Forecasting TDRs Under CECL
In June 2017, the Transition Resource Group discussed several implementation issues for the new credit impairment standard known as current expected credit loss (CECL). Common ground was reached on beneficial interests, transitioning purchased credit impaired assets and accounting for prepayments under a discounted cash flow (DCF) approach. However, bankers and regulators had very different opinions on the identification and measurement of troubled debt restructurings (TDR) under the new model and no consensus was reached. In September, the Financial Accounting Standards Board (FASB) clarified three unresolved TDR issues from the June meeting:
- Whether the effect of a TDR should be recorded in the allowance for credit losses
- The timing of when the effects of a TDR are recorded
Financial institutions will offer a debtor in financial difficulty some modifications or concessions to protect as much of their investment as possible. A concession occurs when a bank does not expect to collect all amounts due under the loan’s original contractual terms as a result of the restructuring. These modifications can comprise one or a combination of the following:
- Interest rate reduction for the debt’s remaining original life
- Extension of the maturity date or dates at a stated interest rate lower than the current market rate for new debt with similar risks
- Principal reduction
- Reductions of accrued interest
- Transfer of assets to the creditor to fully or partially satisfy the borrower’s debt
- Issuing an equity interest in the borrower to the creditor
All TDRs are loan modifications, but not all loan modifications are TDRs. CECL does not change the rules for the identification of a TDR. A TDR is defined as a restructuring in which a creditor—for economic or legal reasons related to a debtor’s financial condition—grants a concession to the debtor that it would not otherwise consider. Both criteria must be met for a loan to be considered a TDR. Once a loan is impaired, a bank is required to measure the individually impaired loan using the present value of expected future cash flows discounted at the loan’s original effective interest rate, assuming the creditor does not apply one of two available practical expedients, i.e., the loan’s observable market price or the fair value of the loan’s collateral if collateral dependent.
FASB clarified that CECL requires all effects of reasonably expected TDRs to be incorporated into the allowance for credit losses including:
- Economic losses related to the concession granted to a borrower
- Benefits of the loss mitigation strategy on credit losses
- Additional exposure to credit risk over an extended term
Reasonably expected TDR is a new concept that will require significant management judgment. There generally are indications of a reasonably expected TDR before individual negotiations with a borrower begin. Entities will need to consider their own policies and practices for modifying assets when determining the point in time a TDR is considered reasonably expected, e.g., a policy that requires a modification for all loans past a certain delinquency threshold.
This may accelerate timing compared to current generally accepted accounting standards and may result in process changes to identify assets that eventually will be subject to a TDR earlier.
Measuring reasonably expected TDRs will be an operational challenge because TDRs can take a variety of forms and banks may be limited by the way information is stored. For example, a bank’s loss history likely will reflect both the credit risk for troubled loans and the offsetting loss mitigating effect of successful TDRs. Some effect of TDRs may already be captured in a portfolio’s historical loss information—a principal reduction would be included as a loss, while a reduction in accrued interest may not be reflected due to a bank’s nonaccrual policies.
CECL offers flexibility in the methods used to measure expected credit losses, and there may be situations in which some effects of TDRs, e.g., the effect of loss mitigation, already are reflected in the day one allowance, while other effects, e.g., the economic effect of concessions, are considered later—that is, at the point that a reasonable expectation exists—in a refinement of the initial estimate. If a DCF method is used to measure credit losses on a performing loan portfolio, any effects of TDRs that are incremental to what is embedded in the historical loss information should not be incorporated as an input to the DCF method until a TDR is individually identified. FASB concluded that at the point a loan is specifically identified as a reasonably expected TDR, an entity must use a DCF method if the TDR involves a concession that can only be captured using a DCF (or reconcilable) method, such as an interest rate or loan term concession.
CECL requires credit losses to be evaluated on a pool basis unless risk characteristics change to an extent that they must be assessed separately. The standard is silent on the unit of account for measurement of the effects of TDRs; therefore, entities can measure the effects of TDRs either on a portfolio or individual basis depending on which is most appropriate for the facts and circumstances of the assets and as long as all concessions are being captured. For example, an entity may have compiled historical TDR data on past loans with similar characteristics and could be able to measure the effect of expected TDRs on a pooled basis.
These changes will NOT have an effect on the timing of when a TDR is reflected in disclosures, which will continue to be at the time a TDR is executed.
BKD will continue to monitor this project. If you have questions about the credit impairment standard, contact
your BKD advisor.