CECL Changes in Merger Accounting and Purchasing Loan Pools

Introduction

With the requirement now being that institutions have to calculate the CECL allowances for all amortizable financial assets, it can be challenging to ensure the accuracy of the purchase price and to complete the proper accounting for credit risk. This whitepaper provides insights on how bank mergers and purchasing of loan pools and HTM securities (financial assets) have been impacted by CECL. Discover strategies for before, during, and after a merger or purchase, and learn how to navigate the new landscape of accounting standards.

Replacement of Purchase Credit Impaired with Purchase Credit Deteriorated

Under CECL, Purchase Credit Deteriorated (PCD) replaces Purchase Credit Impairment (PCI) that existed with ILM. Under ILM, loans were determined to be either PCI or non-PCI.

• PCI loans were generally assumed to be impaired loans and as such were treated as PCI at the time of a merger/purchase. These loans were recorded with premiums/discounts and at Fair Value, with special accounting (SOP-03-3), as these loans were recorded with a credit mark, but no allowance.
• Non-PCI loans were recorded on the acquirer/purchaser’s books at Fair Value with a discount/premium and a credit mark. No special accounting treatment (SOP-03-3) was afforded these loans and an allowance may be recorded at some time after purchase.

In contrast, CECL requires institutions to estimate the expected credit losses for applicable financial assets regardless of whether they were originated by that institution or purchased. By recording an allowance, the financial statements present a more complete picture of the institution’s financial health, as it includes all expected future losses through the allowance. Under CECL, PCD and non-PCD loans are all recorded with allowances and discounts/premiums, or their Fair Value.

Purchased Credit Deteriorated

PCD is a term used to describe acquired individual financial assets (or acquired groups of financial assets with similar risk characteristics) that as of the date of acquisition have experienced a more-than-insignificant deterioration in credit quality since origination, as determined by an acquirer/purchaser’s assessment. This is a significant change for CECL with mergers and purchased assets because it requires companies to estimate their life-time expected credit losses at the time of acquisition, rather than waiting for the credit quality of the purchased loan portfolio to deteriorate.

• PCD financial assets are purchased assets that have experienced a deterioration in credit quality after origination but before the assets were acquired by the institution.
• Non-PCD financial assets are purchased assets that have not experienced a deterioration in credit quality since origination. The CECL allowance for non-PCD assets are treated as originated assets and recorded at the time of purchase on the purchaser’s income statement.

Guidelines

This section provides an overview of the steps and considerations involved with a focus on CECL, from initial discussions and due diligence to the final integration. The guidelines presented here can serve as a starting point for the planning and implementation:

Enhanced Credit Risk Assessment

An enhanced credit risk assessment is a thorough review of the financial condition and creditworthiness of purchased assets or the institutions involved in a merger. The assessment typically includes a review of the credit risk factors at the time of origination and current, loan types and terms, and other relevant data to assess the ability of borrowers to repay debt, through the forecast period for CECL. The assessment also considers the market risks and economic conditions that may impact the value of the portfolio. The results of the enhanced credit risk assessment play a significant role in understanding the historical data available for CECL analyses and determining differences between the different institutions’ assessments of Charge-Offs, Prepayments, Probability of Default, and Loss Given Default.

Bifurcate PCD and Non-PCD Assets in the Purchase Process

Determining whether an asset will be considered PCD or non-PCD is based on whether the credit quality of the asset has deteriorated since its origination. Examples of some steps that can be applied are as follows:

1. Review of credit information: Evaluate the credit history of the borrower and assess their creditworthiness at the time of purchase, such as FICO, LTV, DSCR.
2. Analysis of payment history: Analyze the borrower’s payment history and determine if there are any late payments or defaults.
3. Assessment of collateral: Evaluate the value of the collateral and assess its ability to support the loan.
4. Classification of the credit quality: Based on the above analysis, determine the credit quality of the asset and classify it as PCD or non-PCD.

Evaluate the Data for Issues

When two institutions merge or when purchasing loan pools, there are several potential data issues that may impact the CECL allowance. These may include:

• Data compatibility: This may involve converting data from one format to another, or reconciling data from different systems.
• Data completeness: This may involve identifying and obtaining any missing data, such as historical loss data.
• Data quality: This may involve identifying and correcting any errors or inconsistencies in the data, such as duplicate records or missing fields, at risk balances for accrued interest, payment amounts, and participating current balances.
• Data governance: This may involve ensuring that data is being handled and stored in compliance with regulatory and legal requirements, such as ensuring data is accurate, complete and protected from unauthorized access.
• Data integration: This may involve integrating data from different systems or platforms, and ensuring that the data is accurate and consistent. Specific issues to consider may include:
  • Duplicated loan type or collateral codes
  • Different unique identifiers, such as loan number only or account number/loan number combinations that create unique loan identification
  • Different types of loans

Assessing and Integrating the CECL Allowances

The acquirer/purchaser should evaluate the assets in the portfolio for the following:

• Initial pool segmentation, historical loss, and prepayment assessments: Consider if the historical loss, prepayment, PD, and LGD of the loan pools are similar to the history of the purchasing/acquiring institution. This assessment should also include contractual terms and cycle variances for charge-offs, prepayments, and probability of default. If the institutions have different cycles, that would ultimately change the modeling. Additionally, acquired loan pools may need to be pooled separately, so assessing this ahead of time will decrease volatility after purchase.
• Integrating the purchased assets into the CECL model: Update the inputs and assumptions used in the CECL model to reflect the credit quality of the purchased assets. This may include incorporating data on the credit history and performance of the purchased assets, as well as updating the model’s assumptions about the credit risk inherent in the assets. The acquirer/purchaser may need to modify the model’s calculation methodology to account for any differences between the purchased assets and their existing portfolio if loan assets are combined.
• Validating the CECL model: Evaluate the updated CECL model to ensure that it accurately reflects the credit risk of the combined portfolio, including the purchased assets. This may involve performing sensitivity analysis to assess how changes in certain variables would impact the model’s results and a back-testing analysis to see how the model would have performed in the past. An independent third-party may be engaged to review the updated CECL model and assess its validity and reliability.
• Impact of purchase accounting on the allowance calculation: There will be a difference between the allowance calculation on the both institutions’ books for the difference in the amortized cost basis of the assets. Premiums and discounts are not only part of the calculation, but they also affect the effective interest rates used in Discounted Cash Flow (DCF) calculations.
• Documentation: It is critical that these assessments are documented so auditors can review and the institution sets the baseline expectations for the updated CECL model. This must be done before a purchase price is determined. Under CECL, allowances are recorded at purchase and then adjusted through time. Incorrect estimations upfront can lead to significant issues after acquisition.

Determining and Analyzing the Purchase Price

For a merger, the credit risk of an acquired portfolio can have a significant impact on the purchase price for a merger under CECL. The addition of lifetime losses would generally have a larger impact on remaining goodwill and overall purchase price. When purchasing loan pools, the credit risk of a purchased pool can also have a significant impact on pricing of the purchased pool.

In either scenario, the higher the credit risk of the portfolios, the lower the purchase price is likely to be, because the credit risk of the portfolios represents the potential for losses that may be expected to incur throughout the life of the loans. Factor in these expected losses when determining the purchase price. There are several assessments of the overall risk of the portfolios, such as:

• Overall due diligence: Conduct a thorough due diligence process to assess the credit quality of the portfolios. If the portfolios are of lower quality than expected, this may result in a lower purchase price.
• Confirming forecast variables: Use forecasting to estimate the future performance of the portfolios. The acquirer/purchaser should prepare their own assessment of external variables to ensure the relationships will be valid in their model and how those variables may change if pools are combined.
• Expected market conditions: The overall market conditions can also impact the purchase price. Significant changes in prepayment risk, as well as interest rate risk, can affect the overall credit risk of a portfolio and the size of the estimated premium or discount recorded. The addition of the CECL amortized cost basis, including premiums and discounts, will have an impact on the CECL calculation on the acquirer/purchaser’s books as well after purchase.
• Estimating Fair Value: Under CECL, risks such as liquidity, interest rate, and credit must be considered at the loan level to accurately estimate the Fair Value. Proper documentation of the credit risk assessment is important to minimize double counting and ensure accuracy in the Fair Value estimate. The credit risk must be recorded as an allowance under CECL, whereas previously it was a credit mark under ILM, making it imperative for management to understand the credit risk in the portfolio ahead of time to avoid errors that could affect their income statement. ILM did not require such attention to credit risk, but under CECL, the accuracy of the credit risk estimate is essential. The credit risk is part of Fair Value and is also recorded as an allowance. Management must get the estimate correct upfront, because any error will run through the acquirer/purchaser’s income statement after purchase.

Specifically with a merger, determining if premiums and discounts were appropriately calculated and adjusted for credit risk is an important step in determining goodwill. In either situation, the following steps can be taken regarding premiums and discounts:

• Assessing credit risk: Assess the credit risk of the portfolios to determine the potential for future CECL losses. This can be done through a due diligence process that includes a review of the portfolios’ credit history and performance, as well as an analysis of current market conditions. A pre-CECL calculation should be performed.
• Evaluating market risks: Assess the liquidity risk, prepayment risk, interest rate risk as well as other market risks of the portfolios.
• Validation: Validate the calculations used to determine the premium or discount, including the assumptions used in the calculation and the data sources used.
• Documentation: Document the calculation and adjustment of the premium/discount, including a clear explanation of the calculation methodology, the assumptions used, and the sources of data used.

CECL Journal Entries

Journal entries are an important aspect of recording a merger or purchase in the accounting records of a company, which will generally include:

• Recording the purchase price: The purchase price will be recorded as Fair Value assets/liabilities and corresponding allowances for loans, investments, and off-balance sheet commitments.

In the case of a merger, there are additional pieces of information that need to be included:

• Recording goodwill: Goodwill is recorded as the excess of the purchase price over the Fair Value of the net assets acquired, including corresponding allowances. This represents the value of the acquiree that is not attributed to specific assets and liabilities.
• Recording the amortization of goodwill: Goodwill is amortized over time, which is recorded as an expense in the income statement.

Premiums and Discounts Under CECL

Premiums or discounts under are recorded when financial assets are acquired/purchased at above or below their par value and are part of the assets Amortized Cost Basis (ACB). They are accounted for in the following way:

• The premium/discount is amortized over the life of the asset, using the interest method which matches interest received with the corresponding amortization or accretion through the income statement.
• If an asset pays-off early or is charged-off, the remaining premium/discount should be recorded as an adjustment to the loss provision account. This is a change under CECL, because allowances are calculated using the ACB as the basis for loss determination.

Support From ARCSys:

ARCSys is the solution to simplifying the complex and time-consuming merger and purchase process. With the requirement now to calculate the CECL allowances for all assets, it can be challenging to ensure the accuracy of the purchase price and to do the proper accounting for credit risk. ARCSys specializes in providing expert support to manage credit risk and calculate allowances, streamlining the process and giving management the confidence needed to make informed purchase decisions. Let ARCSys simplify the process and support your success.

Contact ARCSys to discuss your merger or purchasing loan pools!