Understanding Collateral Dependent Loans Under CECL

CECL has brought about many changes to long established accounting practices. The concept of impaired loans as well as the impaired loan process has been removed under CECL (ASU 2016- 13). However, FASB allows for loans to be evaluated based on the current value of the underlying collateral should certain criteria be met. This methodology is known as collateral dependent and is very similar to the current impaired loan process when it comes to allowance calculation (not identification). Worth noting is that there are fundamental differences between the two and collateral dependent loans are not intended to be a direct replacement of the current loan impairment process.

Let’s first define the three primary ways of measuring credit risk under CECL:

• First, loans are collectively evaluated in pools with loss forecasted over the contractual term of the pool. Loans within the same pool should have similar risk characteristics.
• Second, if a loan does not fit any risk profiles, the entity may develop a borrower specific risk profile and forecast losses over the contractual term of the loan using any CECL method. However, using the current value of collateral is not acceptable.
• Third, loans can be determined to be collateral dependent if foreclosure of the loan’s underlying collateral is probable or as a practical expedient if the borrower is experiencing financial difficulties and the repayment is to be provided substantially through the operation or sale of the collateral.

The use of collateral dependent as a practical expedient is not a requirement of the CECL standard. You are only required to treat a loan as collateral dependent if foreclosure is probable. However, you can elect to use this method for other collateralized loans if the loan meets certain requirements. Let’s discuss both applications of this method and the complexities which institutions must consider.

Application One: Probable Foreclosure

When an entity determines that foreclosure is probable for a loan secured by collateral it is by definition a collateral dependent loan. Foreclosure indicates that the borrower is experiencing financial difficulties and that the sale of the collateral is imminent or expected. Therefore, current fair value is the best measure of credit risk and possible loss. Foreclosure is also generally associated with repossession of real estate, so this would primarily apply to loans with real estate as the collateralized asset.

Application Two: Practical Expedient

For loans not in foreclosure to be classified as collateral dependent under the practical expedient, the borrower must be experiencing financial difficulties. Therefore, for each collateral dependent loan, you must determine that the borrower is experiencing financial difficulties currently and on an ongoing basis in order to continue to classify as collateral dependent. Could past due status be an indicator of financial difficulties? Yes, but what happens when the borrower becomes current again? Moving a loan in and out of collateral dependent status may be cumbersome based on past due status alone.

Additionally, the repayment of the loan must be substantially provided through the operation or sale of the collateral in order to apply the practical expedient to a collateralized loan.

Considerations When Utilizing the Practical Expedient

The guidance within the standard is largely open to interpretation especially when determining if loan qualifies as collateral dependent under the practical expedient. Therefore, institutions must carefully consider the following.

First, FASB does not define “substantially”, however the dictionary defines substantially as “considerable in quantity”. Each institution will have to consider how they evaluate this subjective definition. Why is this important? Sometimes, the collateral’s value has diminished, and the repayment may have to come from the guarantor. The deterioration of the collateral’s value can also affect the guarantor’s ability to fund the guaranty. In addition, accepting payments over a longer period may show that the threshold of substantiality will not be met. The ARCSys team believes the concept of “substantially” here is critical because if the loan is not repaid substantially through the sale or operati on of the collateral, it would not fit the definition. In the community bank environment, it is not unusual for loans to stay on nonaccrual for periods longer than 90 days. Leaving a loan in collateral dependent status for a long period of time is in stark contrast to the concept behind the inclusion of collateral dependent loans within the CECL standard. Why? Because the calculation is based on current collateral value and collateral value can change significantly over time. In addition, the longer you hold a loan in this status it calls into question whether the borrower is having financial difficulties and why the institution has not taken action to sell the asset.

FASB also does not define “through the operation of”. In general, this indicates that the revenue generated by the asset would cover the repayment of the loan. However, when can this actually happen if the borrower is experiencing financial difficulties and does the institution need to take over possession of the asset? For most community banks, the asset is directly tied to either the business of the borrower (i.e. the borrower’s business operates out of or uses the collateral), or the collateral is the business such as a hotel or rental property. In addition, for most community institutions, the collateral as well as the revenue of the associated business were used to underwrite the loan. So, if the borrower is experiencing financial difficulties due to poor business performance is it reasonable to expect that it would not continue to have financial difficulties if operated by the lender? Determining and documenting how to operate the asset without taking over control of it may be difficult. Also, determining cashflows from the business operations may be time consuming especially if the institution does not take control of the collateral and constantly updating and monitoring the cashflows through time would be costly.

Other Considerations for Collateral Dependent Loans

If you have an asset in collateral dependent status for a long period, the estimated loss is also not part of the actual charge-offs within the risk pool the loan belongs to. Having many assets classified as collateral dependent will affect modeling and forecasting because these estimated losses will not be part of the loss history unless partial charge offs are taken through time.

Remember that CECL requires institutions to calculate 100% of all future losses anticipated through the loan’s contractual term. Therefore, if repayment is expected through the sale of the collateral, the current fair value is a good indicator of risk. This is accurate should the collateral be sold in the shorter term, but the accuracy of the collateral dependent calculation decreases as time goes on since changes in fair value over time would have an effect on the loss. Again, the concept of collateral dependent is recognition of future losses based on the difference between the current fair value of the collateral and the amortized cost of the loan. While the standard does allow for updating changes in fair value, the longer the loan is in this status, the more support will be necessary to defend designation of the loan as collateral dependent especially in times of significant economic change.

Given the complexities when managing collateral dependent loans, what are some of the best practices an institution should consider? Deliberate effort and focus to will be required to manage the collateral dependent portfolio, especially when used as a practical expedient. In addition, charging off consistently and through time will also be important for modeling and forecasting all risk pools. Inconsistently charging off loans or waiting longer periods of time before charging off a loan will build volatility into your models, risk assessments and forecasts.