Methodology

A credit union establishes and implements a CECL methodology to reasonably estimate credit losses on loans, leases, held-to-maturity debt securities and unfunded commitments. In focusing on the ACLLL, the methodology should be systematic, consistently applied, and compliant with GAAP. Furthermore, a credit union’s size, organizational structure, economic environment, and loan portfolio characteristics will impact its CECL methodology.

A prudent credit union will base its CECL methodology on a comprehensive, adequately documented, and consistently applied analysis of the credit union’s loans, leases, held-to-maturity debt securities, and unfunded commitments, and account for credit union-specific factors.

The CECL methodology:

  • Determines the appropriate reserve amount by applying ASC 326-20, Financial Instruments—Credit Losses, Measured at Amortized Cost

  • Is supported by thorough documentation, including clear explanations of the supporting analysis and rationale

  • Includes a systematic and logical method to segment or pool loans by similar characteristics when determining estimated charges for loan losses

The CECL methodology covers all financial instruments carried at amortized cost, including:

  • Loans held for investment

  • Net investment in leases

  • HTM debt securities

  • Trade and reinsurance receivables

  • Receivables that relate to repurchase agreements and securities lending agreements

  • Any financial instrument with contractual rights to receive cash

  • Off-balance-sheet credit exposures not accounted for as insurance, including:

    • Loan commitments

    • Standby letters of credit

    • Financial guarantees

The CECL methodology does not include:

  • Trading assets

  • Loans held for sale

  • Financial assets for which the fair value option has been elected

  • Loans and receivables between entities under common control, such as with a wholly owned CUSO

In applying the CECL methodology to various financial instruments, the ACL will be generally grouped by credit losses on loans and leases (Call Report account AS0048), credit losses on investment securities (Call Report account AS0041), and credit losses on off-balance sheet credit exposures (Call Report account LI0003).

This topic addresses:

Troubled Debt Restructurings

Changes to CECL requirements under ASU 2022-02, Troubled Debt Restructurings and Vintage Disclosures eliminated the recognition and measurements accounting requirements for TDRs. TDRs will be:

  1. Accounted for like other loans on the credit union’s books

  2. Included in the credit union’s process with all other loans to estimate the ACLLL

While CECL eliminates the specialized accounting for TDRs, credit unions are still required to apply the loan and restructurings guidance (ASC 310-20, Nonrefundable Fees and Other Costs) to all loan modifications, including those provided to borrowers experiencing financial difficulty. Credit unions are required to evaluate (consistent with the accounting for other loan modifications) whether the modification represents a new loan or a continuation of an existing loan. (ASC 310-20-35-9 to 11, Loan Refinancing or Restructuring)

The implementation of the CECL accounting standard ASC 326, Financial Instruments—Credit Losses, eliminates the TDR accounting model. The CECL methodology now incorporates credit losses from loans modified as TDRs.

Financial statement disclosures are also required for loan modifications, to borrowers experiencing financial difficulty, in the form of principal forgiveness, an interest rate reduction, an other-than-insignificant payment delay, or a term extension, or a combination thereof. For more information, see ASC 310-10-50-45, Determining Whether a Debtor Is Experiencing Financial Difficulties and ASC 310-10-50-46, Evaluating Whether a Restructuring Results in a Delay in Payment That Is Insignificant. These disclosures include payment defaults of loan modifications made within the previous twelve months (ASC 310-10-50-44).

If a modified loan is collateral-dependent, the ACLLL account is estimated using the fair value of collateral. Additionally, if a financial asset is modified and considered to be a continuation of the original asset, a credit union should use the post-modification contractual interest rate to derive the effective interest rate when using the discounted cash flow method for measuring expected credit losses.

Renewals, extensions, and modifications are excluded from the contractual term of a financial asset for purposes of estimating the ACLLL account unless the renewal and extension options are part of the original or modified contract and are not unconditionally cancellable by the credit union. If such renewal or extension options are present, management must evaluate the likelihood of a borrower exercising those options when determining the contractual term.

Investments

This section is provided as a supplement to the Examiner’s Guide Investment chapter to address CECL related updates.

HTM debt securities are covered under CECL guidance. When the net realizable value of an HTM debt security is less than its amortized cost, a credit union must assess whether a credit loss exists. Credit losses are recognized through the ACL on investment securities. Credit unions will calculate the allowance based on their chosen method for HTM securities on a collective or pool basis, similar to the method used for loans. Different treatments may be required across the investment products (U.S. Treasuries, agency-backed mortgage securities, and other asset-backed securities). Credit unions need to consider whether consistent approaches are applied across assets with similar risk characteristics to those within the lending portfolios (for example, mortgage, auto, student, etc.).

Debt securities, where expected credit losses are zero, do not require an allowance for credit losses, such as for U.S. Treasury and government sponsored enterprises (ASC 326-20-55-48).

CECL also makes targeted improvements to the accounting for credit losses on AFS debt securities, including lending arrangements that meet the definition of debt securities under GAAP. The improvements include replacing the concept of Other Than Temporary Impairments. Under the new standard, credit losses associated with an AFS debt security are recognized through the ACL on investment securities, rather than a direct write-down as required by previous GAAP.

AFS debt securities are required to be evaluated individually for credit loss when (a) fair value is less than carrying amount and (b) the credit union:

  • Intends to sell the security

  • More likely than not will be required to sell the security

  • Does not expect to recover the amortized cost basis

If a credit loss event exists, credit unions should calculate and record an allowance using the Discounted Cash Flow approach. Favorable and unfavorable changes in cash flows adjust through a valuation allowance.

Summary of Methodology

While CECL is a new accounting standard, credit union management will still be expected to:

  • Use the most appropriate estimation method for the credit union

  • Ensure the approach is scalable to a credit union’s asset size and the complexity of its financial assets

  • Recognize credit loses

  • Establish and follow a process for evaluating credit risk

  • Include historical loss rates or other appropriate loss determination processes (for example, probability of default/loss given default) in the calculation

  • Incorporate qualitative factors

  • Define policies for nonaccrual of interest and charge-off

Current Expected Credit Loss Tools

The NCUA developed the Simplified CECL Tool to assist noncomplex credit unions with the implementation of CECL. A credit union may select from many proprietary tools including the Simplified CECL Tool for GAAP compliance. The Federal Reserve also developed tools for noncomplex financial institutions called:

  1. Scaled CECL Allowance for Losses Estimator Method and Tool (commonly referred to as the SCALE Method and Tool)

  2. Expected Loss Estimator Tool (commonly referred to as the ELE Tool)

CECL does not require using a specific estimation method. Moreover, the NCUA does not prescribe or state a preferred estimation method a credit union may use for its CECL solution. The Simplified CECL Tool is available to credit unions but is only one of many approaches.

Credit unions may choose an expected credit loss estimation method that builds on its existing credit risk management systems and processes, as well as existing methods for estimating credit losses. Some acceptable methods include:

Loss-Rate Method

A net loss-rate method measures the amount of charge-offs, net of recoveries, over the contractual term of a financial asset or pool of financial assets.

Generally, expected net loss rates are derived from historical loss information. Management applies the expected net loss rates to the outstanding balance of the subject financial asset or pool of financial assets as of a specific point in time—this does not include expected losses on future assets not currently recorded or recent changes in credit quality. Typically, calculations used to develop a net loss rate are relatively simple; however, certain inputs may need additional analysis. To address current conditions and reasonable and supportable forecasts, management must consider qualitative adjustments as part of the overall ACL estimation processes. For more information, see ASC 326-20-30-9).

Loss-rate methods can involve a variety of approaches. Three common loss-rate approaches are as follows:

  • Open pool or snapshot method: The starting point for the calculation consists of pools of assets that are outstanding at the end of a given period and are made up of assets that were originated in various years. Additional assets may be added to pools of loans under an open pool method.

  • Closed pool or cohort method: This method consists of pools of assets originated only in one period. The pools of assets under a closed pool method are static and pay down over time.

  • WARM method: A loss-rate method that estimates expected credit losses over the remaining life of the financial assets and uses a weighted average of the assets’ contractual terms to estimate the pool’s remaining contractual term. Scheduled amortization and estimated prepayment rates are applied to adjust the contractual term of the financial asset to represent its estimated remaining life. An average annual net charge-off rate is then applied to the amortization- and prepayment-adjusted remaining life to arrive at the quantitative loss estimate. Qualitative adjustments may be included to arrive at the total ACL estimate.

Weighted Average Remaining Maturity Method

The WARM method is a type of loss rate method. To determine the estimated ACL using the WARM method, use the following equation:

(Current Amortized Cost) x (Annual Net Charge-Off Rate) x (WARM factor)

The above equation also includes qualitative adjustments added for current conditions and reasonable and supportable forecasts. For more information, please see ASC 326-20-30-9. This method provides the estimate of credit losses over the contractual life of the loans. In applying CECL, loans are pooled based on common attributes like type, risk rating, term, geographic location, etc.

Loans that do not fit into pooled segments, such as delinquent loans, can be individually evaluated. The related ACL is estimated from inputs sourced from the credit union regarding current loan balance and the amount expected to be collected on a loan level basis. This ACL is estimated as the deficit, if any, between the expected amount to be collected and the current loan balance.

Thus, the total ACLLL is the aggregate of the ACL on each pooled loan segment plus the ACL on individually evaluated loans.

The Simplified CECL Tool and the Expected Loss Estimator Tool both use the WARM method. Regardless of the tool, review the following for information about the components of the ACLLL.

Net Charge-Off Rate

The annualized NCO rate for each loan segment is usually the simple average NCO rate over a historical period. When determining the historical period used to determine the average annual charge-off rate, the credit union should properly support and document this significant judgment in accordance with paragraph ASC 326-20-30-8. In general, the NCO rate should be based on financial assets with similar risk characteristics.

WARM Factors

The WARM factors, or life-of-loan factors, are usually determined by segmenting the pool of assets by common attributes, such as new autos, credit cards, etc. The WARM factors represent the remaining term to contractual maturity, adjusted for scheduled amortization and prepayments. The scheduled amortization is calculated based on an individual loan’s contractual maturity date and its amortization type (principal and interest, interest only). Prepayment rates may be estimated using historical experience or external prepayment studies. The WARM factor will be less than the weighted average maturity value because the WARM factor includes prepayments.

Roll-Rate Method

The roll-rate method uses estimates of transitions across delinquency categories (including default/non-accrual status) as well as loss-given-default rates to estimate future losses. More frequently applied to retail portfolios, this method uses migration analysis to track loans as they migrate (or roll) through different delinquency categories (for example, 60-day, 90-day, etc.) to estimate roll rates. The financial assets in the portfolios are segmented based on delinquency. This method is best used for very short-duration, unsecured loans, such as credit cards.

After the roll rates are calculated, they are applied to the outstanding balances at period end for each delinquency category. For any transitions to default status, the loss-given-default rate is applied to arrive at the expected loss. Under the roll-rate method, adjustments for qualitative factors, which include reasonable and supportable forecasts, can be applied within the model at the individual roll-rate level or as an adjustment to model output.

Vintage Analysis

The vintage method measures the charge-offs, net of recoveries, over the contractual term of a pool of financial assets. It is a closed pool method focusing on the origination period (referred to as a vintage). A vintage can reflect changes in underwriting, regulations, or economic conditions during a particular year, quarter, month, or another period, depending upon the product and origination volume.

The vintage method is best suited for portfolios that have large data sets and predictable loss patterns comparable with past and future periods, with patterns that may be partially driven by the time of origination. The vintage method may be inappropriate for a portfolio in which losses are idiosyncratic (for example, losses vary by loan or loan segments) or when the pool contains a small number of assets.

In this method, assets are segmented and stratified by origination period. Assets can be sub-segmented by a secondary risk characteristic, such as a risk rating.

The loss rate by vintage is calculated as the ratio of the losses in the period to the original vintage balance.

To calculate the lifetime loss rate, the NCO of each vintage is divided by the original principal balance, which remains the denominator in each calculation. The loss experience of the original balance is tracked and summed over the contractual term, yielding a cumulative life-of-loan loss rate based on historic averages.

This process is repeated for each vintage pool. After accumulating the data and calculating the loss rates, management can analyze trends and calculate expected vintage loss rates for future periods.

To start estimating loan losses, management estimates loss rates for future periods” based on historical trends. Adjustments to historical loss rates may be necessary based on changes in current conditions and the reasonable and supportable forecast period outlook. Depending on differences in the composition of the vintages, different adjustment factors may be necessary for each vintage.

Once management estimates the loss rates for future periods for each vintage, the original principal balance for each vintage is multiplied by the total of all the loss rates for future periods to determine the ACL.

For determining the ACL at the end of the next reporting period, the original principal balance is multiplied by the total of remaining loss rates for future periods for each vintage. That is, the total of all loss rates for future periods decreases by the losses incurred during the period. This process continues for each reporting period, with the remaining loss rates for future periods decreasing by losses incurred to date.

Qualitative adjustments can then be made by vintage or evaluated at the pool level. Management should not double count losses in both the loss rates and qualitative factors, as this would be inconsistent with accounting standards.

Discounted Cash Flow Method

CECL allows the DCF method to estimate expected credit losses. A DCF method is more commonly used for large volume loan portfolios or for more complex loan loss estimation models. The DCF method was previously required for TDRs to estimate the effects of the economic loss associated with a modification, including an interest rate concession.

Under the DCF method, the requirement to estimate lifetime expected credit losses still applies, and this method considers available information relevant to the collectability of the cash flows, including current conditions and reasonable and supportable forecasts. Examiners should evaluate management’s best estimate of expected future cash flows based on reasonable and supportable assumptions and projections. If management estimates a range for either the amount or timing of cash flows, examiners should also assess the documentation and support for the estimate.

ACL measurements using a DCF method may be applied on a pool basis using assumptions reflecting average characteristics of the assets in the pool (for example, average contractual term, prepayment speed, default rate) or applied to an asset evaluated individually. According to the DCF method, the ACL is estimated as the difference between the amortized cost and the present value of expected cash flows. If the DCF method is used, expected cash flows must be discounted to the asset’s EIR.

The EIR used to discount cash flows of a financial asset is the contractual interest rate adjusted for net deferred fees or costs, premium, or discount existing at the origination or acquisition of the asset. The EIR represents management’s expected yield over the contractual life of the asset upon its origination or acquisition.

If the financial asset’s contractual interest rate varies based on subsequent changes in an independent factor, that financial asset’s EIR is calculated based on the factor as it changes over the life of the financial asset. Examples of independent factors include the reference rate or covenants that change pricing based on collateral coverage or leverage ratio.

Management is not required to project changes in the independent factor for purposes of estimating expected future cash flows. If management does project changes in independent factors, examiners should:

  • Determine whether management projects changes in the factor to estimate future cash flows

  • Confirm that the same projections in determining the EIR were used to discount those cash flows

Lastly, examiners should verify that management’s choice of projecting the discount rate (and cash flows) is applied consistently for all financial assets where the contractual interest rate varies based on subsequent changes in an independent factor.

Last updated on June 05, 2023