SAVE E THE D E DATE! E! 22nd An Annua ual CFO C Coun ouncil C Con onferen ence The Disneyland Hotel | Anaheim, CA | May 15 – 18, 2016
A Practical Guide to the Allowance for Expected Credit Loss FASB Subtopic 825-15 2
Agenda Introduction 1 Calculating the Allowance for Expected Credit Loss 2 Required Disclosures 3 Conclusions 4 Notice: FASB is still deliberating and has not made a final accounting standards update! 3
Introduction Allowance for Expected Credit Loss: Main Objective More Discussion and Disclosures The main objective of the Accounting Standards Update is to provide financial statement users with more decision useful information about an institution’s expected credit losses by requiring consideration of a broader range of reasonable and supportable information. -No “Probable” Threshold -Past, Current, and Future 4
Introduction Allowance for Expected Credit Loss: Balance Sheet Statement of Financial Condition (Balance Sheet) Assets Total Loans $100,000,000 Less Allowance for Expected Credit Loss <$2,000,000> Net Loans $98,000,000 Current estimate of cash flows NOT expected to be collected. 5
Introduction Allowance for Expected Credit Loss Dec. 31, 2015Mar. 31, 2016 From prior period Beginning Balance $2,100 $2,000 -Charge-offs $700 … +Recoveries $100 … Balance Before Expected Credit Loss Provision $1,500 … +Provision for Expected Credit Loss $500 … Ending Balance $2,000 … Then use the You first calculate the required Provision to balance Allowance for Expected Credit Loss 6
Introduction Allowance for Expected Credit loss: Income Statement Statement of Financial Performance (Income Statement) Interest Income Loans $10,000,000 Etc. $ 1,000,000 Total $11,000,000 Interest Expense Deposits/Shares $ 2,000,000 Etc. $ 0 Total $ 2,000,000 The provision reduces the Net Interest Income Net Interest Income $ 9,000,000 Less Provision for Expected Credit Loss <$ 500,000> Net Interest Income After Provision for Expected Credit Loss $ 8,500,000 7
Agenda 1 Introduction Calculating the Allowance for Expected Credit Loss 2 Required Disclosures 3 Conclusion 4 Notice: FASB is still deliberating and has not made a final accounting standards update! 8
Calculating the Allowance for Expected Credit Loss Steps Step 1. Properly Segment the portfolio Step 2. Decide on Credit Quality Indicator (CQI) to use for each Segment Step 3. Estimate the Expected Loss Rate for each Segment Step 4. Multiply the Expected Loss Rate by the Segment/CQI Balance 9
Calculating the Allowance for Expected Credit Loss Steps Step 3. Estimate an appropriate Step 1. Properly segment Expected Loss Rate, including the portfolio Expected Loss Expected economic adjustments, for each Balance Rate Credit Loss Segment Residential Mortgages A (1) $200,000,000 0.28% $560,000 B (2) 150,000,000 0.30% 450,000 C (3) 75,000,000 0.75% 562,500 D (4) 25,000,000 2.70% 675,000 Step 4. Multiply each Segment/CQI E (5) 5,000,000 6.75% 337,500 balance by its Expected Loss Rate and Sub-total $455,000,000 0.57% $2,585,000 then sum each Segment’s sub-total to calculate the Allowance for Expected Consumer-Auto Credit Loss A (1) Step 2. Decide on an appropriate Credit B (2) Quality Indicator for each Segment Etc. 10
Calculating the Allowance for Expected Credit Loss Step 1: Properly Segment the Portfolio The level at which an entity develops and Example: documents a systematic methodology to Business/Commercial determine its allowance for credit losses. SBA Commercial Real Estate a. Type of debt instrument Commercial Other b. Industry sector of the borrower Consumer c. Risk rate(s). Credit Card Auto Other Secured Too little detail Too much detail Other Unsecured Residential Find the right First Mortgage balance Other Other 11
Calculating the Allowance for Expected Credit Loss Step 2. Decide on which Credit Quality Indicators (CQI) to use for each Segment Description Credit Quality Indicator Credit scores are provided by _____ credit bureau and are updated Credit Score quarterly. The LTV is based on a loan’s combined balance (including senior liens) Loan-to-Value (LTV) divided by a current value. The PD calculates a borrower’s likelihood of defaulting, expressed between 0% and 100%. The PD model used is a hazard survival model, which is a Probability of Default (PD) conditional model that allows probabilities to change based on how long the loan has survived and based on changing loan characteristics. We assign internal risk rating based on… Internal Risk Ratings* *Must show how internal grade/rating relates to likelihood of loss 12
Calculating the Allowance for Expected Credit Loss Step 2. Decide on which Credit Quality Indicators (CQI) to use for each Segment Segment Credit Quality Indicator (CQI) Business/Commercial: All Internal Risk Rating Consumer: Credit Card PD Consumer: Auto PD Consumer: Other Secured PD Consumer: Other Unsecured Credit Score Residential: First Mortgage PD Residential: Other PD 13
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment: There are three main methods to calculating the Expected Loss Rate 1. Probability of Default Method (PD) 2. Loss Rate Method 3. Discounted Cash Flow Method (DCF) 14
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment Segment Expected Loss Rate Method Each segment can use a different Expected Loss Rate Business/Commercial: All Loss Rate-Static Pool Consumer: Credit Card PD Consumer: Auto PD Consumer: Other Secured PD Consumer: Other Unsecured Credit Scores Residential: First Mortgage PD Residential: Other PD 15
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment Economic Economic Adjustments: Adjustments: Expected Loss Base Loss Rate Reasonable & Current Rate Supportable Conditions Forecasts Think of each method for calculating the Expected Loss Rate in three parts: 1) a base rate, 2) an economic adjustment for current conditions, and 3) an economic adjustment for reasonable and supportable forecasts, even though they may all get rolled up into one or the economic adjustments may apply equally to all segments. 16
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment: PD Method 1. Probability of Default Method (PD) 2. Loss Rate Method 3. Discounted Cash Flow Method (DCF) 17
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment: PD Method Each major loan There are different type uses a different types of PD models A survival default model is type of “conditional” PD model: model -Probabilities can change based on how long a loan has “survived” -Probabilities can change based on changing characteristics of the loan Commercial Credit Card Residential Real Auto Loan Student Real Estate Etc* Model* Estate Model* Model* Lending Model* Model* Credit Score + LTV + DTI + BAL. + Unemployment + Home Prices Borrower/Loan Attributes Macro-Economic Factors *Each model has different covariates 18
Calculating the Allowance for Expected Credit Loss Step 3. Estimate the Expected Loss Rate for each Segment: PD Method For given directional change in the covariate what is the impact on PD? Covariate Direction PD Credit Score Down Up Loan to Value (LTV) Up Up Debt to Income (DTI) Up Up Balance Up Up Home Price Index Down Up Unemployment Rate Up Up 19
Calculating the Allowance for Expected Credit Loss This is an average Step 3. Estimate the Expected Loss Rate for each Segment: PD Method loan in the Los Angeles MSA Seven different loans, varying just one component of the model at a time 5 Year 5 year Credit Unemployment Change Estimated Loan ID Balance ($) Score LTV (%) DTI (%) (%) HPI (%) PD (%) F100Q1008171 175498 729 73 34 8.4 -2.21 1.52% F100Q1008175 175498 674 73 34 8.4 -2.21 2.31% F101Q4125720 175498 729 88 34 8.4 -2.21 2.75% F104Q4044107 175498 729 73 45 8.4 -2.21 1.96% F103Q1014290 185297 729 73 34 8.4 -2.21 1.53% F101Q2408723 175498 729 73 34 10.7 -2.21 2.08% F199Q3210068 175498 729 73 34 8.4 -9.91 1.61% The resulting PD LTV = Loan-to-Value DTI = Debt-to-income For example, if the credit score declines from 729 to 674, HPI = Home Price Index the PD increases from 1.52% to 2.31%. PD = Probability of Default 20
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