Loan Participations, CECL, Stress Testing, Loan Modeling for Banks and Credit Unions

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To be a scientist…

When the coronavirus was first discovered to be a looming pandemic, scientists did what scientists do. They guessed. They extrapolated. They tested. Guesses were based upon other viruses and other epidemics and pandemics. They extrapolated early trends and early data. They started running tests on every aspect of the virus, the human biological response, and the social aspects.

In the long run, scientists are always “wrong”, because science is a process of finding the boundaries and failures of current knowledge and adapting. The process of science is succeeding when flaws are found and boundaries are pushed. In this era of coronavirus, we are seeing the process of scientific discovery in real time.

Are face masks useful? Maybe. No. Yes, but don’t we don’t have enough good ones. Then finally, YES! Everyone! Now! Anyone who expressed a view in the past cannot be punished for stating what we thought we knew then. We did not have enough time to wait for a final answer. We have to do the best with what we know at each moment. (By the way, this is absolutely true of climate change, also.)

So, the mask debate seems pretty well settled. Wear a non-medical mask to protect others from yourself. It’s called civic duty or social responsibility or the optimal solution of an iterated prisoner’s dilemma type of problem. Choose your favorite paradigm.

The next bit of advice due for revision is the “six feet of separation”. That was based upon thinking that the virus is not airborne and would fall to the ground over six feet. (Actually, more like 12.) In fact, evidence has been mounting that the virus forms aerosols, meaning that it is airborne just like a flu virus. Reluctantly, the WHO admitted as much last week. Reluctantly, because the implications are unpleasant.

If the virus is airborne, then few of our old indoor spaces are safe. Yes, masks and plastic barriers and social distancing help, but the viral concentration will build in the air. What really matters is airflow. We need to accept that we need a hard rethink of all of our indoor spaces.

Summertime gives us a little breathing space. We can move (most) everything outdoors. Outdoor concerts, church, restaurants, bars, social gatherings, classrooms – yes, as long as people are still spread apart. An open-air setting reduces the concentration of the virus in the air you breathe as it diffuses in the atmosphere. To make an indoor space safe, we need to accomplish the same.

Some businesses are already reengineering their airflow. Most office spaces are designed around a push of air into the space, passive air return, and only coarse filtering. The office of the future will need fans pulling air from the space, strategically located above where people are most concentrated. That pulled air needs to go straight out or through medical grade filters before return.

Any space that cannot be fully reengineered will accumulate airborne virus. Then it’s a race against the clock. The more stale the air, the less time you want to spend there. That means an unimproved space can be used for pick-up service only. A partially improved space can be used for in-store shopping of limited duration, etc. In you want in-door bars, dining, schools, and church services, then circle the calendar month when it will be too cold for outdoor service and get busy renovating.

This is not a wasted effort when we finally have a coronavirus vaccine. We should have been considering the health aspects of indoor spaces long ago. We can lessen the cost of cold and flu season and reduce the risk of the next pandemic through the same investments. Healthy spaces make for healthy businesses, healthy consumers, and ultimately more economic growth. Why not include building renovation loans in the next stimulus package as a way of winterizing our economy?

While we’re putting this constructive stimulus into the economy, we will keep learning more about how to manage, control, and ultimately defeat this virus and get a head start on the next one.

Software Delivery After running the scenario updates, the new scenarios were only slightly different from the previous ones. To avoid information overload, we have decided not to push these scenarios to our software users. Instead, we will wait two weeks for the early August data updates. We expect to see significant adjustments at that time. Please contact us if you have any questions or would like any custom scenarios.

Webinar Summary: Comparing CECL to FAS5 Results

Webinar Summary: Comparing CECL to FAS5 Results

Credit Unions can expect at least a 22% increase and Community Banks a 59% decrease in reserves as a result of CECL?

Deep Future Analytics (DFA) and Prescient Models (PM) recently conducted a joint study across 103 CECL clients to determine how much their loss reserves could change if CECL were adopted today. The results were presented in a 10/17 webinar which we summarize in this article.

Modeling Accuracy Since loan modeling is such a complex animal, the first question you should always ask is: “Can I trust the numbers?” For this, Dr. Joe Breeden, world renowned credit analyst and author of the “Living with CECL” book series, takes you through how advanced loan modeling works and the data and equations behind it. I provided a “stripped down” version of this below for those less familiar with loan modeling.

For the study we used a MultiHorizon Survival Model. This highly advanced method of computing credit risk is actually a two-step approach which adds to overall accuracy and application of the data. When you take multiple factors like Lifecycle, Environmental, and Credit Quality the information must be handled correctly or the results will be erratic. Therefore, this approach accounts for the changes in variable significance across multiple horizons. For example, delinquency is a very strong indicator of PD in the early months but then becomes less important. All in all, as we look at lifetime losses it is important to have a model that will stand the test as we look multiple years into the future.

Among community banks, the most common result (median) was a significant reduction of -59% in reserves. For credit unions the model reveals an increase in reserves of 22%. These estimates are before any Q-Factor adjustments. While the banks may be able to add Q-Factors to bring the new requirements more in line with existing practices, the credit unions will have a much more difficult time “selling” a negative Q-Factor to their auditors.

Next, we took the client data and further stress tested using the FRB Severe scenario for a near-term recession. As a result the CECL loss reserves see a significant increase with the banks going from a -59% up to +69%, and credit unions from +22% up to +107%.

Product Results To understand the differences by product, we are taking our model’s 12 month horizon and comparing to a lifetime horizon. This will measure the number of years of coverage you need under CECL, compared to what you would’ve had before.

The median ratio of CECL / 12Mo. loss rate for the individual products is essentially the average life of the loan. For example, we computed the average life of Consumer Loans to be 1.59, thus resulting in a 59% increase in reserves of the current 12 month horizon. For Auto loans the result was an increase of 135%, 55% for Consumer Line, 78% for Credit card, 140% for Residential RE, and 342% for HELOC. The HELOC is sort of an interesting case because it cannot be canceled. This poses many issues in how we manage loss estimates and this actual estimate could actually be understated.

On the commercial side, we show increases for all products as well: Ag Loans (197%), Ag Lines (2%), C&I Loans (93%), C&I Lines (140%), CRE Loans(251%), and CRE Lines(310%)

There are still plenty of institutions today that have yet to prepare for the new CECL standards. Based on these results we feel the time is now to find out your institution’s new reserve requirements so you can make the appropriate course corrections today to ensure a smooth transition tomorrow.

Click Here to view the Webinar