Math Gets Tough for Loan Losses

The nation’s accounting board recently gave credit unions another year to meet a tougher standard for accounting for loan losses, and credit unions will need every second.

Trade groups have regularly complained about more detailed reporting required by regulators, but extra data will be gold for credit unions trying to meet the demands of the Financial Accounting Standards Board.

This isn’t a case of meddlesome government bureaucrats or overreaching lawmakers; it’s just business.

FASB is a private, not-for-profit group whose mission is to set and improve the Generally Accepted Accounting Principles used by businesses. Regulators, including the NCUA, defer to its standards for regulatory benchmarks.

The U.S. standard for estimating credit losses was revised in June 2016 from one that used losses from the previous 12 months to estimate losses for the next 12 months. The new standard for Current Expected Credit Loss would reflect all losses that were likely to occur during the lifetime of the loan based on loan history, current conditions, and “reasonable and supportable” forecasts.

In July, FASB clarified its calendar, stating credit unions and other non-SEC filers have to start using CECL with beginning balances on Jan. 1, 2022 in order to capture the year ending Dec. 31, 2022. Previous instructions were interpreted to mean credit unions had to set CECL beginning balances a year earlier.

Yet time remains critical, according to those involved in implementing the standard.

Fiserv, a financial services company based in Brookfield, Wis., is one of many vendors ready to help credit unions.

John Dalton, Fiserv’s director of product strategy management for Financial & Risk Management Solutions, said a common misconception is that the standard will be enforced less for smaller institutions.

“This is a GAP accounting standard, as opposed to a financial regulation,” Dalton said. “Everybody is going to have to comply.”

Credit unions need to make a plan, amass their data and choose models – ideally by 2019. They will need a full year to parallel test their models against actual losses. They will need another three to six months for an outside vendor to validate their models.

Unless they are planning on perfection, they will need to allow more time to correct for errors and allow for improvements.

“You want to make sure your CECL estimates are going to be working going forward and ready to go once the light kicks on,” said Jeff Prelle, head of risk modeling at MountainView Financial Solutions, a Denver, Colo.-based provider of advisory and analytics to the financial services industry.

Dalton outlined three steps credit unions need to be taking to prepare:

1. Build a team representing all asset classes.
2. Determine what data is available. If vital data is missing, start collecting it now and find out if comparable data can be bought.
3. Pick your models. They can differ by class and they don’t have to be complicated.

Credit unions are likely going to want to shift their methods over time, so they should start collecting and storing more detail now so data can be disaggregated later as needed.

“You need lots of history so you can project over the entire behavioral life of the loan,” Dalton said.

He added, “Get your data collection system in place as quickly as possible. When CECL enforcement comes, you want to have as much data collected as possible given the amount of time that was available to prepare.”

Data requirements are huge and the balance sheet impact will be significant, Derek A. Fuzzell, vice president of finance at Northwest Federal Credit Union near Washington, D.C., said.

With CECL, credit unions will be using internal and external data to predict the potential for losses on each loan or loan pool over the full life of the loan from the moment of origination.

“CECL is a radical change in accounting for loan and lease losses, which has remained totally unchanged over the last 85 years since FASB was first established,” Fuzzell said.

The Herndon, Va.-based Northwest Federal ($3.4 billion in assets, 258,476 members) had an Allowance for Loan and Lease Losses of $18.9 million, or 0.55% of assets, on March 31, up from $16.5 million, or 0.51% of assets, a year earlier.

At Northwest Federal, Fuzzell said preliminary analysis indicates that its ALLL will double or triple under CECL, while conversations with SEC filers indicates their ALLLs will increase two-fold to five-fold.

“That is a drastic change,” he said. “It will immediately impact their capital.”

The changes stemmed from the financial crisis of 2008. One problem identified by FASB was the tendency of the rear-view-mirror estimations to delay recognition of loan losses. For example, in the four years leading up to the crash, bank loans rose 45% while their loan loss reserves fell 10% to historic lows in relation to lending.

Credit unions need to become more agile in responding to the new demands, and more sophisticated in their analysis. The direct payoff will be a more accurate and timely estimation of losses. The indirect payoff will be better data, and better facility with the data to better serve members.

FASB is flexible, allowing institutions to choose their own method – simple or complex.

However, choosing a method is more like a game show where behind every door is a special prize. One door opens to a hot tub; the other reveals a goat.

The hot tub will be the method that’s reliable in predicting losses, and is based on data that your credit union can easily gather and maintain. The goat will be the one that either is unreliable, or consumes more time, money and expertise than you can afford.

“This is what makes CECL such a burden for credit unions,” Fuzzell said.

In South Jersey, Robert Millard is expecting a goat.

Thunderbolt Area Federal Credit Union in Millville, N.J. ($23.7 million in assets, 2,907 members) has only five employees, and Millard, its president/CEO, said he expects he would need to hire another employee to meet the reporting demands of the standard.

“They’re going after a fly with a sledgehammer for small credit unions,” Millard said. “They’ve created a cottage industry for the auditing firms.”

Thunderbolt’s ALLL was $345,848 on March 31, or 1.48% of assets, up from $298,686, or 1.38% of assets a year earlier. He now uses an Excel spreadsheet to calculate ALLL for about six to eight loan groups.

While he can continue to use a simple method under CECL, going from a 12-month allowance to a life-of-loan allowance is going to make his variances even greater.

His credit union generates about 25 to 30 car loans, signature loans and home equity lines of credit each month. He has seen estimates that he needs at least 80 fields of data for each loan, which comes out to about 24,000 to 30,000 data points per year.

Millard doesn’t think that the standard should apply to small institutions. He suggests those with less than $250 million in assets be exempted.

“We’re probably going to be forced to merge,” he said. “This is going to be the demise of the smaller credit unions.”

Northwest Federal began preparing for CECL three years ago. One of the biggest surprises for Fuzzell was the amount of analysis needed just to choose methods for calculating CECL.

It has chosen different estimation methods for different parts of its portfolio. It used a method called “static pool” for auto loans. The method is data-intensive, but manageable for cars. It used “vintage” for mortgages, which requires tracking the performance of loans based on their point of origination. Commercial loans are analyzed individually, which is more complicated, but better suited for high-dollar loans where the credit union has less history and more variables.

Now the credit union is preparing for testing and validation.

“It’s going to be a high burden to bear for small credit unions,” Fuzzell said. “From the data requirements we have, I don’t see how credit unions with 20 to 25 employees are really going to be able to manage the bulk of what they need to handle appropriately.”

He added, “Unfortunately, this is one of those regulations where size will help. The larger the credit union, the better they will be to weather the storm.”