  • Develop models based on historical data.
  • Convert PCI loans to PCD loans.
  • Convert impaired loans to an acceptable CECL method.

Acceptable CECL Calculation Processes

Loans under CECL are evaluated for expected credit loss using one of the three following methods:

  1. Determine Expected Credit Loss (ECL) using homogeneous risk pools, adjusted historical loss, forecasted prepayments and forecasted risk factors. These would include models such as discounted cash flow, probability-of-default, historical loan reversion and WARM models.
  2. Determine individual loan ECL calculations using individual borrower statistics and forecasted prepayment and loss analysis. Note that attaining individual borrower statistics for each loan requires significant additional effort. In order to use this method, the loan must not meet the risk characteristics of the institution’s established risk pools. Generally, these loans would be evaluated based on the borrower’s cash flows with documented loss and prepayment statistics applied. Using collateral value would not be an acceptable method for these loans.
  3. Perform a collateral dependent individual loan analysis which is similar to the collateral value impaired loan calculation used today. Collateral values should be adjusted for changes in economic environmental changes. Collateral dependent calculations will require significant effort and analysis.

Since the primary goal of CECL is to evaluate, calculate and forecast expected losses by homogeneous risk pools, the use of collateral dependent and individual loan forecasts, are significant decisions that will require additional effort and analysis initially and on a going-forward basis.

Converting Impaired Loans including TDRs

The concepts in the standard today governing impaired loans (provided under paragraph 310-10-35) were removed under the new CECL, standard. The former guidance provided stated that TDRs are, by definition, impaired loans. However, under CECL a TDR should be handled like any other originated loan. Therefore, not only do impaired loans have to be converted to an applicable CECL method, but institutions must also change processes and policies for how CECL will be evaluated and applied in future periods.

Many assume that at adoption, all impaired loans will convert to collateral dependent status. However, some impaired loans and many TDRs that are performing would not qualify as a collateral dependent because the borrower is no longer experiencing financial difficulties. Therefore, at adoption, not all impaired loans may be converted to collateral dependent loans or evaluated individually. For a loan to qualify as a collateral dependent under CECL, the evaluation requires the following:

  • Impaired loans without collateral would not qualify for collateral dependent treatment. However, they could be evaluated and forecasted individually if the loan does not share similar risk characteristics with any established risk pools. The effort to individually assess and forecast cash flows on an individual loan basis without related pool statistics will require significant effort. Therefore, all impaired loans without collateral would generally be included in the CECL allowance calculations’ pool level.
  • For collateral secured impaired loans where foreclosure is probable, the loan is by definition a collateral dependent loan. Foreclosure indicates that the borrower is experiencing financial difficulties and that the collateral’s sale is imminent or expected. Therefore, the current fair value is the best measure of credit risk and possible loss. Impaired loans in foreclosure or probable foreclosure would use the fair value of collateral as the basis of the initial CECL allowance.
  • For impaired loans with collateral that are not in foreclosure to be classified as a collateral dependent under the CECL standard, the borrower must be experiencing financial difficulties. Therefore, for each impaired loan with collateral, you must determine that the borrower is experiencing financial difficulties currently and on an ongoing basis to continue to classify the loan as a collateral dependent. Determining what borrower statistics qualify to determine that the borrower is “experiencing financial difficulties” is important to this conclusion. Could past due status be an indicator of financial difficulties? Yes, but what happens when the borrower becomes current again? Moving a loan in and out of collateral dependent status may be cumbersome based on past due status alone. Institutions need to develop policies that define when a loan meets the standard’s requirements. Since this part of the standard is a practical expedient, not required, we recommend using collateral dependent only when pool modeling is significantly underestimating the expected loss.
  • As a secondary requirement of the practical expedient, if the borrower is “experiencing financial difficulties,” the loan’s repayment must be substantially provided through the collateral’s operation or sale to apply the collateral dependent method to a collateralized loan. FASB does not define “substantially.” However, the dictionary defines substantially as “considerable in quantity.” Each institution will have to consider how they evaluate this subjective definition. FASB also does not define “through the operation of.” In general, this indicates that the asset’s revenue would cover the repayment of the loan.
  • A loan that does not fit into a risk pool can be evaluated individually as a final option. To be clear, you CAN NOT use the fair value of collateral to indicate the estimated loss. Individually evaluating a loan would require an analysis of the borrower’s ability to meet the cash flow needs of the loan and forecast borrower specific risks into the future economic environments, just like pool loans. The author believes this method takes significantly more effort than other methods. During FASB deliberations, a bank CEO in a meeting with FASB commented that all 1,500 of his commercial loans were different and did not fit into a pool structure. FASB staff commented that they could perform 1,500 individual loan forecasts with varying risk profiles if that were the case. That is not a functional or practical option!

The author believes the concept of “substantially” here is critical because if the loan is not repaid substantially through the collateral sale or operation, it would not fit the definition. It is not unusual for loans to stay on nonaccrual for periods longer than 90 days in the community bank environment. Leaving a loan in collateral dependent status for a long time is in stark contrast to the concept behind collateral dependent loans within the CECL standard. Why? Because the calculation is based on current collateral value, and collateral value can change significantly over time. Also, the longer you hold a loan in this status, it calls into question whether the borrower is having financial difficulties and why the institution has not taken action to sell the asset.

Converting Purchase Credit Impaired Loans (PCI)

In general, current impaired loans are classified as such because the borrower is having financial difficulties as of the current period. However, PCI loans are classified when purchased and, in many cases, if the loan survives for a period of time on the institution’s ledger, without charge off or re-underwriting, the presumption of “having financial difficulty” may not apply when the loan is converted to PCD under CECL.

Under current purchase accounting guidance, loans impaired on the purchased institution ledger generally become PCI loans under the acquirers’ purchase accounting entries. At purchase, these loans typically have a credit mark and a premium or discount mark applied in determining fair value at purchase. Since all PCI loans need to be converted to PCD upon conversion to CECL, each PCI loan allowance will need to be recalculated based on a CECL method and applied to each loan in converting to a PCD loan. The allowance at conversion would be calculated in one of three ways.

  1. If the borrower is “not experiencing financial difficulties,” then the allowance could be calculated either as (i) part of the risk pool the loan belongs to or (ii) individually if the loan does not fit into a risk pool. Either method requires historical analysis and forecasting cash flows into the future.
  2. If the loan is in foreclosure or probable foreclosure, the initial allowance would have to be calculated using the collateral’s fair value.
  3. If the borrower is “experiencing financial difficulties,” then the allowance could be calculated based on the fair value of collateral less related expenses.

In adjusting the PCI accounting-related values to PCD related accounting values, the net effect will be zero and, therefore, will not be part of the CECL capital adjustment. A decrease or increase in the PCI credit mark to a CECL allowance would correspond to an equivalent adjustment to the discount or premium on the respective loan.

Because these conversions only happen at adoption, we recommend that the current impaired loans and PCI loans be reviewed, but do not make the conversions until the adoption date. For most institutions, the effect of the conversion would not be material. However, if the institution has significant PCI loans with significant credit marks, the institution needs to analyze the borrowers to determine if they qualify as collateral dependent. Many of our larger institutions that have significant PCI pools have found that the conversion of the remaining credit marks to a CECL allowance have been material and, in many cases, have resulted in a reduction of the amount allocated to credit risk.

As your institution moves toward CECL adoption, there are many facets of the new CECL standard that will require significant effort and planning. Understanding how your institution will operationalize the adoption and adjusting your policies and procedures will require an understanding of all of the CECL requirements to be successful.