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How the Proposed Current ExpectedCredit Loss (CECL) Rule Will Affect your

Allowance for Loan and Lease Losses

Presented by Wilary WinnBrenda Lidke, Director

September 22, 2014

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

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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 valuee.g. AFS securities not included in scope

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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

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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

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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

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Not without controversy

FASB FAQ• Issued on March 25, 2013Continued 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

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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 experience8

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

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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

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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

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0%

2%

4%

6%

8%

10%

12%

14%

16%

2007 2008 2009 2010 2011 2012 2013

Unemployment Rates 2007-2014 GA 7.9%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

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0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Market Interest Rates - US Treasury Rates Forecast at 6/30/14

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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

Inflation and GDP Forecast

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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

 

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‐15.00%

‐10.00%

‐5.00%

0.00%

5.00%

10.00%

15.00%

2004

 Q2

2004

 Q4

2005

 Q2

2005

 Q4

2006

 Q2

2006

 Q4

2007

 Q2

2007

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2008

 Q2

2008

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2009

 Q2

2009

 Q4

2010

 Q2

2010

 Q4

2011

 Q2

2011

 Q4

2012

 Q2

2012

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2013

 Q2

2013

 Q4

2014

 Q2

FHFA Seasonally Adjusted House Price Index for USA

Quarterly Appreciation Annualized Appreciation from Same Quarter 1 Year Earlier

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0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%

Expected Home Price Long Term Average

Data from Pulsenomics quarterly surveys

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0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%

Expected Housing Appreciation by Region

20142015

Data provided by Case-Shiller / CoreLogicvia CNN Money

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0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

30+ Day Residential 1st Mortgage Loans By Region 

Northeast 7.10%

North Central 6.06%

South 6.90%

West 4.31%

National 6.04%

Data from SNL Financial

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

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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

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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

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Discounted Cashflow AnalysisKey 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

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Loan Example - 620 FICO group Discounted Annual Annual AnnualSched. 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%

Risk LayeringReal 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

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0.0%

2.5%

5.0%

7.5%

10.0%

12.5%

15.0%

>775 725 - 774 700 - 724 650 - 699 600 - 649

CD

R%

FICO

Average 12 month CDR% by LTV% and FICO

> 125%

105% - 125%

95% - 105%

80% - 95%

< 80%

Example of Current ALLL Calculation

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Historical Historical TDR Known TotalLoan Ending Average C/O Loss Loss Loss Q & E RequiredType Balance Balance Ratio Allowance Allowance Allowance Change AllowanceAll Mortgages 125,000,000 112,500,000 0.50% 562,500    250,000    500,000     200,000  1,512,500 

Example of Proposed ALLL Calculation - DCF Analysis

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Discounted DiscountedAnnual Annual Gross Discount Discounted Lifetime Annual

Loan Payment Credit LTV Ending Prepay % Default % Loss Avg Future Rate Future Future FutureType 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 BucketsCurrent 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%

Difference in MethodologyMuch 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

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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%

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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

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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.

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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

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Miscellaneous ItemsRedefines 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.

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Miscellaneous Items - ContinuedDefines 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

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Contact Information

Wilary Winn LLCFirst National Bank Building

332 Minnesota Street, Suite 1750WSaint Paul, MN 55101

651-224-1200

www.wilwinn.com

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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

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