There was an avalanche of articles regarding Current Expected Credit Losses (CECL) a couple of years ago as just about everyone was freaking out over the requirements of the Financial Accounting Standards Board pronouncement (ASU 2016-13, Financial Instruments – Credit Losses, Topic 326) as well as the timing of the requirement. Publicly owned companies were under the gun as their date of compliance was, and still is, December 15, 2019. Others had more time to comply. Due to a lot of concern on the part of both companies and some members of the FASB board, the timing of adoption has been delayed for most of us in the auto finance business. The new deadline for non-public companies has been delayed until December 15, 2021. While that gives most finance companies additional time to properly build and implement the forecast models to plan future losses, the overall consequences are still quite concerning.
Essentially, CECL requires that the total of all expected losses during the lifetime of a portfolio of loans must be recognized in total (loss provision) in the same month that the loans are originated. Currently, losses are spread over the expected life of the portfolio based upon historical losses. This is not an exact science and requires modeling and judgment on the part of the accounting staff.
Let’s say that there are $20,000,000 in loans originated during an example month. Based upon the company’s historical loss performance, an overall lifetime net financial loss of 12.5 percent of the original principal of the portfolio is anticipated. The monthly net loss is spread over the life of the portfolio following a curve that will approximate the magenta line in Table 1. The blue line illustrates the aggregate losses over the life.
Typically, a sub-prime finance company would assign a loss provision equal to the first five or six months of expected losses in month one just so some conservatism is shown. In the example curve above, that would suggest an initial provision of about 4.5 percent of the original portfolio principal. Then the following months’ provisions attributable to month one’s portfolio would pick up the remainder of the expected losses following the remaining curve. Typically, losses peak during the first year of portfolio history, then taper off rapidly over the remaining life of the portfolio. In the above example, the peak is reached at about the tenth month after origination.
As each month’s loan originations are made, the loss provision analysis proceeds and as time goes by, the provisions are summed for each calendar month thereby making up the total monthly loss provision. So, a fair amount of modeling and monitoring losses is necessary to make all this work properly.
This loss provision methodology has been in place for many years, but the fear of misleading financial information being published followed the mortgage collapse in 2009-2010. That fear rapidly spilled over into all credit businesses, and the FASB reacted, partially to stave off a regulatory move by the SEC. The decision was not unanimous at FASB, but the majority rules and CECL resulted.
Under the new rules, the projected losses that will result from a month’s originations will be booked in total during that same month. A curve depicting that interpretation looks like Table 2. The blue line represents expected losses over the life of the portfolio while the orange line represents the interest income month by month. Although the total expected loss is an expense of month one, it will take approximately 11 months of interest income to begin to generate a gross profit – interest income being greater than losses for a portfolio.
And, if this same origination volume continued month after month, it would take eight months for the overall portfolio to begin making any gross profit. So, at the least, there will be a long dry spell where gross profit is concerned. If the originations go through a growth period, thus requiring higher loss provisions, the time until profitability returns can be longer.
Existing portfolio loss provisions must also make a “catch-up” entry the month of CECL adoption to recognize ALL of the remaining expected credit losses associated with the existing portfolio. Taken together, this adjustment can delay any gross income even longer.
There is no difference in cash flow, but GAAP profit is seriously affected during the first several months of the portfolio’s life.
Table 2: CECL Loss Provision
Note the concentrated spike in the loss provision in the first month with no further loss provision over the life of the one month portfolio.
In the example below, origination volume is assumed to be the same each month. Note that loss provision is a straight line as the same provision is posted each month. In this example, the originator shows an overall loss for the first eight months. If the originations were growing month over month, the loss situation would be much longer.
And here is the overall philosophical driver: the credit industry does NOT wish to understate losses, so using the best modeling methodology to incorporate all reasonable future occurrences, all losses are reported up front and the results will not be overly optimistic, thus not misleading the investment community.
The overall effect of CECL is that in the early going, and then going forward in a company that is increasing its rate of originations, losses will be brought forward which will reduce current GAAP income significantly. If originations go stagnant or decrease, then loss provisions will decrease and GAAP income will again increase due to the CECL rules. In a growing company, net equity in the company will be negatively impacted due to the increased GAAP losses.
Providers of warehouse lines of credit who have as a part of their underwriting requirements applicable to auto finance companies a requirement for a minimum equity ratio will either be forced to reduce the required equity ratio, or, fewer and smaller warehouse lines of credit will result. This could have a material impact on the ability of auto finance companies to obtain credit lines necessary to fund their growth.
Thinking of GAAP accounting, CECL could have been named “The Equity Absorbing Model of Financial Accounting.”