Credit Unions Face Challenges Identifying Credit Losses on AFS Debt Securities

To the chagrin of many, CECL is finally upon us. Credit unions will need to start reporting CECL beginning this year with their March 31 Call Reports. And while the CECL credit loss approach does not apply to available-for-sale (AFS) debt securities, the financial accounting standard – ASU 2016-13 (Topic 326), which issued CECL – did make targeted changes to GAAP that eliminates the concept of Other-Than-Temporary Impairment (OTTI) and requires credit losses on AFS debt securities to be recorded in an Allowance for Credit Losses (ACL). ACL requires credit unions to estimate and record expected credit losses on financial assets, including debt securities classified as AFS. Without the right tools and support, that’s a tall order.

Prior to ACL, OTTI only required credit unions to recognize a credit loss on debt securities if it was considered other-than-temporary, meaning it was expected to be long-lasting and result in a permanent reduction in value. Under OTTI, credit unions only had to recognize credit losses if they intended to sell the security or if it was more likely than not that they would be required to sell it before recovery.

The ACL model, on the other hand, requires credit unions to estimate expected credit losses for all financial assets, including debt securities classified as AFS, regardless of their intent to sell or not. In short, a discounted cash flow analysis must be performed to determine the present value of future expected cash flows for each security whose fair value (market price) is less than its amortized cost (book price). This calculated amount is then compared with the amortized cost. The difference is the potential amount of credit loss for the security. I say “potential” credit loss because there are other factors to consider when determining if a decline in fair value below amortized cost is a credit loss or due to something else i.e., a rise in interest rates. Any additional unrealized loss between the security’s fair value and amortized cost is considered the non-credit portion of the loss and continues as usual to be recorded through OCI.

The implementation of ACL presents several challenges for credit unions in identifying and reporting credit losses in their portfolios, particularly for AFS debt securities. Treasuries and Government Agencies are excluded from ACL, but corporate bonds, taxable munis and other types of bonds used in Employee Benefits Pre-Funding, 457(f) deferred compensation arrangements or Charitable Donation Accounts need to be reviewed on a security-by-security basis.

First, credit unions must develop a comprehensive process for estimating expected credit losses. This process must be based on historical information, current conditions, and reasonable and supportable forecasts. This requires credit unions to have a deep understanding of the credit risk associated with their debt securities portfolio and to have access to current and relevant information about the creditworthiness of their issuers.

Second, credit unions must have a robust system for monitoring and updating their expected credit loss estimates. This requires regular review and analysis of the portfolio, including tracking of changes in credit risk and market conditions, and updating expected credit loss estimates accordingly.

Third, credit unions must have a clear understanding of the credit quality of their AFS debt securities portfolio and the potential impact of changes in market conditions on the credit risk of these securities. This requires credit unions to have a strong credit analysis and monitoring process in place to stay informed about changes in the creditworthiness of their issuers.

Fourth, credit unions must also consider the impact of market conditions on the value of their AFS debt securities portfolio. Market conditions can have a significant impact on the value of these securities, and credit unions must be able to assess and estimate any changes in value that may result from changes in market conditions.

Finally, credit unions must be able to communicate their expected credit losses accurately and effectively to stakeholders, including regulators. This requires clear and transparent reporting on expected credit losses, including the methodology used to estimate expected credit losses, the assumptions and judgments made, and any changes in expected credit losses over time.

In conclusion, the implementation of the ACL model presents several challenges for credit unions in identifying and reporting credit losses, particularly for AFS debt securities. To successfully navigate these challenges, credit unions must have a robust process for estimating and updating expected credit losses, a clear understanding of the credit risk associated with their AFS debt securities portfolio, and an effective system for monitoring and communicating expected credit losses to stakeholders.

Matthew Butler is the Founder and Managing Principal of Elite Capital Management Group, LLC in Cheshire, Conn.