There has been a lot of talk recently about lines of credit (LOCs) in CECL – and for good reason! When CECL demands an estimate of lifetime loss for an asset class without a well-defined lifetime, people are going to talk. One of the key steps in carrying out any CECL-compliant loss methodology is to determine the loss period, or the period over which expected losses are to be calculated. Depending on the methodology, this might take the form of a lookback period, a look-forward period, or some similar concept. The correct loss period for a true CECL calculation should be at least the remaining contractual term of the class. While this is easy to determine for closed-end loans with clearly defined contractual terms, it is less obvious what to use as the loss period for revolving loans.
The Transition Resource Group (TRG) for credit losses released a memo related to this topic in June of 2017. In it, they conclude that there is flexibility in the determination of the “life” of a credit card receivable, but that a preferred approach would be to treat the receivable as a closed-end loan whose lifetime is the time it takes for future payments to exhaust the current principal (where the totality of future payments is allocated to the current principal until it reaches zero). Visible Equity uses this as a guide in our line-of-credit CECL calculations. For each LOC class, there are actually two resulting outcomes: expected losses on the reporting date receivable (funded portion) and expected losses on the reporting date unfunded commitments. Of course, the further we look into the future, the more the risk is transferred from the funded to the unfunded portion of the balance as the funded portion gets paid down by anticipated payments.
After a certain point in the future, the bulk of the reporting date balances should be paid off, and most of the balance will be due to future payments or withdrawals. We were curious about when that point of time would be, so we looked at an example institution. Using Vintage analysis on a credit card portfolio, we carried out calculations using look-forward periods ranging from 1-30 years.
We then observed the resulting funded and unfunded loss rates. The results are shown in the above chart (note that the curves represented are not “loss curves” but are the estimated cumulative loss rates resulting from the x-axis look-forward periods). Of course, the longer the look-forward period, the higher the loss rates. But what we are interested in is the slope of the increase. Observe the funded rates represented in orange (if this asset class is unconditionally cancellable, the orange line is all we need to worry about). Notice that the loss rate slowly increases until we reach a look-forward period of 15 years at which point it is almost constant. This means that, according to historical behavior, almost all the risk in our reporting date balance is represented in the next 15 years. After that, any charge-offs observed will most likely come from future purchases. It follows that a reasonable “lifetime” of this portfolio’s credit card receivable is 15 years.
On the other hand, observe that the unfunded rates continue to climb almost linearly up until the 30-year mark. This indicates that we can reasonably expect losses 25-30 years into the future on our current credit card accounts, but they will most likely be on current unfunded commitments. It is unclear from current FASB guidance what should be considered the “lifetime” of unfunded commitments. We do anticipate future direction from FASB, but for now we feel that using the lifetime of the reporting date receivable (15 years in this example) is sufficient for both the funded and unfunded calculations.