SAVE E THE D E DATE! E! 22nd An Annua ual CFO C Coun ouncil C - - PowerPoint PPT Presentation

SAVE E THE D E DATE! E!

22nd An Annua ual CFO C Coun

• uncil C

Con

• nferen

ence The Disneyland Hotel | Anaheim, CA | May 15 – 18, 2016

A Practical Guide to the Allowance for Expected Credit Loss

FASB Subtopic 825-15 2

Introduction

2

Notice: FASB is still deliberating and has not made a final accounting standards update!

1 3

Calculating the Allowance for Expected Credit Loss Conclusions Required Disclosures

3

Agenda

4

Introduction The main objective of the Accounting Standards Update is to provide financial statement users with more decision useful information about an institution’s expected credit losses by requiring consideration of a broader range of reasonable and supportable information.

More Discussion and Disclosures

• No “Probable” Threshold
• Past, Current, and Future

Allowance for Expected Credit Loss: Main Objective 4

Statement of Financial Condition (Balance Sheet)

Assets Total Loans $100,000,000 Less Allowance for Expected Credit Loss <$2,000,000> Net Loans $98,000,000 Current estimate of cash flows NOT expected to be collected.

Introduction

Allowance for Expected Credit Loss: Balance Sheet 5

• Dec. 31, 2015Mar. 31, 2016

Beginning Balance $2,100 $2,000

• Charge-offs

$700 … +Recoveries $100 … Balance Before Expected Credit Loss Provision $1,500 … +Provision for Expected Credit Loss $500 … Ending Balance $2,000 … Then use the Provision to balance You first calculate the required Allowance for Expected Credit Loss

From prior period

Introduction

Allowance for Expected Credit Loss 6

Statement of Financial Performance (Income Statement)

Interest Income Loans $10,000,000 Etc. $ 1,000,000 Total $11,000,000 Interest Expense Deposits/Shares $ 2,000,000 Etc. $ 0 Total $ 2,000,000 Net Interest Income $ 9,000,000 Less Provision for Expected Credit Loss <$ 500,000> Net Interest Income After Provision for Expected Credit Loss $ 8,500,000

The provision reduces the Net Interest Income

Introduction

Allowance for Expected Credit loss: Income Statement 7

Introduction

1

Notice: FASB is still deliberating and has not made a final accounting standards update!

3

Calculating the Allowance for Expected Credit Loss Conclusion Required Disclosures Agenda

4 2

8

Calculating the Allowance for Expected Credit Loss

9 Steps

Step 1. Properly Segment the portfolio Step 2. Decide on Credit Quality Indicator (CQI) to use for each Segment Step 3. Estimate the Expected Loss Rate for each Segment Step 4. Multiply the Expected Loss Rate by the Segment/CQI Balance

Balance Expected Loss Rate Expected Credit Loss Residential Mortgages A (1) $200,000,000 0.28% $560,000 B (2) 150,000,000 0.30% 450,000 C (3) 75,000,000 0.75% 562,500 D (4) 25,000,000 2.70% 675,000 E (5) 5,000,000 6.75% 337,500 Sub-total $455,000,000 0.57% $2,585,000 Consumer-Auto A (1) B (2) Etc. Step 3. Estimate an appropriate Expected Loss Rate, including economic adjustments, for each Segment Step 4. Multiply each Segment/CQI balance by its Expected Loss Rate and then sum each Segment’s sub-total to calculate the Allowance for Expected Credit Loss Step 2. Decide on an appropriate Credit Quality Indicator for each Segment Step 1. Properly segment the portfolio 10

Calculating the Allowance for Expected Credit Loss

Steps

Calculating the Allowance for Expected Credit Loss

Step 1: Properly Segment the Portfolio 11

The level at which an entity develops and documents a systematic methodology to determine its allowance for credit losses.

• a. Type of debt instrument
• b. Industry sector of the borrower
• c. Risk rate(s).

Example: Business/Commercial SBA Commercial Real Estate Commercial Other Consumer Credit Card Auto Other Secured Other Unsecured Residential First Mortgage Other Other

Too much detail Too little detail Find the right balance

Calculating the Allowance for Expected Credit Loss

Step 2. Decide on which Credit Quality Indicators (CQI) to use for each Segment 12

*Must show how internal grade/rating relates to likelihood of loss

Credit Quality Indicator Description Credit Score

Credit scores are provided by _____ credit bureau and are updated quarterly.

Loan-to-Value (LTV)

The LTV is based on a loan’s combined balance (including senior liens) divided by a current value.

Probability of Default (PD)

The PD calculates a borrower’s likelihood of defaulting, expressed between 0% and 100%. The PD model used is a hazard survival model, which is a conditional model that allows probabilities to change based on how long the loan has survived and based on changing loan characteristics.

Internal Risk Ratings*

We assign internal risk rating based on…

Calculating the Allowance for Expected Credit Loss

13 Segment Credit Quality Indicator (CQI) Business/Commercial: All Internal Risk Rating Consumer: Credit Card PD Consumer: Auto PD Consumer: Other Secured PD Consumer: Other Unsecured Credit Score Residential: First Mortgage PD Residential: Other PD Step 2. Decide on which Credit Quality Indicators (CQI) to use for each Segment

Calculating the Allowance for Expected Credit Loss

14 Step 3. Estimate the Expected Loss Rate for each Segment:

• 1. Probability of Default Method (PD)
• 2. Loss Rate Method
• 3. Discounted Cash Flow Method (DCF)

There are three main methods to calculating the Expected Loss Rate

Calculating the Allowance for Expected Credit Loss

Step 3. Estimate the Expected Loss Rate for each Segment 15 Segment Expected Loss Rate Method Business/Commercial: All Loss Rate-Static Pool Consumer: Credit Card PD Consumer: Auto PD Consumer: Other Secured PD Consumer: Other Unsecured Credit Scores Residential: First Mortgage PD Residential: Other PD Each segment can use a different Expected Loss Rate

Calculating the Allowance for Expected Credit Loss

16

Economic Adjustments: Reasonable & Supportable Forecasts Economic Adjustments: Current Conditions Base Loss Rate Expected Loss Rate

Step 3. Estimate the Expected Loss Rate for each Segment Think of each method for calculating the Expected Loss Rate in three parts: 1) a base rate, 2) an economic adjustment for current conditions, and 3) an economic adjustment for reasonable and supportable forecasts, even though they may all get rolled up into one or the economic adjustments may apply equally to all segments.

Calculating the Allowance for Expected Credit Loss

17 Step 3. Estimate the Expected Loss Rate for each Segment: PD Method

• 1. Probability of Default Method (PD)
• 2. Loss Rate Method
• 3. Discounted Cash Flow Method (DCF)

Calculating the Allowance for Expected Credit Loss

18 Credit Card Model* Auto Loan Model* Residential Real Estate Model* Commercial Real Estate Model* Borrower/Loan Attributes Macro-Economic Factors

Credit Score + LTV + DTI + BAL. + Unemployment + Home Prices

*Each model has different covariates

A survival default model is type of “conditional” PD model:

• Probabilities can change based on how long a loan has “survived”
• Probabilities can change based on changing characteristics of the loan

Step 3. Estimate the Expected Loss Rate for each Segment: PD Method Each major loan type uses a different model Student Lending Model* Etc* There are different types of PD models

Calculating the Allowance for Expected Credit Loss

19 Covariate Direction PD Credit Score Down Up Loan to Value (LTV) Up Up Debt to Income (DTI) Up Up Balance Up Up Home Price Index Down Up Unemployment Rate Up Up For given directional change in the covariate what is the impact on PD? Step 3. Estimate the Expected Loss Rate for each Segment: PD Method

Calculating the Allowance for Expected Credit Loss

20

LTV = Loan-to-Value DTI = Debt-to-income HPI = Home Price Index PD = Probability of Default

Loan ID Balance ($) Credit Score LTV (%) DTI (%) Unemployment (%) 5 Year Change HPI (%) 5 year Estimated PD (%)

F100Q1008171 175498 729 73 34 8.4

• 2.21

1.52% F100Q1008175 175498 674 73 34 8.4

• 2.21

2.31% F101Q4125720 175498 729 88 34 8.4

• 2.21

2.75% F104Q4044107 175498 729 73 45 8.4

• 2.21

1.96% F103Q1014290 185297 729 73 34 8.4

• 2.21

1.53% F101Q2408723 175498 729 73 34 10.7

• 2.21

2.08% F199Q3210068 175498 729 73 34 8.4

• 9.91

1.61%

Step 3. Estimate the Expected Loss Rate for each Segment: PD Method Seven different loans, varying just one component of the model at a time The resulting PD This is an average loan in the Los Angeles MSA For example, if the credit score declines from 729 to 674, the PD increases from 1.52% to 2.31%.

Calculating the Allowance for Expected Credit Loss

21

PD = Probability of Default LGD (%) = Loss Given Default (on a percentage basis) EAD = Exposure at Default (aka outstanding balances)

Loan ID Grade EAD ($) Collateral Value ($) Selling Costs (%) Net Proceeds ($) LGD (%) PD (%) Expected Loss Rate (%) 3909209029 A 100,000 110,000 25% 82,500

• 17.5%

1.5%

• 0.3%

7487401448 A 200,000 240,000 25% 180,000

• 10.0%

1.3%

• 0.1%

4974071057 A 300,000 300,000 25% 225,000

• 25.0%

0.8%

• 0.2%

9414970941 B 200,000 280,000 25% 210,000 0.0% 3.0% 0.0% 1247047074 C 100,000 120,000 25% 90,000

• 10.0%

5.0%

• 0.5%

1290407755 B 200,000 150,000 25% 112,500

• 43.8%

3.3%

• 1.4%

1398984324 C 95,000 114,000 25% 85,500

• 10.0%

4.5%

• 0.5%

Total/Average 1,195,000 Collateral Value x (1 – Selling Costs) (Net Proceeds – EAD) / EAD LGD x EAD Including Senior Liens From model (includes Economic Adjustments) Step 3. Estimate the Expected Loss Rate for each Segment: PD Method KEY POINT: Each loan has an Expected Loss Rate, which is then used to derive the Segment/CQI Expected Loss Rate. Avg.for Grade A = -0.2%

Loan ID: 3909209029 ($100k original balance) Month EAD ($) Collateral Value ($) Selling Costs (%) Net Proceeds ($) LGD (%) PD (%) Expected Loss Rate (%) 1 99,626 100,000 25.0% 75,000

• 24.7%

0.10%

• 0.02%

2 99,250 100,500 25.0% 75,375

• 24.1%

0.10%

• 0.02%

3 98,873 100,500 25.0% 75,375

• 23.8%

0.10%

• 0.02%

4 98,494 101,000 25.0% 75,750

• 23.1%

0.10%

• 0.02%

5 98,114 101,100 25.0% 75,825

• 22.7%

0.11%

• 0.02%

6 97,732 101,500 25.0% 76,125

• 22.1%

0.11%

• 0.02%

… … … … … … … … 180 145,000 25.0% 108,750 0.0% 0.09% 0.00% TOTAL 1.50%

• 0.30%

Calculating the Allowance for Expected Credit Loss

22 KEY POINT: EAD, Collateral Value, Selling Costs, PD, all can change over the life of the loan! This is important for incorporating forecasts. Let’s look at a real loan over it’s “lifetime” This loan’s contribution to Expected Loss Rate. Effectively $300 ($100,000 x 0.3%) is added to the Allowance on “Day 1”. Step 3. Estimate the Expected Loss Rate for each Segment: PD Method

PD = Probability of Default LGD (%) = Loss Given Default EAD = Exposure at Default

Balance ($) Expected Loss Rate (%) Expected Credit Loss ($) Residential Mortgages A (1) 600,000 0.2% 1,200 B (2) 400,000 0.7% 2,800 C (3) 195,000 0.5% 975 D (4)

• E (5)
• Sub-total

$1,195,000 .42% $4,975 Consumer-Auto A (1) B (2) Etc. The Segment/CQI Expected Loss Rate is found by averaging all the applicable individual loans’ Expected Loss Rates Each loan is then categorized into an appropriate Segment/CQI 23

Calculating the Allowance for Expected Credit Loss

Step 3. Estimate the Expected Loss Rate for each Segment: PD Method The Expected Credit loss for the Segment/CQI is found by multiplying the Balance by the Expected Loss Rate The sub-total is combined with other Segment/CQI sub-totals and rolled up into the required Allowance for Expected Credit Loss

Calculating the Allowance for Expected Credit Loss

24 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate Method

• 1. Probability of Default Method (PD)
• 2. Loss Rate Method
• 3. Discounted Cash Flow Method (DCF)

Calculating the Allowance for Expected Credit Loss

25 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate Method

• 2. Loss Rate Method

by Segment by Original Grade by Current Grade

What about credit quality distribution? What about credit deterioration? Do all loans start out in high quality tiers? What about credit deterioration? Do all loans end in a low quality tiers? What about the risk inherent in the higher tiers? Is “Static Pool” or “Loss Migration” the solution? Probably insufficient…

Calculating the Allowance for Expected Credit Loss

Loss Experience in Year Following Origination Base Loss Rate Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Segment 1: Original Grade A (1) 2015

• %

2014 0.0% 0.0% 2013 0.0% 0.0% 0.0% 2012 0.0% 0.0% 0.1% 0.1% 2011 0.0% 0.0% 0.1% 0.1% 0.2% 2010 0.0% 0.0% 0.2% 0.4% 0.0% 0.6% 2009 0.0% 0.1% 0.0% 0.2% 0.0% 0.0% 0.3% 2008 0.1% 0.2% 0.5% 0.2% 0.1% 0.0% 0.0% 1.1% 2007 0.1% 0.3% 0.7% 0.5% 0.0% 0.0% 0.0% 0.0% 1.6% 2006 0.0% 0.0% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.3% Avg. 0.0% 0.0% 0.2% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.4% Sum of yearly loss experiences Charged-off loans divided by original balance 26 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Static Pool Method Use in Segment 1: Current Grade A (1)

Calculating the Allowance for Expected Credit Loss

Loss Experience in Year Following Origination Base Loss Rate Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Segment 1: Original Grade A (1) 2015 0.0% 0.0% 0.2% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.5% 2014 0.0% 0.0% 0.2% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.5% 2013 0.0% 0.0% 0.2% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.5% 2012 0.0% 0.0% 0.1% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.4% 2011 0.0% 0.0% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.2% 2010 0.0% 0.0% 0.2% 0.4% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.6% 2009 0.0% 0.1% 0.0% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.3% 2008 0.1% 0.2% 0.5% 0.2% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 1.1% 2007 0.1% 0.3% 0.7% 0.5% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 1.6% 2006 0.0% 0.0% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.3% Avg. 0.0% 0.0% 0.2% 0.3% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Sum of yearly loss experiences Charged-off loans divided by original balance 27 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Static Pool Method Or you could use the average loss rate in each year after origination and apply it to the unknown years (shaded cells), but then need to segment by year! Apply to Segmentation by Year

Balance Base Loss Rate Economic Adjustment Expected Loss Rate Expected Credit Loss Segment 1 A (1) $200,000,000 0.40% .01% 0.41% $820,000 B (2) 150,000,000 0.55% .01% 0.56% 840,000 C (3) 75,000,000 0.75% .01% 0.91% 682,500 D (4) 25,000,000 2.70% .01% 3.52% 880,000 E (5) 5,000,000 6.75% .01% 10.14% 507,000 Sub-total $455,000,000 $3,729,500 From Static Pool Analysis by Original Grade 28

Calculating the Allowance for Expected Credit Loss

Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Static Pool Method Balances by Current Grade More on this later…

Calculating the Allowance for Expected Credit Loss

as of 12/31/15 Loss Migration-CQI History Loan ID Charge-off Date Charge-off Balance ($) Q4 2015 Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 …. 253463479 12/15/15 100 D C A A A A A A 563818949 11/15/15 75 E C B B A A A A 122773297 10/15/15 100 E D C C C A A A 998440233 9/15/15 50

• D

C C C B B B 345421123 8/15/15 25

• C

B B B B B B

29 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Loss Migration Method

CQI = Credit Quality Indicator

Charge-offs not included in periods after charge off date Go back in time to each loan’s origination date Could use month, quarter, year

Calculating the Allowance for Expected Credit Loss

30 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Static Pool Method

as of 12/31/15 Loss Migration-Segment 1: Grade A Q4 2015 Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 … Charge-offs ($) 100 100 175 275 275 275 … Balance1 ($) 100,000 90,000 95,000 105,000 100,000 95,000 100,000 105,000 …. Loss Rate2 (%) 0% 0% .42% .38% .70% 1.16% 1.10% 1.05% ….

1 Beginning balance of period 2 Annualized

as of 12/31/15 Loss Migration-CQI History Loan ID Charge-off Date Charge-off Balance ($) Q4 2015 Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 …. 253463479 12/15/15 100 D C A A A A A A 563818949 11/15/15 75 E C B B A A A A 122773297 10/15/15 100 E D C C C A A A 998440233 9/15/15 50

• D

C C C B B B 345421123 8/15/15 25

• C

B B B B B B

We now have an annualized charge-off ratio for each quarter reflecting data up through 12/31/15 Notice only looking at Grade A

Calculating the Allowance for Expected Credit Loss

31 Step 3. Estimate the Expected Loss Rate for each Segment: Loss Rate-Loss Migration Method

as of 12/31/15 Loss Migration-Segment 1: Grade B Q4 2015 Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 … Charge-offs ($) 100 100 25 75 75 75 … Balance1 ($) 80,000 85,000 82,000 83,000 81,000 80,000 79,000 83,000 …. Loss Rate2 (%) 0% 0% .49% .48% .12% 0.38% 0.38% 0.36% ….

1 Beginning balance of period 2 Annualized

as of 12/31/15 Loss Migration-CQI History Loan ID Charge-off Date Charge-off Balance ($) Q4 2015 Q3 2015 Q2 2015 Q1 2015 Q4 2014 Q3 2014 Q2 2014 Q1 2014 …. 253463479 12/15/15 100 D C A A A A A A 563818949 11/15/15 75 E C B B A A A A 122773297 10/15/15 100 E D C C C A A A 998440233 9/15/15 50

• D

C C C B B B 345421123 8/15/15 25

• C

B B B B B B

Notice only looking at Grade B

KEY POINT: Repeat for each Segment/CQI. Then derive an appropriate Loss Rate (average over certain time period, weight and average from prior analysis dates, etc.)

Calculating the Allowance for Expected Credit Loss

32 Step 3. Estimate the Expected Loss Rate for each Segment: PD Method

• 1. Probability of Default Method (PD)
• 2. Loss Rate Method
• 3. Discounted Cash Flow Method (DCF)

Calculating the Allowance for Expected Credit Loss

33 Step 3. Estimate the Expected Loss Rate for each Segment: DCF Method

Discount Rate must be the Effective Interest Rate (per FASB)

Calculating the Allowance for Expected Credit Loss

34

Pa Path 1 h 1: W Wha hat i is the Pr he Pres esen ent V Value e if t the l he loan goes es full ter erm? $100,000 Pat ath 2 2: W What at is is the Present Val Value ue if if t the l loan an pay pays o

• ff in

in ful ull af after jus just 4 year ars? ? $100,000

Loan Amount = $100,000 Term = 180 Months Rate = 5.0% Payment = $790.79 Discount Rate= 5.0%

If pr present val alue ue al alway ays e equal quals t the bal balan ance (am amortiz ized d cost), what at is is the po poin int of do doin ing a a dis discoun unted d cas ash flow an anal alysis is? ? Pat ath 3: Tim imin ing of D Defaul aults do does mat atter Path 1-Full maturity Path 2-Prepay with no loss to principal Path 3-Default (Prepay with loss to principal)

Step 3. Estimate the Expected Loss Rate for each Segment: DCF Method

Calculating the Allowance for Expected Credit Loss

35 Balance = $90,577 Net Proceeds = $75,000* PV of Payments = $17,310 PV of Net Proceeds = $68,593 PV = $85,902 Loss = $14,098

Default occurs at 24 months

Balance = $80,166 Net Proceeds = $75,000* PV of Payments = $33,691 PV of Net Proceeds = $62,078 PV = $95,769 Loss = $4,231

Default occurs at 48 months Default occurs at 72 months

Balance = $68,662 Net Proceeds = $75,000* PV of Payments = $48,516 PV of Net Proceeds = $56,182 PV = $104,699 Loss = $0

*For simplicity we assumed the net proceeds from the sale of collateral was the same in each scenario.

Loan Amount = $100,000 Term = 180 Months Rate = 5.0% Payment = $790.79 Discount Rate= 5.0% Step 3. Estimate the Expected Loss Rate for each Segment: DCF Method

Calculating the Allowance for Expected Credit Loss

36

The Problem is we don’t know when defaults will occur…(at 24 months? 48 months? 72 months?) We need a similar analysis as the Probability of Default (each loan contributing a little bit to the

• verall expected loss).

Conditional Default Rate (CDR)

• r Default Proportion

Conditional Prepayment Rate (CPR) Conditional Repayment Rate (CRR) = +

In a pool of loans some portion will “Prepay” Some portion of the “Prepay” will include defaults Step 3. Estimate the Expected Loss Rate for each Segment: DCF Method

Calculating the Allowance for Expected Credit Loss

37 Month CPR Default Proportion Loss Severity Beginning Balance Prepayments Expected Loss Discounted Expected Loss Expected Loss Rate 1,000,000 1 10% 70% 20% 982,363 8,663 1,213 1,027 0.1% 2 15% 70% 20% 964,826 8,508 1,191 1,009 0.1% 3 15% 70% 20% 947,387 8,354 1,170 991 0.1% … … … … … … … … 360 10% 70% 20% 0.0% Total 522,421 73,139 61,982 6.1% CPR and default statistics can vary

• ver time

Used in the Allowance for Expected Credit Loss (Beginning Balance – Principal Payment) x (1- CPR)

Adjusted to monthly rate

Pre- payments Default Proportion Loss Severity x x Step 3. Estimate the Expected Loss Rate for each Segment: DCF Method KEY POINT: DCF turns out to be a very similar methodology to the PD Method.

Calculating the Allowance for Expected Credit Loss

38

Economic Adjustments: Reasonable & Supportable Forecasts Economic Adjustments: Current Conditions Base Loss Rate Expected Loss Rate

Step 3. Estimate the Expected Loss Rate for each Segment

Calculating the Allowance for Expected Credit Loss

39

“Under an expected credit loss model, the consideration of past and current conditions may be a good starting point in estimating credit losses. However, an expected credit loss model would also require incorporating reasonable and supportable forecasts about collectability over the remaining contractual cash flows.” (FASB)

Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments

Calculating the Allowance for Expected Credit Loss

40 Expansion Peak Contraction Trough

Interest Rates Increasing High Decreasing Low Loan Demand Increasing High Decreasing Low Deposit Growth Moderate Low Moderate High Liquidity Decreasing Low Increasing High Monetary Policy Tightening Tight Easing Ease Yield Curve Rising/Flattening Flat/Falling Reverse Rising Steeply

Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Economic Cycle)

Calculating the Allowance for Expected Credit Loss

41 Expansion Peak Contraction Trough Deposits/ Liabilities: Shorten Maturities Minimize Maturities Lengthen Maturities Maximize Maturities Loans: Lengthen Maturities Maximize Maturities Shorten Maturities Minimize Maturities Loan Quality: Acquire Fixed Rate Upgrade Quality Restrict Fixed Rate Restrict Fixed Rate Investments: Acquire Investments Lengthen Maturities Upgrade Quality Plan Sales Shorten Maturities Sell Investments Minimize Maturities Credit Lines: Replenish Purge Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Economic Response)

Calculating the Allowance for Expected Credit Loss

42 GDP Interest Rates (Index) Consumer Sentiment Index House Price Index (HPI) Unemployment No-Collinear or Insignificant Yes Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts) Which variables to include? Which variables to forecast?

Calculating the Allowance for Expected Credit Loss

43 Industry Forecast Your Own Forecast ARIMA Model Custom Model Use Directly Adjust Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts) How to forecast?

Calculating the Allowance for Expected Credit Loss

44 Industry Forecast ARIMA Model Custom Model Use Directly Adjust House Price Index (HPI) Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts) Your Own Forecast

Calculating the Allowance for Expected Credit Loss

ARIMA (Auto-Regressive Integrated Moving Average)

45

3 1 Use previous data points to predict future data points Analyze correlation between an observation (xt) and the one that precedes it (xt-1) If correlation exists, an auto-regressive model is likely useful 2

Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts)

Calculating the Allowance for Expected Credit Loss

46

House Prices

Current values highly correlated with previous ones ( r = .9873)

1975 1985 1995 2005 2015

Forecast

Using ARIMA you can forecast on the MSA level:

• Affects PD
• Affects LGD (forecast actual home

prices)

Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts)

Calculating the Allowance for Expected Credit Loss

47 Industry Forecast ARIMA Model Other Model Use Directly Adjust Unemployment Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts) Your Own Forecast

Calculating the Allowance for Expected Credit Loss

48 National Forecast What about MSA? Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts)

Calculating the Allowance for Expected Credit Loss

49 Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts)

Calculating the Allowance for Expected Credit Loss

50

2 4 6 8 10 12 14 1/1/2005 4/1/2005 7/1/2005 10/1/2005 1/1/2006 4/1/2006 7/1/2006 10/1/2006 1/1/2007 4/1/2007 7/1/2007 10/1/2007 1/1/2008 4/1/2008 7/1/2008 10/1/2008 1/1/2009 4/1/2009 7/1/2009 10/1/2009 1/1/2010 4/1/2010 7/1/2010 10/1/2010 1/1/2011 4/1/2011 7/1/2011 10/1/2011 1/1/2012 4/1/2012 7/1/2012 10/1/2012 1/1/2013 4/1/2013 7/1/2013 10/1/2013 1/1/2014 4/1/2014 7/1/2014 10/1/2014 1/1/2015 4/1/2015 7/1/2015

Unemployment Rates (%) National Los Angeles Highly Correlated Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts)

Calculating the Allowance for Expected Credit Loss

51

Economic Adjustments: Reasonable & Supportable Forecasts Economic Adjustments: Current Conditions Base Loss Rate Expected Loss Rate

PD Models: Included in PD Loss Rate: Direct Adjustments Needed DCF Models: Included in CDR*

Step 3. Estimate the Expected Loss Rate for each Segment: Economic Adjustments (Forecasts) From PD Model Intuition-Probably not sufficient *Research pending Correlation with Loss Rates

Balance Expected Loss Rate Expected Credit Loss Residential Mortgages A (1) $200,000,000 0.28% $560,000 B (2) 150,000,000 0.30% 450,000 C (3) 75,000,000 0.75% 562,500 D (4) 25,000,000 2.70% 675,000 E (5) 5,000,000 6.75% 337,500 Sub-total $455,000,000 $2,585,000 Consumer-Auto A (1) B (2) Etc. Step 3. Estimate an appropriate Expected Loss Rate, including economic adjustments, for each Segment Step 4. Multiply each Segment/CQI balance by its Expected Loss Rate and then sum each Segment’s sub-total to calculate the Allowance for Expected Credit Loss Step 2. Decide on an appropriate Credit Quality Indicator for each Segment Step 1. Properly segment the portfolio 52

Calculating the Allowance for Expected Credit Loss

Review Steps

Introduction

1

Notice: FASB is still deliberating and has not made a final accounting standards update!

2

Calculating the Allowance for Expected Credit Loss Conclusion Required Disclosures Agenda

4 3

53

Required Disclosures

Broad Goals 54

• 1. Understand the credit risk inherent in the portfolio and how

management monitors the credit quality of the portfolio.

• 2. Understand management’s estimation of expected credit

losses.

• 3. Understand changes in the estimate that have taken place

during the reporting period.

Required Disclosures

Sections 55

• Level of Disaggregation (Segmentation)
• Credit Quality Indicators
• Allowance for Expected Credit Loss
• Roll Forward Information
• Vintage Analysis
• Past Due/Nonaccrual Status
• Other

Required Disclosures

Level of Disaggregation-Example 56

We segment our portfolio by the following lines of business. Business/Commercial SBA Commercial Real Estate Commercial Other Consumer Credit Card Auto Other Secured Other Unsecured Residential First Mortgage Other Other Include a description of each segment and sub-segment.

Required Disclosures

Credit Quality 57

1 A description of the credit quality indicator per segment 2 The amortized cost by credit quality indicator 3 For each credit quality indicator the date or range of dates last updated

Required Disclosures

Credit Quality-Example 58

Other Unsecured

We monitor credit quality for

• ur other unsecured portfolio by

credit score. Credit scores are updated quarterly. The scores were last updated 6/30/15.

Need to disclose wh en last updated by Segment

Required Disclosures

Allowance for Expected Credit Loss 59

• 1. Understand the method(s) used
• 2. Understand the information management used in developing

its estimate of expected credit loss

• 3. Understand the economic assumptions that caused changes to

the allowance, which affects the credit loss expense

Required Disclosures

Allowance for Expected Credit Loss 60

A description of how the expected loss estimates are developed A description of the factors that influenced management’s current estimate of expected credit losses (Past events, current conditions, reasonable and supportable forecasts) A discussion about the risk characteristics of each segment A discussion about any changes in factors that influenced the expected loss A discussion of any changes in an entity’s accounting policies, methodology, and/or estimation techniques An explanation of any significant changes in the amount of write-offs.

Required Disclosures

Allowance for Expected Credit Loss (Roll Forward)-Example 61

• Sept. 30, 2015
• Dec. 31, 2015Mar. 31, 2016

Beginning Balance $2,200 $2,100 $2,000

• Charge-offs

$800 $700 … +Recoveries $0 $100 … Balance Before ECL Provision $1,400 $1,500 … +Provision for Expected Credit Loss$700 $500 … Ending Balance $2,100 $2,000 …

Segment: Mortgage Method: Probability of Default

Required Disclosures

Vintage Analysis-Example 62

+5 Full Years +YTD +Prior Periods

Credit Quality Indicator Balance ($) % of Subtotal % of Portfolio Grade A+ 2015 (YTD) 25,000,000 10.7% 6.9% 2014 52,000,000 22.2% 14.4% 2013 54,000000 23.1% 15.0% 2012 40,000,000 17.1% 11.1% 2011 38,000,000 16.2% 10.6% 2010 10,000,000 4.3% 2.8% All Others 15,000,000 6.4% 4.2% Subtotal 234,000,000 100% 65%

Required Disclosures

Delinquency Aging 63

Required Disclosures

Delinquency Aging-Example 64

Required Disclosures

Other Disclosures 65

• Reconciliation between Fair Value and Amortized Cost for

Certain Debt Instruments

• Purchased Credit Impaired Financial Assets
• Transition Disclosures for Interim Reporting Periods
• Reversion Method After “Reasonable & Supportable Forecast

Period”

• Collateral Dependent Qualitative Disclosure

Introduction

1

Notice: FASB is still deliberating and has not made a final accounting standards update!

2

Calculating the Allowance for Expected Credit Loss Conclusion Required Disclosures Agenda

3 4

66

Conclusion The main objective of the Accounting Standards Update is to provide financial statement users with more decision useful information about an institution’s expected credit losses by requiring consideration of a broader range of reasonable and supportable information.

More Discussion and Disclosures

• No “Probable” Threshold
• Past, Current, and Future

Allowance for Expected Credit Loss: Main Objective 67

Statement of Financial Condition (Balance Sheet)

Assets Total Loans $100,000,000 Less Allowance for Expected Credit Loss <$2,000,000> Net Loans $98,000,000 Current estimate of cash flows NOT expected to be collected.

Conclusion

Allowance for Expected Credit Loss: Balance Sheet 68

Balance Expected Loss Rate Expected Credit Loss Residential Mortgages A (1) $200,000,000 0.28% $560,000 B (2) 150,000,000 0.30% 450,000 C (3) 75,000,000 0.75% 562,500 D (4) 25,000,000 2.70% 675,000 E (5) 5,000,000 6.75% 337,500 Sub-total $455,000,000 $2,585,000 Consumer-Auto A (1) B (2) Step 3. Estimate an appropriate Expected Loss Rate, including economic adjustments, for each Segment Step 4. Multiply each Segment/CQI balance by its Expected Loss Rate and then sum each Segment’s sub-total to calculate the Allowance for Expected Credit Loss Step 2. Decide on an appropriate Credit Quality Indicator for each Segment Step 1. Properly segment the portfolio 69

Conclusion

Review steps to calculating the Allowance for Expected Credit Loss

Three Main Methods to Calculate Expected Loss Rate:

• 1. Probability of Default Method (PD)
• 2. Loss Rate Method (w/ Static Pool or Loss Migration)
• 3. Discount Cash Flow Method (DCF)

[ ]

• Dec. 31, 2015Mar. 31, 2016

Beginning Balance $2,100 $2,000

• Charge-offs

$700 … +Recoveries $100 … Balance Before Expected Credit Loss Provision $1,500 … +Provision for Expected Credit Loss $500 … Ending Balance $2,000 … Then use the Provision to balance You first calculate the required Allowance for Expected Credit Loss

From prior period

Conclusion

Allowance for Expected Credit Loss 70

Statement of Financial Performance (Income Statement)

Interest Income Loans $10,000,000 Etc. $ 1,000,000 Total $11,000,000 Interest Expense Deposits/Shares $ 2,000,000 Etc. $ 0 Total $ 2,000,000 Net Interest Income $ 9,000,000 Less Provision for Expected Credit Loss <$ 500,000> Net Interest Income After Provision for Expected Credit Loss $ 8,500,000

The provision reduces the Net Interest Income

Conclusion

Allowance for Expected Credit loss: Income Statement 71

Conclusion

Tips to a smooth transition 72

Decide on segmentation, credit quality indicator, and expected loss rate method you will use. 2 1 3 4 Run new model in parallel to existing methodology. Don’t panic! There will be transition time and this is easier than many are making it out to be… Start building out required discussion and disclosures items. 5 Identify data elements and analytics needed (internal and external).

THANK YOU

FOR MORE INFORMATION PLEASE CONTACT: IAN.DUNN@VISIBILEEQUITY.COM 888-409-1560

73

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