This last week Visible Equity hosted a virtual webinar on CECL and how it affects your ALLL. We had a huge turnout and would like to thank everyone for attending. During the webinar there were many questions that did not get answered. The answers to most of the questions can be found below. If you missed the webinar you can watch it above or download the slides below.
We are also hosting part 2 of the webinar on Thursday June 25th. If you are interested in attending you can register by clicking on the link at the bottom of the article.
Why did FASB require the discount rate to be the effective interest rate?
We think the primary reason is for consistency in financial reporting. FASB states that the balance sheet should faithfully represent the present value of cash flows expected to be collected. If the discount rate does not match the interest rate, the net loans reported on the balance sheet could be misleading. Allowing flexibility in determining the appropriate discount rate could also lead to difficulty in auditing and understanding credit loss assumptions.
When we talk about cash flows on the loan over the life of the loan, I have heard that this includes P&I, not just cash flow from principal repayment. Are we reserving for lost interest as well?
The Allowance for Expected Credit Loss is the estimate of all cash flows (principal and interest) not expected to be collected, but in practice the interest portion is offset by discounting the cash flows by the effective interest rate (explicitly in a discounted cash flow model or implicitly in other methods), so we believe the net result is that you do not end up reserving for lost interest.
Is the Collateral Value at current level of value or future value? If present, is the future collateral value (appreciation) just ignored?
In a discounted cash flow model, it is conceivable to project a collateral value (or the loss severity) on a loan by loan basis for future periods, as we did in the example in the webinar. In the probability of default model the collateral value is the current value and future values are not taken into consideration. In a loss rate method, collateral values are only considered in calculating past losses, so obviously future values are not considered. That said, all methods need to include an economic adjustment for reasonable and supportable forecasts, which should likely include an analysis of area home prices.
How will you gather the factor for past events? Give an example.
The most obvious example is charge-off experience over a certain point in the economic cycle. In addition, our probability of default models were developed based on past events. Of course, updated information is inputted into the models to give current results, but the models themselves are based on past events.
Will all three methods (Discounted Cash Flow, Probability of Default, Loss Rate) provide a similar result? If not, does this not just muddy the waters even more?
In theory, with appropriate adjustments, all three methods should provide similar results. In practice, this will be heavily institution specific. We caution users not to pick a method based on results, but rather what makes the most sense for their institution and product mix.
Which method do you prefer?
Visible Equity is not taking a stand on a preferred method. All have their pros and cons and each institution will need to make a decision based on their unique situation. From a personal perspective, I like the probability of default method. It’s sophisticated, but not overly complicated. However, it’s not appropriate for all institutions and all loan types. A simple loss rate model will probably be the right choice for a lot of institutions.
Shouldn’t defaults be included in prepayments?
A default is a form of prepayment. A variation on the discounted cash flow method is to estimate prepayments that include both loans that default and loans that prepay in full and then use a default proportion and a loss severity to estimate expected credit losses. The benefit of this variation is you get cash flow estimates. The drawback is it involves an extra step not required to calculate the expected credit loss. With either analysis you end up in the same place. Visible Equity will probably take the more direct route and separate prepayments in full from prepayments due to defaults.
On the probability of default slide, you show loans with a zero expected loss. Is this allowed?
We think so. We are not aware of anything in the accounting standards update prohibiting such a calculation and it makes intuitive sense to us that if a loan defaults, but the collateral is sufficient to cover the debt and expenses then no net loss will occur. If further guidance prohibits such analysis we will make appropriate adjustments.
Does Visible Equity’s Expected Loss by Probability of Default essentially fill the FASB requirement, or will it be substantially expanded in the next few years?
Both. At a very core level we believe our expected loss model fills FASB’s requirements. However, we first developed our expected loss model in 2007, before the financial crisis hit in full force, and well before FASB began this project. So, while the intent and core of our expected loss model presciently fills FASB’s requirements, we will be making significant changes to our software to more intuitively integrate economic data and forecasts, improve the overall display of the data, and provide more convenient disclosure reporting.
Can you change methods?
Yes, assuming you have a legitimate reason, but any changes require disclosure and may be seen as a red flag that an institution is shopping methods for “better” expected loss results.
Can you use different methods for different loan types?
Yes, certain methods are more appropriate for certain loan types. For example, a probability of default model may not be the best method for business and CRE loans so an institution may want to use a discounted cash flow or loss rate method for such loans.
What does CECL stand for?
Current Expected Credit Loss
Does the probability of default have to be assigned to an individual loan? Where do we get these probabilities?
Not necessarily, but Visible Equity provides loan level probability of default metrics and we think it’s best practice to calculate key metrics on the loan level for easy disaggregation and reporting.
Will we get to choose which method to use?
Yes, we intend to allow users to select their preferred method(s).
Can we get some Visible Equity socks? Yes! Anyone who wants some Visible Equity socks can email firstname.lastname@example.org and we’ll get some sent to you right away…