CECL: Simple Description for Business Solutions


 An Application to Risk Sharing Loan Transactions
 
CECL should be approached as a business solution, beyond complying with the FASB pronouncement. While the implementation of CECL can be a burdensome process, using CECL to drive business decisions is simple and intuitive. This blog explains how CECL can be applied to many banking processes. Simply put, CECL is the cumulative credit loss allowance over the life of a loan. CECL can be represented by the CECL model below simply expressed as:

CECL = expected loss rate X option adjusted spread (OAS) duration

The expected loss rate is the expected annualized loan loss provision. OAS duration is related to the weighted average life, whereby OAS duration incorporates discounting of the projected cash flows, consistent with market loan pricing and can be used for option embedded balance sheet items.

CECL as a Business Solution

Reiterating FASB Board member R. Harold Schroeder's sentiment, CECL should be part of a business solution. For this reason, the economics of CECL should be clearly understood. How should CECL be used? What does CECL tell us about our earnings?

This blog addresses these important questions. The value of CECL is often masked by implementation details from the accounting perspective and is viewed as another regulatory burden. But in fact, CECL can be understood based on two commonly used metrics: (1) expected loan loss, (2) weighted average life (WAL). The idea is quite simple.

CECL is the loan loss allowance for the life of the loan. Therefore, CECL should be the annual expected loss rate over the expected life of the loan.  That is:

CECL = expected loss rate X WAL.

However, CECL has to be reconciled with the fair valuation of the loans, incorporating the present value computation. For this reason, WAL is replaced by the OAS duration measure.

 

Innovation for Bank-to-Investor Risk Sharing: Loss Allowance Warranty (LAW)


Challenges: Current low-interest rates lead to increased demand for long term fixed-rate mortgages.  Should lending officers turn customers away when the agencies will not purchase these loans and other financial institutions cannot invest in them for many reasons?

Purpose: Today, borrowers demand long-duration mortgages. However, community banks and credit unions may not have the capacity to hold these loans on their balance sheet. The purpose of this blog is to discuss ways for depository institutions to originate these loans and sell to alternative investors.
Investors can buy whole loans and a Loss Allowance Warranty (LAW) from the sellers, particularly community financial institutions. This allows investors to purchase loans with the potential credit loss partially offset by purchasing a "warranty" from the seller. The warranty obligates the seller to pay the buyer a prespecified amount at the stated occurrence of certain credit-related events.
LAW allows sellers to eliminate interest rate risk and mitigate the impact of the loss provision on Tier 1 capital requirements.

Description of the Transactional Flow of a Loss Allowance Warranty (LAW)

The funds flow can be represented by the schematic diagram below. Potential investors include hedge funds, insurance companies, asset managers, and depository institutions. Investors pay a price comprised of two separate transactions: (1) The loan price, without risk-sharing, which is Par, plus a premium; (2) a warranty price, which can be related to the Current Expected Credit Loss (CECL), an implied accounting loss provision booked by the Bank. The all-in price that the originator receives should represent an amount to offset a portion of the capital charge for CECL.
 
The return to the investor consists of the interest and principal payments of the loan. If the borrower defaults on the loan, based on a prespecified "default event" such as becoming 90+ days delinquent the bank/loan seller is obligated to remit the pre-specified amount at the sale of the warranty amount.
Economics of Risk-Sharing

 A Loss Allowance Warranty (LAW) facilitates loan transactions among borrowers, originators and investors by letting the seller provide a limited credit loss warranty, exposing the seller to limited credit loss, or "skin in the game," and receiving a fee in return. As a result, investors can attain higher returns while bank originators gain access to liquidity. LAW is a rider to a referenced loan and is made possible as a financial instrument by the introduction of CECL Pricing Tables, an intuitive and transparent explanation of CECL.

By selling some credit risk via the Warranty, the originating bank can sell the whole loans to more potential buyers, including out of state investors, and may receive a higher price. Therefore, LAW enhances transactions between loan originators and investors by the credit risk-sharing of the Warranty. The Warranty is structured similarly to agreements offered by manufacturers on the products that they produce. In the case of LAWs, the loans are being produced by the banks.
 
Investors may purchase individual whole loans or purchase in pools, bulk or flow. Loans may be purchased service retained or released. Analytical models provide indicative CECL values, along with the attributions of the bid or ask prices. The model analytics assists in the transaction; however, the seller and buyer ultimately determine the purchase price of the whole loans. The LAW prices are provided to buyers, sellers, and other participants in the form of pricing tables. The investor has the option to purchase the warranty.

Description of Loan Allowance Warranty (LAW)

LAWs are sold by financial institutions ("Bank"). The Bank bears the partial default risk of the borrowers via the pre-specified warranty amount. Investors pay the Bank the market price (par plus premium/discount) and the LAW price. The economics of the warranty price is related to the CECL as the credit component, the present value of expected losses for the life-of-the-loan. The investor receives principal and interest payments and the Warranty Payment, in the event of a default.

The whole loan transaction price is negotiated by the buyer and seller. The seller retains a contingent liability for a portion of the expected credit losses on the Warranty.  When a loan is deemed uncollectible, investors will receive the Warranty payment from the seller.

For clarity of exposition, let us consider a bank selling a $300,000 single family 30-year fixed-rate mortgage to an investor. The buyer and seller have agreed on the price of the loan to be 102. As a separate transaction, the buyer has the option to purchase a Warranty from the seller. The buyer can review the CECL Pricing Table provided by a third party in the business of modeling CECL values.  The CECL pricing table presents the Warranty Prices which are based on the 3rd party CECL model. The columns represent Loss Given Default (LGD) in %. The buyer determines the probability of Default that the warranty will cover.

The CECL Pricing Table is offered to buyers and sellers for a range of types, terms, and conditions of the reference loans.  For example, if the buyer would like to receive 10% of the outstanding unpaid balance at the time of default, then the buyer can decide a price in the column 10% LGD, based on the buyer's view on the creditworthiness of the loan, as measured by the model's probability of default (PD).
Warranty Payment at the Event of Default:

Loan Borrower Default Event: The originating bank transfers loan title to the investor at the time of sale. In the event the borrower is delinquent 90+ days, the originating bank pays the investor a payment based on an agreed-upon CECL model as specified by the LAW purchased, based on a Warranty Pricing Table. The LGD is, therefore, the coverage level of the potential credit loss. The originating bank does not retain effective control at the time of sale. That is, the originating bank sells a performing loan, and in the event of default, must pay a mathematically pre-determined amount, the Warranty Payment. LAW is an obligation of the originating bank to pay the investor when the referenced loan is 90-days delinquent.

Originating Bank Default Event: When the originating bank declares a default, the title of loan is already held by the investors. The Bank Default Event would trigger the above Warranty Clause. Note: default is defined as an FDIC assisted transaction or liquidation, distinctly different than an acquisition/merger. Since 2012, no federal savings bank has failed, requiring an FDIC assisted transaction.

Letter of Intent Conditions: The due diligence process should be simpler than a typical loan transaction. The due diligence process will focus less on the borrower of the loan.

Closing

CECL has provided impetus to risk-based pricing of loans. With the growing use of CECL in financial reporting and in business management, Banks can separate interest rate and credit risks on their balance sheet, enabling banks to use CECL as a business solution.  

Do you think the "credit box" approach leaves money on the table without using Risk-Based Pricing for management?
 
Feel free to share your thoughts, and if you are interested to see how we can take this approach to enhance your risk-based pricing please reach out to us at 269-275-3720 or email us at support@thomasho.com
 
For more resources be sure to also subscribe to our YouTube channel at http://www.youtube.com/c/ThomasHoCompanyLtd 

References
Current Expected Credit Loss (CECL): THC Model  
Thomas Ho Company research
What is the THC λ Lambda Report? Thomas Ho Company research
THC Webinar Series
Part 1 Episode 1 CECL Implementation
                           Part 2 Episode 2 Credit Retained Loan - Risk Sharing
                           Part  6 Episode 3 Community Banking Environment: Auto loans
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