Cecl Mortgage Loans: Understanding the New Accounting Standard

The Current Expected Credit Loss (CECL) standard has been a game-changer for mortgage lending, requiring lenders to estimate potential credit losses on existing loans.

This means lenders must consider the likelihood of borrowers defaulting on their mortgages and set aside funds accordingly.

Under CECL, lenders must use a forward-looking approach to estimate credit losses, rather than relying on historical data.

This approach can be more accurate, but it also requires lenders to be more proactive in monitoring their borrowers' creditworthiness.

Lenders must now regularly review their loan portfolios and update their credit loss estimates as needed.

By doing so, lenders can better manage their risk and make more informed lending decisions.

CECL, or Current Expected Credit Loss, is a significant change to how financial institutions calculate credit loss reserves. It's a major shift from the incurred-loss approach to an expected-loss model that considers the magnitude and timing of potential losses.

Financial institutions outside of the US have already implemented IFRS 9, a similar standard that has been adopted by over 140 countries. One of the key differences between IFRS 9 and CECL is the three-stage classification used to assess the time horizon for reserving, with a shorter 12-month credit loss period for exposures performing as expected.

To prepare for CECL, financial institutions need to focus on planning, data, models, and governance. This includes adjusting historical loss experience for current conditions and reasonable and supportable forecasts, as well as adopting special rules for purchased loans with credit deterioration.

Here are some key changes that non-banks need to be aware of:

A Cecl mortgage loan is a type of loan that is subject to the Current Expected Credit Loss (Cecl) accounting standard. This standard requires lenders to estimate the expected credit losses on their loan portfolios and set aside provisions to cover these losses.

Cecl mortgage loans are typically originated by banks and other financial institutions, which then hold the loans on their balance sheets. The loans are usually secured by collateral such as a house or property.

The Cecl standard is designed to provide a more accurate picture of a lender's financial health by requiring them to account for expected credit losses upfront. This can help prevent the buildup of bad debt on a lender's balance sheet.

Lenders use a variety of factors to estimate the expected credit losses on Cecl mortgage loans, including the borrower's credit history and the current state of the economy.

The changes brought about by CECL are significant and far-reaching. CECL requires financial institutions to recognize expected credit losses for the entire life of a loan, on day one.

Under CECL, the accounting framework has shifted from an incurred loss to an expected credit loss model. This means that financial institutions must establish a lifetime credit loss allowance on day one of each exposure.

CECL requires more complete and detailed data, including macro-level data and risk factors, to assess the impact of various scenarios on credit losses. This is a significant change from current practices, where historical data on credit losses was sufficient.

Financial institutions can use a static pool/vintage analysis or a discounted cash flow (DCF) method to calculate CECL. A vintage analysis is best for pools that are homogeneous in risk and term, with high loan counts. However, it may not be applicable to all loan types, such as revolving lines of credit.

The DCF method represents cash flows in the future on a per loan basis and can be applied with relatively few loan-level details. It is a good option for specialty financial companies with little to no historical data.

The way purchased credit deteriorated assets are treated is a significant change to current GAAP practices. Financial institutions must adopt the credit impairment standard, which will have a large operational and financial statement impact.

Here are the key changes that financial institutions must prepare for:

IFRS 9 was implemented in 2014 and is used by more than 140 countries worldwide.

It's a global standard that addresses expected credit loss accounting, similar to CECL in the US.

IFRS 9 uses a three-stage classification to assess the time horizon used for reserving, which is different from CECL.

The first stage of IFRS 9 uses a 12-month credit loss period for exposures performing as expected.

US financial institutions can learn from their international counterparts who have already implemented IFRS 9.

Implementations of IFRS 9 are unique due to each organization's internal systems and processes.

Some common themes and practices that emerged from IFRS 9 implementations include planning, data, models, and governance.

These themes and practices can be useful for US financial institutions implementing CECL.

Here are the common themes and practices that emerged from IFRS 9 implementations:

Financial institutions must break down silos in current allowance and regulatory processes to use components in a more integrated solution. This will help them avoid designing systems and processes that continually tax staff or jeopardize deadlines each quarter.

Institutions should focus on solutions with a modular, open design approach that are adaptable to changing interpretations of the new standards. This will enable them to efficiently address the evolving accounting standards and regulatory compliance requirements.

To achieve early success, lenders should look for systems and processes that support iterative development cycles with the ability to revise and upgrade individual model components as new models are tested and reviewed.

A key consideration is that the CECL process is more computationally intensive than the current incurred credit loss method. This means institutions must plan for additional capacity of their model execution platforms to efficiently execute models.

An effective architecture and adaptable framework for CECL solutions include a centralized model library, a common data platform, centralized workflow orchestration, dynamic reporting capabilities, audit support, and robust governance and controls.

Change management is a critical aspect of implementing and managing credit loss models. It's essential to have a sound framework for processing, approving, and monitoring changes to the model.

To ensure that changes to the model are properly managed, you should work with your internal teams and model providers to establish a suitable audit trail or reporting mechanism. This will enable you to quickly and efficiently analyze changes to key model settings on a quarterly basis.

Several factors must be considered when reviewing model settings, including how loans are amortized, the length of the forecast period, and the time to recovery. These settings can significantly impact the model results.

Here are some key model settings to focus on:

Regularly reviewing these settings is crucial to gaining comfort with the model results and ensuring that changes are not causing unexpected period-over-period variations.

To implement CECL successfully, institutions should focus on breaking down silos that exist in current allowance and other regulatory processes. This will allow them to capitalize on a more integrated solution.

Financial institutions should avoid designing systems and processes that continually tax their available staff or jeopardize their deadlines each quarter. This can be avoided by designing systems and processes that are efficient and sustainable.

The CECL process is more computationally intensive than the current incurred credit loss method. This means that institutions need to plan for additional capacity of their model execution platforms to ensure they can handle the increased workload.

Lenders looking for early success should focus on solutions with a modular, open design approach that are adaptable to the changing interpretations of the new standards. This will help them stay ahead of the curve and avoid costly rework.

Systems and processes that support iterative development cycles with the ability to revise and upgrade individual model components as new models are tested and reviewed are crucial. This will help institutions refine their models and improve their accuracy over time.

To achieve an effective architecture and adaptable framework, institutions should consider the following key components:

Institutions should look for CECL solutions that use a modular, open, adaptive architecture, such as the SAS Solution for CECL. This will provide them with a more efficient, dynamic, and sustainable solution that can adapt to changing regulatory requirements.

Off-Balance Sheet Commitments can be tricky to navigate under CECL. A key difference from the previous incurred loss method is how off-balance sheet commitments are reported.

Under CECL, no credit losses should be recognized for off-balance sheet credit exposures that are unconditionally cancellable by the issuer. This means that if an institution has the ability to unconditionally cancel available lines of credit, an allowance for unfunded commitments should not be established.

Bank M, a credit card issuer, is a great example of this. Their card holder agreements stipulate that the available credit may be unconditionally cancelled at any time. As a result, they don't record an allowance for unfunded commitments on the unfunded credit cards.

Instruments to consider for whether they are unconditionally cancelable include, but are not limited to:

It's essential to assess the terminology of the agreements for these instruments to determine whether they are unconditionally cancelable. We've seen institutions make updates to their agreements to be unconditionally cancelable to reduce required reserves.