Miles To Go Before ‘VE’ Sleep!
April 2019

On our last rendezvous, I told you how I was neck deep working on our Investment Analytics Module. A quick update for those of you who are eager to find out - it is coming along really well! We will talk about it more in the next few months to come. Today, let’s talk about CECL – Current Expected Credit Loss. Why, you may ask?

First, CECL is one of the most talked about topics at Visible Equity and I suspect it will continue to be so for a while as we help our clients implement their chosen CECL methodology. Secondly, we can't talk about CECL without talking about the impact it has on investments. See where I'm going with this?

On a more serious note, the CECL clock is ticking and it's time to make sure you are prepared. As you can imagine, it is very important to understand what CECL means from an investment's perspective for a financial institution. I mustered the courage and energy to read through the FASB Accounting Standards Update (ASU) and delved-in to understand the scope. At the outset we need to understand what's in the scope and what's not. Here's what I found.

The FASB ASU only includes securitized financial assets that have an associated contractual cash flow (such as interest payments, fixed rate dividends etc.). What this means is that, any securitized financial assets that do not involve a contractual cash flow such as common stock, equity securities etc. are excluded.  In other words the scope narrows down to include only securities that result in a predetermined contractual cash flow. Here is a summarized definition of what is in scope for CECL according to FASB:

Any security representing a creditor relationship with an entity; which are either debt securities or required to be accounted for like debt securities:

  • Preferred stock that by its terms either must be redeemed by the issuing entity or is redeemable at the option of the investor
  • A collateralized mortgage obligation (or other instrument) that is issued in equity form but is required to be accounted for as a non-equity instrument regardless of how that instrument is classified (that is,whether equity or debt) in the issuer’s statement of financial position
  • U.S. Treasury securities
  • U.S. government agency securities
  • Municipal securities
  • Corporate bonds
  • Convertible debt
  • Commercial paper
  • All securitized debt instruments, such as collateralized mortgage obligations and real estate mortgage investment conduits.
  • Interest-only and principal-only strips

From an accounting standpoint, financial Institutions classify their investment securities into one of the below three categories. All of the above-mentioned security types fall under one of these three classifications based on a financial institution’s investment strategy.  

Trading Securities: Securities that are bought and held principally for the purpose of selling in the near term. This would typically include Equities or Debt securities. The new accounting standard does not apply to Trading securities.

Held to maturity (HTM): Debt securities that the firm has positive intent and ability to hold until maturity. (Equities can’t be included in this category since they don’t have an associated maturity date.) 

Available for sale (AFS): A catch-all for debt and equity securities not captured by either of the above definitions. These are securities that a financial institution may retain for long periods but that may also be sold.

A few aspects to know about these classifications-  

  • Trading Securities (such as equities or debt) are bought and sold in the short term.
  • Available For Sale and Held To Maturity securities are generally intended to be held for investment rather than short-term sale.
  • Trading Securities and Available For Sale securities are recognized at their fair value whereas Held to Maturity securities are measured at amortized cost. [It is the cost of a security, plus or minus adjustments for any purchase discounts or premiums associated with the purchase of the security. Note: The market value here could potentially be much higher or lower than the original cost of an asset net of its amortized cost.]
  • Though both AFS and trading securities are marked to market at fair value, there is a difference. With AFS unrealised gain/loss is excluded from earnings and with trading securities unrealised gain/loss are included in earnings.

Below is an example of how these three classifications looks in the Credit Union industry over a 10 year period.

Clearly, HTM and AFS makes for the lion’s share of the aggregate investments in this industry, and that is in our SCOPE for CECL calculations. The ASU applies to all financial instruments carried at amortized cost, though the new accounting standard also makes targeted improvements to the accounting for credit losses on available-for-sale (AFS) debt securities. In addition, institutions will need to determine how to segment their HTM debt securities portfolio so that they share similar risk characteristics.

There is a lot more to the complexity of how the CECL calculation will need to be done for investments. That will be a discussion in our future installment of this topic. We at Visible Equity (VE) are committed and saddled up on this journey! Our emotions are riding high and well captured by Robert Frost’s words –

The woods are lovely, dark and deep,

But I have promises to keep,

And miles to go before I sleep,

And miles to go before I sleep!

 

Brinda Jaikumar
Product Director

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