Pub. 10 2020-2021 Issue 5

O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S — H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S www.coloradobankers.org 18 CECL Can Convert Purchase Credit Impaired and Impaired Loans S ince CECL was issued by FASB, most of the attention has been paid to data needs, modeling and forecasting in adopting CECL. However, for many institutions, the conversion of Purchased Credit Impaired (PCI) to Purchase Credit Deteriorated (PCD) and adjusting Impaired Loans to one of three CECL methods is equally important. The conver- sion to CECL requires the following significant steps once the historical dataset has been loaded, reconciled and validated. • Perform risk assessment and documentation for seg- ment/class structure. • Structure pool loans to determine loss rates, prepay- ment rates, probability of default, loss given default and other historical pool statistics. • Determine loan commitments that need to have CECL allowances applied by segment/class structure. • Either statistically or by another method, determine which external market factors such as unemploy- ment rate correlate with pool statistics for forecast- ing purposes. • Develop models based on historical data. • Convert PCI loans to PCD loans. • Convert impaired loans to an acceptable CECL method. Acceptable CECL Calculation Processes Loans under CECL are evaluated for expected credit loss using one of the three following methods: 1. Determine Expected Credit Loss (ECL) using homo- geneous risk pools, adjusted historical loss, forecast- ed prepayments and forecasted risk factors. These would include models such as discounted cash flow, probability-of-default, historical loan reversion and WARM models. 2. Determine individual loan ECL calculations using individual borrower statistics and forecasted prepay- ment and loss analysis. Note that attaining individual borrower statistics for each loan requires significant additional effort. In order to use this method, the loan must not meet the risk characteristics of the institution’s established risk pools. Generally, these loans would be evaluated based on the borrower’s cash flows with documented loss and prepayment statistics applied. Using collateral value would not be an acceptable method for these loans. 3. Perform a collateral dependent individual loan anal- ysis which is similar to the collateral value impaired loan calculation used today. Collateral values should be adjusted for changes in economic environmen- tal changes. Collateral dependent calculations will require significant effort and analysis. Since the primary goal of CECL is to evaluate, calculate and forecast expected losses by homogeneous risk pools, the use of collateral dependent and individual loan forecasts, are significant decisions that will require additional effort and analysis initially and on a going-forward basis. Converting Impaired Loans including TDRs The concepts in the standard today governing impaired loans (provided under paragraph 310-10-35) were removed under the new CECL, standard. The former guidance provid- ed stated that TDRs are, by definition, impaired loans. How - ever, under CECL a TDR should be handled like any other originated loan. Therefore, not only do impaired loans have to be converted to an applicable CECL method, but institu- tions must also change processes and policies for how CECL will be evaluated and applied in future periods. Many assume that at adoption, all impaired loans will convert to collateral dependent status. However, some impaired loans and many TDRs that are performing would not qualify as a collateral dependent because the borrower is no longer experiencing financial difficulties. Therefore, at adoption, not all impaired loans may be converted to collat- eral dependent loans or evaluated individually. For a loan to qualify as a collateral dependent under CECL, the evaluation requires the following: • Impaired loans without collateral would not qualify for collateral dependent treatment. However, they could be evaluated and forecasted individually if the loan does not share similar risk characteristics with any established risk pools. The effort to individually assess and forecast cash flows on an individual loan basis without related pool statistics will require sig- nificant effort. Therefore, all impaired loans without collateral would generally be included in the CECL allowance calculations’ pool level. • For collateral secured impaired loans where fore- closure is probable, the loan is by definition a collat - eral dependent loan. Foreclosure indicates that the borrower is experiencing financial difficulties and that the collateral’s sale is imminent or expected. Therefore, the current fair value is the best measure of credit risk and possible loss. Impaired loans in foreclosure or probable foreclosure would use the fair value of collateral as the basis of the initial CECL allowance. • For impaired loans with collateral that are not in foreclosure to be classified as a collateral dependent BY MICHAEL UMSCHEID, PRESIDENT AND CEO, ARCSYS™