The Allowance for Loan Losses: Critical Issues for Credit Union Leaders

The Allowance for Loan Losses: Critical Issues for Credit Union Leaders Michael J. Sacher, CPA Sacher Consulting Foreword by Dr. Harold M. Sollenberger Professor Emeritus of Accounting and Information Systems Michigan State University

The Allowance for Loan Losses: Critical Issues for Credit Union Leaders Michael J. Sacher, CPA Sacher Consulting Foreword by Dr. Harold M. Sollenberger Professor Emeritus of Accounting and Information Systems Michigan State University

Copyright 2011 by Filene Research Institute. All rights reserved. Printed in U.S.A.

Filene Research Institute Deeply embedded in the credit union tradition is an ongoing search for better ways to understand and serve credit union members. Open inquiry, the free flow of ideas, and debate are essential parts of the true democratic process. The Filene Research Institute is a 501(c)(3) not-for-profit research organization dedicated to scientific and thoughtful analysis about issues affecting the future of consumer finance. Through independent research and innovation programs the Institute examines issues vital to the future of credit unions. Ideas grow through thoughtful and scientific analysis of toppriority consumer, public policy, and credit union competitive issues. Researchers are given considerable latitude in their exploration and studies of these high-priority issues. Progress is the constant replacing of the best there is with something still better! Edward A. Filene The Institute is governed by an Administrative Board made up of the credit union industry s top leaders. Research topics and priorities are set by the Research Council, a select group of credit union CEOs, and the Filene Research Fellows, a blue ribbon panel of academic experts. Innovation programs are developed in part by Filene i 3, an assembly of credit union executives screened for entrepreneurial competencies. The name of the Institute honors Edward A. Filene, the father of the U.S. credit union movement. Filene was an innovative leader who relied on insightful research and analysis when encouraging credit union development. Since its founding in 1989, the Institute has worked with over one hundred academic institutions and published hundreds of research studies. The entire research library is available online at www.filene.org. iii

Acknowledgments The author would like to thank Bill Eckhardt, Daniel McCue, and Norm West of Alaska USA Federal Credit Union for their encouragement and incisive feedback in the preparing of this report. In addition to his generous foreword, Professor Harold Sollenberger provided initial guidance and a welcome final review. Filene would also like to acknowledge members of the Filene Research Council and their staffs for their timely and helpful advice. These members include: Gerry Agnes Elevations Credit Union, Boulder, Colorado. Patricia Campbell Christian Financial Credit Union, Roseville, Michigan. Teresa Freeborn Xceed Financial Federal Credit Union, El Segundo, California. Laida Garcia Florida Central Credit Union, Tampa. Steve Post VSECU, Montpelier, Vermont. iv

Table of Contents Foreword Executive Summary and Commentary About the Author vi vii ix Chapter 1 Introduction 2 Chapter 2 Relevant ALL Accounting Standards and Principles 7 Chapter 3 A Sound ALL Approach for Credit Unions 17 Chapter 4 Q&E and TDR Factors 24 Chapter 5 Common ALL Mistakes: A Great Recession Post-Mortem 29 Chapter 6 Final ALL Considerations 33 Endnotes 39 v

Foreword The seriousness of valuating loan portfolios cannot be overstated at any time, much less during the recent past, present, and coming time periods. Probably no other element in credit union financial reporting has as great an impact on a credit union s reported earnings and financial position. Equity levels that were once very strong have been significantly impacted by loan losses and allowance account balances. These losses have come from loans charged off as uncollectible, debt restructurings, and foreclosures and from numerous other causes that have reached levels unheard of over the lifetimes of every current credit union manager. by Dr. Harold M. Sollenberger, Professor Emeritus of Accounting and Information Systems Michigan State University Accounting for expected and even unexpected losses during this unusual period has required careful application of both old accounting practices and newly instituted accounting rules and regulations. Historic methods have had difficulties handling current loss volumes while trying to fairly reflect a credit union s true financial position. Also, new directives from accounting authorities have, at times, become moving targets. There is mounting uncertainty regarding the adequacy of allowance for loan loss accounts and methodologies used for calculating loan loss provisions, determining loan portfolio fair values, and ensuring that the matching principle is actually working properly. This research report addresses a broad set of issues related to loan loss accounting and reporting. The most troublesome issues surround estimates of loan loss how to make estimates, how to apply management judgment as to the probability of losses, how to determine the adequacy of allowances, and how to account for these estimates. With examples, actual experiences of the author, references to appropriate accounting regulations and standards, and a straightforward attack on loan loss accounting and management, this report is an excellent primer for credit union managers. The author, Michael J. Sacher, is highly qualified to discuss these critical financial and accounting issues. His prior experience includes many years as an auditor of credit unions and a partner in a major CPA firm. As a consultant, he has focused much of his work on credit unions and on loan valuation problems. His knowledge of accounting theory, the history and current status of financial accounting reporting standards, credit union regulators needs, and the CPA profession s best practices for auditing and reporting combine in a unique way to give insight into actual problems arising from the financial crises of the past four years. Here, he combines the theory, reporting requirements, financial market information needs, and common sense into a clear picture of how credit union loan valuation reporting should be handled. vi

Executive Summary and Commentary by Ben Rogers, Research Director The Washington Mutual (WaMu) collapse of 2009 stands as the nation s largest- ever bank failure. Economic, strategic, and market challenges all coalesced against the thrift at the end, but the more immediate cause of its failure was an insurmountable mismatch on its balance sheet: bad loans overwhelmed the bank s ability to stay solvent. WaMu s allowance for loan losses (ALL) was not big enough. Today s financial landscape is littered with the bones of banks and credit unions alike done in by bad loans. But credit losses are a story as old as banking itself: Financial institutions suffer, and some collapse, when borrowers cannot (or will not) repay their loans. Regulations and accounting standards are enacted with the best intent to control and measure credit losses. But marketplace volatility exhibited by devaluation of collateral and negative earnings has focused increased scrutiny of the ALL. Add to the mix complex accounting requirements heretofore not applicable to most credit unions and the result has been confusion, disagreement, and contention over the ALL. What Is the Research About? The Allowance for Loan Losses: Critical Issues for Credit Union Leaders illuminates the ground on which credit unions calculate their particular allowance. Respected CPA and industry veteran Michael Sacher unpacks the various accounting standards at play and matches them with the expectations of CFOs and credit union examiners alike. The result is a useful document that can be used as both a template and a reference for finance managers, supervisory committee members, and boards of directors walking the fine line between too much and not enough ALL. In some cases the fate of the credit union depends on that line. The report breaks down into four parts: An introduction to the current ALL trends among US credit unions. An examination of the relevant accounting standards and interpretations, including credit union specific guidance around FASB and NCUA requirements. A model ALL approach for credit unions, with specific guidance and suggestions for qualitative and environmental (Q&E) factors. Common ALL mistakes, a Great Recession post- mortem that identifies specific areas for review for those involved in day-to- day management or long- term supervision of the allowance. vii

What Are the Credit Union Implications? This analysis of credit unions ALL deals directly with a pressing current problem: What is the right way to reserve for credit losses? The issue is made more challenging because it is not just a management issue but a regulatory issue in which reasonable people with differing perspectives often disagree. And for CFOs to disagree with examiners, even respectfully, requires a firm basis in the relevant accounting principles. Several points in the report are particularly salient for credit unions today: What goes up must come down. Loan loss and allowance trends are at least stable and, in many cases, declining for a majority of credit unions. This calls for a measured reanalysis of the ALL, and credit unions should consider carefully the author s suggestions on how to formulate sound Q&E positions. Learn how to properly account for troubled- debt restructure (TDR) loans and properly consider impairment for all loans that do not meet the homogenous definition. History can be misleading. An overreliance on historical trends and ratios accounted for some of credit unions ALL confusion at the beginning of the crisis. Conversely, credit unions should not dwell too much on midcrisis trends in building today s allowance. The turmoil of the last three years calls for a thorough review of every credit union s ALL policy. Track with the right tools. Included is a helpful list of analytical tools and the factors boards of directors and supervisory committees should consider based on the metrics presented by financial managers. It also provides a useful list of available ratios for improved supervisory tracking. The ALL is just one of many accounting variables that a credit union should manage well. But its importance has been reinforced during the Great Recession. This timely, tactical report will help your credit union manage it better. viii

About the Author Michael J. Sacher Mike Sacher is a CPA with over 30 years experience providing services to credit unions. Mike has earned a national reputation for his expertise in areas such as accounting and finance, internal control, asset liability management, and governance issues of importance to credit unions. In 2008, Mike launched his own consulting practice, Sacher Consulting, with the goal of assisting credit unions as a trusted business advisor and partner. From 2001 to 2008, Mike was the partner in charge of the Los Angeles office of McGladrey & Pullen s National Credit Union Division, where he oversaw the delivery of audit and consulting services to over 150 credit unions annually ranging in size from $5 million to $7 billion in assets. Mike was also the assurance leader of the division, where he helped to resolve complex accounting and auditing matters, and he led the firm s efforts to customize the approach to credit union audits. Prior to joining McGladrey & Pullen, Mike was a senior partner in the O Rourke Sacher & Moulton CPA firm, which was acquired by McGladrey & Pullen in 2001. In 2008, Mike became a member of the board of directors of Kaiser Federal Bank, and he also serves as chairman of the Audit Committee. Mike is a member of the American Institute of Certified Public Accountants and the California Society of Certified Public Accountants. Mike has a bachelor s in Business Administration (Accounting Concentration) from California State University, San Francisco. He has been a certified public accountant since 1978. ix

CHAPTER 1 Introduction The objectives of this report are to clarify the accounting theory surrounding the allowance for loan losses, to discuss specific areas where errors have been common in credit unions, to provide best practices for consideration of management, and to discuss internal controls that are critical to the allowance for loan losses process.

The allowance for loan losses (ALL) is arguably the most important accounting estimate in a credit union s financial reporting structure. Unlike many accounting applications that are precise and highly objective by their very nature, determining the appropriate balance of the ALL requires significant judgment by management. The severe recession over the past few years, with its record levels of unemployment, housing value declines, skyrocketing delinquencies and chargeoffs, restructuring of troubled loans, and high level of foreclosures in many areas of the United States, has significantly impacted management of the ALL. Many credit unions have struggled with the accounting principles that define an appropriate ALL balance as well as practical methods for determining the balance on an ongoing basis. Accounting standard setters and regulators the Financial Accounting Standards Board (FASB), the Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), the National Credit Union Administration (NCUA), and state regulators have been concerned about the ability of financial institution management to manage earnings vis-à-vis building ALL balances during periods of strong earnings and high credit quality and depleting the ALL (and bypassing expense recognition) during periods of declining earnings and weakened credit quality. Auditors and regulators have challenged many credit unions on their approach and have demanded significant upward adjustments to the ALL, resulting in significant operating losses and reduced capital levels. The objectives of this report are to clarify the accounting theory surrounding the ALL, to discuss specific areas where errors have been common in credit unions, to provide best practices for consideration by management, and to discuss internal controls that are critical to the ALL process. 3

Current ALL Trends Tell a Story In order to understand the impact of the deteriorating economy on credit unions over the past few years, consider the following statistics as portrayed in the accompanying figures. The delinquency ratio (loans over 60 days delinquent divided by total loans) has increased substantially over the past few years, with credit unions in the sand states (California, Nevada, Arizona, and Florida) significantly exceeding the national peer group averages (see Figure 1). However, it appears that delinquencies have reached a plateau, and hopefully a downward trend is developing. In response to rising delinquency, the ALL as a percentage of loans outstanding has significantly increased over the past few years, especially in the sand states (see Figure 2). With rapidly increasing charge-offs, the ALL became inadequate to absorb one year s worth of net charge-offs for many credit unions, a tell-tale signal of ALL understatement (see Figure 3). However, it appears that as credit unions stepped up ALL funding in 2009 2010, the current ALL balances were much more adequate. The Great Recession led to a remarkable increase in provision for loan loss (PLL) expense, which has significantly eroded earnings over the past few years (see Figure 4). Note that PLL averaged less than 0.5% of average assets prior to the current economic cycle. Figure 1: Delinquent Loans as a Percentage of Total Credit Union Loans 3.0 2.5 Delinquency ratio (percent) 2.0 1.5 1.0 0.5 0.0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007 2008 2009 2010 US overall Sand states Source: NCUA, Callahan & Associates. 4

Figure 2: ALL as a Percentage of Total Loans 3.5 3.0 ALL (percentage of total loans) 2.5 2.0 1.5 1.0 0.5 0.0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007 2008 2009 2010 US overall Sand states Source: NCUA, Callahan & Associates. Figure 3: Net Charge-Offs as a Percentage of Prior-Year ALL Net charge-offs (percentage of prior-year ALL) 250 200 150 100 50 0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007 2008 2009 2010 US overall Sand states Source: NCUA, Callahan & Associates. 5

Figure 4: PLL as a Percentage of Average Assets 2.5 PLL (percentage of average assets) 2.0 1.5 1.0 0.5 0.0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2005 2006 2007 2008 2009 2010 US overall Sand states Source: NCUA, Callahan & Associates. The level of PLL quadrupled to 2% for the sand states and doubled to over 1% for all credit unions in the United States. Consider that total net income during the best of years for the industry was in the range of 1% of average assets (1% return on assets). 6

CHAPTER 2 Relevant ALL Accounting Standards and Principles Credit unions are required to adhere to generally accepted accounting principles (GAAP). This chapter reviews and clarifies those that are most relevant and most likely to affect a credit union s allowance practices.

About Accounting Standards References At the end of 2009, the FASB implemented the Accounting Standards Codification (ASC), which supersedes the prior accounting standards set by FASB and other accounting standard setters (SEC, AICPA, etc.). Those previous standards that were still effective upon adoption of the ASC were combined into the new ASC and were given new topical references. This report makes references to the new ASC, and in some cases also references the original FASB opinion number to facilitate a reference that might be known to the reader by the original FASB reference. What Is the ALL? The ALL represents an estimate of losses that have been incurred on loans in the portfolio that are considered to be impaired as of the balance sheet date, based in part on review of individual loans and in part on high- level analytics of groups of loans sharing common risk characteristics. Credit unions are also familiar with the allowance for loan and lease losses (ALLL) designation, but because leases are usually a minimal slice of credit union portfolios, we use the simpler terminology throughout this report. It should be noted that the ALL is also referred to as the allowance for credit losses, since the same accounting requirements apply to other receivables in addition to loans to borrowers made by financial institutions. The following overview of the ALL is given in the ASC: The allowance for credit losses shall be established at a level that is adequate but not excessive to cover probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance- sheet date. Impairment shall not be recognized before 8

it is probable that impairment has occurred, even though it may be probable that impairment will occur in the future. The measurement of credit losses in a portfolio of loans and receivables consists of two parts: reviewing specifically identified loans and estimating credit losses in the remaining portfolio. 1 [Underlining added for emphasis.] There are several critical points (underlined by the author in the above paragraph) that are worthy of further comment. Adequate but Not Excessive An inadequate ALL results in overstated assets, overstated earnings, and overstated capital. An excessive ALL results in understated assets, understated earnings, and understated capital. In either case, the financial statements are misstated. The goal is to get a reasonable ALL properly supported by appropriate analytics. Due to the great degree of subjectivity in many of the factors used in the determination of the ALL, management must exercise due care not to manage earnings by either understating or overstating the ALL. Earnings management is not acceptable and can result in harsh criticism of those charged with corporate governance. Probable Credit Losses The term probable is not defined by mathematical percentages. However, the accounting standards define a range of outcomes, including remote, reasonably possible, and probable. This range of probability was originally defined in SFAS Statement 5, Accounting for Contingencies (March 1975). The ALL is not meant to measure loans that have less than a probable chance of not paying interest and principal according to their contractual terms. Great care must be taken by preparers of financial statements to ensure that ALL calculation methods properly meet the probable threshold. Incurred As of the Balance-Sheet Date Not only must the loss rise to a level of probable, but the underlying event that gave rise to the loss must have occurred prior to the balance- sheet date. This is a critical concept misunderstood by many. Currently, GAAP in the United States operate under what is referred to as an incurred loss model. Before an ALL is recognized, the circumstances giving rise to a loss must have already occurred (and be estimable). Consideration is being given to adopting an expected loss model, wherein losses would be recognized based on expectations of probable future events that will have a direct impact on the collectibility of principal and interest amounts contractually due. There is 9

strong opposition in the financial services industry to the expected loss model, which is being considered due to the convergence of US GAAP with international standards. However, regulators may in fact prefer the expected loss model, as it is believed to be more forwardlooking and may eliminate some volatility created by the current accounting guidance. Reviewing Specifically Identifiable Loans It is critical to recognize that retail financial institutions such as credit unions have hundreds or perhaps many thousands of loans to individual consumers. It would be virtually impossible to evaluate each loan for impairment on a regular basis. However, certain loans must be individually evaluated once they no longer fit within other homogenous loan categories. The following types of loans are typically evaluated on an individual basis: Individually significant loans, including member business loans that do not have homogeneous risk characteristics. Loans that have already been identified as having credit problems, such as TDRs, loans delinquent over a predetermined period such as 60 days, bankruptcies and other collection accounts, loans in process of foreclosure, and loans where borrowers have requested short sales. Other loans that are no longer accruing interest. This ALL component is commonly referred to as the specific valuation reserve (SVR). Estimating Credit Losses in the Remaining Portfolio Once those loans that are individually evaluated for impairment are identified, the remaining portfolio is typically evaluated based on both analytical and qualitative considerations of each major loan category. Consideration is given to levels of past charge-offs by category, current economic trends, quality of and changes in underwriting, value of underlying collateral, and other related factors. This ALL component is commonly referred to as the general valuation reserve (GVR). It is critical to understand that the GVR is still a measure of probable losses as of the balance- sheet date. However, the manner of estimating those losses is much less precise than the SVR estimation, since various categories of loans are being pooled and impairment assessed using high- level analytical techniques. 10

The Evolution of an Impaired Loan To set the stage for the technical matters, let s consider the various phases of a bad consumer loan from origination to charge-off. Upon origination of a consumer loan (auto, mortgage, unsecured, etc.), the credit union s underwriting process considers the borrower s ability and willingness to repay by evaluating income levels, employment status, credit score, collateral value, and other appropriate underwriting metrics. As evidenced by historical industry charge-off rates, underwriting processes usually result in loans to borrowers who make principal and interest payments throughout the term of the loan according to the contractual provisions, and no credit losses are sustained. 2 Occasionally, however, despite the best underwriting efforts, a loan loss is incurred and a charge-off is recorded. Typically, there is a loss event 3 leading to a loan loss that can be identified with 20/20 hindsight. The borrower may have lost their job, the borrower or a close family member may have had a serious illness or died, or a natural disaster such as an earthquake, fire, or flood may have occurred. Once the loss event occurs, the potential credit problems typically become known to management because a payment is missed and the loan becomes delinquent (a loss event indicator). Or, in today s environment, a borrower who is not even delinquent may contact the credit union and advise of their inability (or unwillingness) to continue making payments on their loan. Ultimately, a loss is confirmed once the delinquency exceeds a set period of time or other conditions (such as a short sale or foreclosure) are initiated. This is referred to as loss confirmation. To illustrate the impact on the ALL, consider a hypothetical situation in which we have one loan in our entire loan portfolio. Every month, we review this loan for the purpose of identifying whether a loss event has occurred. Six months after the origination of the loan, we identify that the borrower lost their job. Even though the loan is not yet delinquent at the end of month six, we are in a position to assess the likelihood of this event impairing the borrower s intent or ability to repay principal and interest according to the contractual terms of the loan. We can certainly conclude that the risk of loss is higher upon the loss of employment than it was prior to this event having occurred. Depending on other factors, such as the borrower s willingness and ability to continue making loan payments, we might conclude that the risk of loss is still remote, or reasonably possible, or probable. If our conclusion is that a loss is probable, we establish 11

an ALL in month six, even though the loan is not yet delinquent. If we conclude that the risk of loss is less than probable, we continue to monitor the loan, and if the risk of loss rises to a level of probable, at that time an ALL for that loan is established. Importantly, the loss of employment in this example prompts a greater need to evaluate the risk of loss and to document the rationale for conclusions regarding impairment. This hypothetical example is illustrative of the complexity involved in ALL theory. First, we need to determine whether a loss event has occurred. Then, we must assess whether the impact of the loss event will result in the inability of the borrower to repay principal and interest according to the contractual terms of the loan. Lastly, once the likelihood rises to a level of probable, we must estimate the amount of the inherent loss arising from the loss event. Now imagine the additional complexity of extrapolating this thought process to various loan segments within the credit union, where each loan segment might contain thousands of individual loans originated over the course of several years. The critical points illustrated by this example are: The ALL is a measure of expected losses incurred for loans that have experienced a loan loss event, the event rendering it probable that principal and interest will not be collected based on the contractual terms of the loan. Although delinquency is an early indicator that a loan loss event has occurred, delinquency alone is not a loss event and cannot be solely relied upon to drive the ALL calculation. The likelihood scenario required before a loan loss provision is recorded must be probable as compared to remote or reasonably possible as these outcomes are defined in the accounting standards. Is the ALL a Fair Value Adjustment? The ALL is not a fair value adjustment. Imagine having a seasoned portfolio of consumer auto loans totaling $100 million (M). Some loans in the portfolio were originated very recently. Other loans have various origination dates, and the average remaining life of the portfolio is approximately two years. The credit union has historically incurred losses of approximately 1% per year. For discussion purposes, let s assume the economy has been stable over the past few years (we wish!). For ALL purposes, the credit union has an ALL balance approximating the one-year loss ratio ($1M), and therefore the portfolio s net book value is $99M. 12

Now, imagine the variables that would enter into estimating the fair value of this portfolio. Said differently, how much would a willing buyer pay to acquire the portfolio? Would the buyer offer book value ($99M)? Not likely. The buyer would most likely consider the following factors: How much in cumulative credit losses will be incurred over the life of the portfolio and what will the timing of such losses be? The fair value assessment would extend way beyond the parameters embedded in the ALL calculation. The buyer is not concerned with whether the losses meet the probable accounting definition or whether the loss events have already occurred. These are concepts invented by accountants, and they have little bearing on the determination of fair value in a free market. What is the average life of the portfolio, and what is the rate of prepayments that should be assumed in order to discount future cash flows? A portfolio with an average weighted life of 2 years has much different fair value characteristics than a portfolio of loans with an average weighted life of 10 years. What is the average interest rate in the portfolio, and how does that rate compare to current market rates of debt instruments with similar risk and duration? The above points clearly differentiate the factors that would be considered for fair value treatment as compared to the ALL model currently required by US GAAP. Directional Consistency: An Important Concept Accountants often use the term directional consistency when describing one of the objectives of the ALL. The term was made well known in a proposed Statement of Position (SOP) issued by the AICPA in 2003. Although this SOP was never finalized, the concept of directional consistency clearly articulates an important ALL concept. The following paragraph from the SOP explains the concept. The measurement of a component of collective loan impairment should be based on the relevant observable data relating to existing conditions and should not project changes in the observable data that may occur in the future. The measurement will rarely be a mathematical function of the observable data; rather, significant judgment will usually be needed to develop an estimate. However, a creditor should consider the directional consistency of the measurement with changes in the related observable data from period to period. For example, if the change in the observable data indicates a deterioration in the credit quality of a pool of loans, an increase in the 13

component of collective loan impairment related to that pool of loans (as a percentage of the pool of loans under assessment) would be directionally consistent with the change in the observable data. Conversely, if the change in the observable data indicates an improvement in the credit quality of a pool of loans, a decrease in the component of collective loan impairment related to that pool of loans (as a percentage of the pool of loans under assessment) would be directionally consistent with the change in the observable data. In applying this principle, creditors should take into account the interaction of components of collective loan impairment over time. For example, in applying this principle to a component established in a previous period to adjust the creditor s historical charge-off experience component for conditions not reflected in the historical experience, the creditor should take into account the extent to which those conditions are currently reflected in the creditor s historical charge-off experience component. Further, the extent to which such directional changes should affect the amount of the allowance for credit losses is a matter of significant judgment and expertise. 4 In other words, during periods of strong economic trends and strong loan quality, there is an expectation of relatively smaller ALL balances and lower provision for loan loss expense. During periods of worsening economic conditions, there is the opposite expectation. This concept is in strong opposition to a practice followed by many financial institutions in past years of building reserves during the good times to avoid the impact of negative earnings during the challenging times. A Walk Through the Accounting Standards Many important aspects of the relevant accounting standards have been discussed above and are elaborated upon further in the remainder of this report. However, it is often necessary to refer back to the specific accounting standards for purposes of responding to auditor/ examiner concerns and addressing practical issues by those charged with governance in credit unions. And because of the newly implemented ASC, it is sometimes difficult, especially for those who are familiar with the original FASB standards, to identify the most current accounting reference materials. There are two primary topics under the ASC that address the ALL. Key concepts extracted from Topics 450 and 310 of the ASC are summarized below. In the opinion of the author, it is critical for 14

credit unions to understand these in order to properly comply with GAAP. Topic 450, Subtopic 20, Loss Contingencies, addresses accounting for loss contingencies. Much of this topic is derived from Statement of Financial Accounting Standards (SFAS) Statement 5, Accounting for Contingencies, which was issued in 1975 and to this day represents one of the foundations of accounting theory. Topic 450 specifically references Topic 310, noting that the ALL is a subset of loss contingencies. Topic 310, Receivables, addresses various issues related to accounting issues subsequent to the origination or acquisition of receivables, such as impairment. Former accounting standards SFAS 5, SFAS 15, and SFAS 114 provide much of the content for this section, which addresses the following: The general concept that impairment of receivables is recognized when, based on all available information, it is probable that a loss has been incurred based on past events and conditions existing at the date of the financial statements. This general concept applies to large groups of smallerbalance homogenous loans and to loans that are individually considered to be impaired, including TDRs. A loss arises when the creditor will not be able to collect principal and interest according to the contractual terms of the loan. Losses must be probable before loss accrual. Probable means the future event is likely to occur (that is, it is likely that principal and interest will not be collected according to the contractual terms of the loan). Appropriate analytics must support the ALL. An insignificant delay in collection of principal and interest does not require ALL recognition. If a loan is individually impaired, the amount of the loss provided in the ALL should be based on the present value of the expected future cash flows discounted at the loan s contractual interest rate that existed prior to any restructured terms. As a practical expedient, impairment for a collateraldependent loan can be measured based on the fair value of the collateral (less costs to sell). 15

Collateral-dependent is defined as a loan for which the repayment is expected to be provided solely by the underlying collateral. Based on this definition, it is unlikely that most TDR loans would be defined as collateral-dependent. If a loan is specifically identified as impaired and is measured for impairment, care should be taken to not doublecount the loan in the general valuation component. It is possible for an impaired loan to have no ALL requirement. For example, if the underlying collateral value of an impaired real estate loan exceeded the loan balance, no ALL would be needed. 16

CHAPTER 3 A Sound ALL Approach for Credit Unions Because every portfolio is different, some of a credit union s ALL decision making must be subjective. But most credit unions are similar enough that the template in this chapter forms a stable foundation on which to build an ALL approach.

There are many methods a credit union can utilize to determine its ALL balance in accordance with GAAP. The approach used should be based on the facts and circumstances encountered at that particular credit union, it should be documented in policy, and it should be consistently applied and tested for reasonableness based on commonsense expectations. The internal controls surrounding the ALL should be tested for appropriateness of design and operating effectiveness. Appropriate qualitative and environmental (Q&E) factors should be considered, and accounting for TDRs should be addressed for propriety. The Sample ALL Calculation section below contains an example of an ALL calculation with explanations of each reserve component. The major categories include: Specific identification and ALL reserves for all loans that have already been identified as being specifically impaired, which include, but are not limited to, TDRs, loans over a set period of delinquency, bankruptcies, and foreclosures in process. A GVR component for all loans that have not been specifically identified as already impaired. Appropriate consideration of Q&E factors. Proper accounting for TDR loans. Proper consideration of impairment for all loans that do not meet the homogenous definition, which in credit unions consist primarily of member business loans. Sample ALL Calculation Figure 5 summarizes a sample ALL calculation for a credit union with a diversified loan portfolio totaling $400M. The methodology presented is consistent with the vast majority of credit unions the author has seen over the years. 18

The ALL calculation reflects the following components with further explanations provided below: Loans that have been identified as requiring an SVR total $5,232,000 with a related ALL of $2,016,000. The SVR component includes TDR loans (see the previous section) as well as other loans that no longer fit the homogenous definition due to delinquency status or other loss events having been identified. The remaining portion of the loan portfolio totals $394,768,000 and has a GVR totaling $7,998,372. It is important to note the GVR is a result of utilization of both historical loss ratios and appropriate Q&E factors. Careful consideration must be given to determining the need for and approach taken to determine the Q&E component of the ALL. At the beginning stages of an economic downturn, historical Figure 5: Sample ALL Calculation ABC Federal Credit Union Allowance calculation As of December 31, 2010 (1) (2) (3) (4) Balance of specifically Remaining identified (unimpaired) Total loan Loan category impaired loans loan balance balance SVR Non-real-estate loans Share-secured loans $0 $10,000,000 $10,000,000 $0 Credit card loans $300,000 $39,700,000 $40,000,000 $300,000 New autos direct $84,000 $39,916,000 $40,000,000 $42,000 New autos indirect $150,000 $59,850,000 $60,000,000 $75,000 Used autos direct $24,000 $39,976,000 $40,000,000 $12,000 Used autos indirect $74,000 $24,926,000 $25,000,000 $37,000 Subprime indirect auto $100,000 $9,900,000 $10,000,000 $50,000 Total non-real-estate loans Real estate loans First trust deed $1,500,000 $98,500,000 $100,000,000 $400,000 Second trust deed including $1,000,000 $39,000,000 $40,000,000 $800,000 HELOC Business loans $1,000,000 $19,000,000 $20,000,000 $200,000 participation purchased TDR loans $1,000,000 $14,000,000 $15,000,000 $100,000 Total real estate loans Total loans $5,232,000 $394,768,000 $400,000,000 $2,016,000 (continued on next page) 19

Figure 5: Sample ALL Calculation (Continued) ABC Federal Credit Union Allowance calculation As of December 31, 2010 (5) (6) (7) (8) (9) 5 2 6 + 7 4 + 8 GVR One-year historical loss Historical loss Q&E Total valuation Loan category ratio component adjustment Total GVR reserve Non-real-estate loans Share-secured loans 0.0% $0 n/a $0 $0 Credit card loans 2.2% $873,400 $100,000 $773,400 $1,073,400 New autos direct 1.6% $638,656 $50,000 $588,656 $630,656 New autos indirect 2.4% $1,436,400 $140,000 $1,576,400 $1,651,400 Used autos direct 1.3% $519,688 $0 $519,688 $531,688 Used autos indirect 2.8% $697,928 $50,000 $747,928 $784,928 Subprime indirect auto 4.2% $415,800 $0 $415,800 $465,800 Total non-real-estate loans Real estate loans First trust deed 2.1% $2,068,500 $200,000 $1,868,500 $2,268,500 Second trust deed including 3.0% $1,170,000 $100,000 $1,270,000 $2,070,000 HELOC Business loans part. 0.2% $38,000 $200,000 $238,000 $438,000 purchased TDR loans n/a n/a n/a n/a $100,000 Total real estate loans Total loans n/a $7,858,372 $140,000 $7,998,372 $10,014,372 Note: For illustration purposes, the loan portfolio is segmented by collateral type. Consideration should also be given to segmenting the portfolio by credit risk, geographic concentrations, and other distinguishing characteristics. loss ratios understate impairment, and unfavorable Q&E adjustments are likely appropriate. As the cycle matures, the historical loss ratio will likely overstate impairment (last year s losses will exceed current impairment), and a favorable Q&E adjustment will likely be appropriate. At the time of writing this report, the author believes that we are generally shifting to improving economic conditions and that neutral or perhaps favorable Q&E adjustments are appropriate for many credit unions. The following explanations provide further insight into the ALL methodology reflected in Figure 5. Share-Secured Loans There is no ALL component provided for share- secured loans, since ABC has never had a loss on this loan type and all of these loans are 100% securitized by the borrower s share balance. 20

Credit Card Loans As of December 31, 2010, ABC had specifically identified loans totaling $300,000 that were pending charge-off in January 2011. Therefore, an SVR has been established for the losses on these loans, which represent 100% of the loan balances. Additionally, the one-year loss ratio results in a GVR of approximately $873,000. However, in recognition of an improving economy over the past 18 months, including more aggressive collections and stronger underwriting, a favorable Q&E adjustment of $100,000 is established. It should be noted that based on the best data and most up-to-date analysis, ABC expects unsecured loan charge-offs to approximate $50,000 per month, which provides further support for the favorable Q&E adjustment. Auto Loans (All Categories) Each of these categories reflects the amounts of pending charge-offs that will occur in January 2011 for the SVR. Q&E factors reflect differing results for each component based on current conditions. Consideration is given to declining early- stage delinquency trends, improving economic conditions, and other relevant factors. In all cases, the resulting GVR exceeds the expected charge-offs for the next 12 months by a margin of approximately 20%. First and Second Trust Deed Loans (Including HELOC) As of December 31, 2010, loans totaling $1.5M have come to management s attention that represent probable loss. Loans in this category are primarily comprised of loans over 60 days delinquent for which collection efforts are approaching exhaustion and foreclosure proceedings will begin shortly. There is also a loan in this group where the borrower has approached the credit union for a short sale due to significant collateral value slippage. Estimated losses for these specifically identifiable loans total $400,000. In addition to the amounts resulting from the historical loss ratio, management has obtained updated combined loan-to-value (CLTV) data for all real estate loans through the use of third- party automated valuation models and combined the CLTV data with updated credit score metrics. Management has made estimates for impairment for all real estate loans based on bandwidth of CLTV and credit scores, with emphasis on loans with CLTV ratios above 125%. Business Loans Business loans typically do not meet the definition of a homogenous loan pool and must be evaluated on an individual basis for impairment characteristics. This process often involves an annual (or more frequent, as appropriate) review of each loan, using a grading system 21

that quantifies impairment and results in specific loss estimates after consideration of current collateral value. When these member business loans consist of participations purchased from other credit unions, great care should be taken by the investor credit union to ensure that the servicing credit union is taking appropriate steps to monitor deteriorating credit characteristics and to maximize collection efforts. Many credit unions have relied on the servicing credit union to identify and quantify impairment on participation loans without the commensurate level of due diligence taken by the investor credit union. Sample Calculation of SVR on a TDR Loan In order to illustrate how to calculate the SVR on a TDR loan, assume the loan in Figure 6 was modified and is considered to be a TDR. Net investment in the loan at the date of restructure (including loan balance, accrued interest, deferred origination costs, etc.) as compared to the present value of the future expected cash flows discounted at the loan s original contractual rate. Therefore, we need to determine the future expected cash flows on this loan and then discount those cash flows to their present value at the original 6% interest rate. There are many tools available for determining the present value. As noted in Figure 6, the present value is $172,560 as compared to the loan balance of $186,376. Therefore, an initial SVR of $13,816 (assuming no re-default) is required at the onset of this modification. Figure 6: Sample TDR Loan Original loan balance $200,000 Original term 30 years (360 months) Original rate 6% Net investment in loan at date of $186,376 restructure Remaining term 300 months Revisions to original contractual terms Rate changed from 6% to 3% for 3 years (36 months), reverts to 6% fully-amortizing loan for remaining 264-month (22-year) term Re-default assumption For illustration purposes, assume no re-default risk Original loan payment (P&I) $1,199 Revised loan payment for next 36 months $884 Revised loan payment for months 37 to 300 $1,166 Present value of next 300 payments $172,560 discounted at 6% interest rate 22

What about re-default? One way of understanding why this is an important question is to consider the impact on expected cash flows if a re-default occurs that results in the need to foreclose on the property securing this loan. If a foreclosure occurred, only one payment would be received subsequent to the re-default, which would approximate the collateral value net of selling expenses. There is no precise way of predicting re-default. However, empirical evidence clearly indicates that the greater the gap between property value and loan balances (first and second loan balances combined), the greater the risk of re-default. In the example given in Figure 6, if the property were located in the sand states and its value had declined 50%, there would be a greater risk of re-default than if the property value were closer to the current loan balance. One final issue needs to be addressed that often raises questions. What if the revised rate offered to the borrower (3% in the example) approximates a market rate for a new loan? If the borrower could refinance their loan at the same rate as other borrowers in an armslength transaction, this modification probably would not be considered a TDR. However, the borrower would have to be able to execute such a transaction given their current credit status (credit score, employment status, debt coverage, etc.) and also given the property s current market value. These considerations result in the vast majority of loan modifications being considered TDRs. There are several critical takeaways from the example in Figure 6: The credit union s loan- tracking system needs to flag this credit as a TDR and apply special impairment testing and regulatory reporting on a go- forward basis. The present value of the future cash flows will change throughout the remaining term of the loan subsequent to the modification. Therefore, all TDR loans will need to have the present value recalculated over their remaining term; at a minimum, this should be performed quarterly for call reporting purposes. Re-default risk is directly related to the loan-to- value ratio (LTV). Therefore, the credit union needs to obtain updated LTV information and carefully document the assumptions used for estimating re-default risk. The absence of delinquency status does not alleviate the need for the present value calculations and for classification as a TDR loan over the remaining loan life. 23

CHAPTER 4 Q&E and TDR Factors Sometimes historical loss ratios are not enough. This chapter illuminates timely Q&E factors that may apply to your credit union. It also examines the increasingly common TDR arrangements and how to properly account for them.

What Are Q&E Factors? As noted earlier, historical loss ratios alone are not adequate to measure impairment on pools of loans, especially during periods of economic volatility. Said differently, the fact that losses last year were x% does not necessarily mean this year s losses will also be x%. The historical loss ratio is a starting point used to measure impairment; it needs to be adjusted up or down depending on other appropriate factors, such as the following, to properly measure impairment in the GVR: A significant downturn in the general economy exhibited by increasing inflation, rising unemployment, or a declining housing market. A significant deterioration in the quality of the underwriting process, exhibited by increasing delinquency and charge-off trends. The occurrence of a natural disaster, such as an earthquake or flood. Economic turmoil in the field of membership, such as a major strike, layoffs, or a merger. Experience, ability, and depth of lending management. Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses. Changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio, including the condition of various segments. Changes in the nature and volume of the portfolio and in the terms of the loans. Changes in the volume and severity of past-due loans, the volume of non- accrual loans, and the volume and severity of adversely classified or graded loans. 25

Most recent charge-off trends (e.g., three-month and six-month annual charge-off trends are higher/lower than amounts reflected in one-year historical loss ratio). Changes in the quality of the credit union s loan review system. The existence and the effect of any concentrations of credit, or changes in the level of such concentrations. The effect of other external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the credit union s existing portfolio. Q&E Factors for Residential Real Estate Loans Can t Be Ignored For credit unions facing significant deterioration of collateral value on real estate loans, unique issues arise that impact the ALL. A real estate loan with significant collateral devaluation may be impaired even if it is not yet delinquent. Conversely, real estate loans with significant collateral devaluation may not be impaired. The ALL process must appropriately assess the impact of declining real estate value, and this process needs to be carefully documented and updated regularly. Lesson In order to develop appropriate ALL analytics for real estate loans in geographic areas facing declining values, credit unions need to obtain updated fair value analytics on the collateral, often done by utilization of automated valuation models (AVMs) provided by third parties. The updated AVM data, combined with updated credit score data on the borrowers, will identify the real estate loans with the highest LTV ratios are those with the highest risk and therefore the greatest likelihood of impairment. Finally, consider that just as historical loss ratios alone may have resulted in ALL understatement at the beginning of the declining economic cycle, historical loss ratios alone will likely result in ALL overstatement as the economy recovers. Q&E Ideas for Your Consideration As the term implies, there is a lot of subjectivity that enters into the methodology and quantification of Q&E factors. Following are six methods that the author has seen successfully employed by credit unions. For residential real estate loans, create a matrix of each major portfolio by CLTV and credit score. Those loans with high CLTV 26

and low credit score are at greatest risk of impairment and might not be properly quantified by loss ratios alone. Estimate the amount of such impairment by regression analysis, sampling of loan files, use of industry standards, or other appropriate analytical methods. Consideration should be given to segmenting the portfolio by year of origination, especially when timing of origination is reflective of loss exposure. Evaluate trends in early-stage delinquency, which are obviously an indicator of future impairment trends. As early-stage delinquency trends begin to decline, favorable adjustment of historical loss ratios should be considered (and vice versa). Compare the calculated ALL balance to the amount of expected charge-offs for the next 12 months. As the ALL balance begins to represent an amount exceeding 150% of expected charge-offs, a favorable Q&E adjustment should be evaluated. Determine the historical correlation between local area unemployment and increased levels of charge-offs. As unemployment rises or falls, impound an appropriate factor into the ALL analysis. Compute an annualized loss ratio based on the past three months and the past six months. If there is a significant difference between these look-back periods compared to the one-year loss ratio, determine which look-back period is most reflective of current conditions. Calculate a loss ratio based on net charge-offs as compared to delinquent loan balances by loan category. If delinquency is falling rapidly, this loss ratio might provide a good perspective for a reduction in the ALL as compared to the conventional approach. Remember, as the economy stabilizes, unemployment rates fall, and real estate values firm up, the historical loss ratios of the past few years could result in an overstated ALL balance. Therefore, the appropriate Q&E factors should be identified and quantified to supplement these loss ratios. What Is a TDR and How Is a TDR Accounted For? A TDR occurs when a creditor, for economic or legal reasons related to the debtor s financial difficulties, grants a concession to the debtor that it would not otherwise consider. That concession either stems from an agreement between the creditor and the debtor or is imposed by law or a court. If a loan is restructured in a manner that would make it difficult or impossible to receive equally favorable 27

terms from another financial institution, there is a good chance the loan meets the definition of a TDR, and further analysis would be required. It should be noted that a rate concession to an equivalent market rate may likely be considered a TDR if the borrower would not otherwise qualify for the market rate due to impaired collateral value or inadequate credit standing. Each real estate TDR must be separately evaluated to determine the amount of impairment that is derived based on discounting expected future cash flows at the loan s original interest rate. Therefore, assumptions must be made as to the amount of the future cash flows, which will take into consideration not only the borrower s willingness and ability to make the payments during a short-term rate reduction period, but also their willingness and ability to return to full payments at the end of the rate reduction period. This is commonly referred to as re-default risk. Depending on the amount and number of restructured consumer loans, similar treatment m ay need to be considered for such loans. An example of how to calculate the SVR on a TDR loan is provided in Chapter 3. My clients often ask why they have to take an accounting loss on a TDR loan simply because the interest rate has been reduced to enable the borrower to make payments and avoid default. Said differently, why not just recognize prospective interest income at the reduced rate reflected in the loan modification? One way to answer this question is to consider what the impact would be if the entire loan portfolio interest rate were reduced, say from a 6% contractual rate to a 3% temporary rate for the next three years. The result would be to impound a significant reduction of earnings into the future, without any recognition of this economic event in the current period s income statement or allowance valuation reserve. When this impact is considered at the entire portfolio level, it is clear that some kind of loss recognition is appropriate. The discounted present value approach enacted by FASB is, in the opinion of the author, a reasonable way to measure the financial loss resulting from the loan modification. Lesson Re-default risk is difficult to assess. However, there is an expectation that the risk of re-default increases as the LTV ratio rises. Since re-default risk impacts future cash flows in a significant manner, credit unions must employ appropriate analytical techniques to measure LTV metrics within the TDR portfolio and make reasonable assumptions about the re-default risk of such loans. 28

CHAPTER 5 Common ALL Mistakes: A Great Recession Post-Mortem With the benefit of 20/20 hindsight, it is clear to this author that mistakes have been made by many charged with governance over the ALL. This chapter outlines some of the most common mistakes seen during the Great Recession and offers lessons on how they can be prevented from happening again.

The incredible economic cycle of 2007 2010 provides the perfect laboratory for assessing how credit unions have accounted for the ALL. During the period of 2007 2009, annual charge-offs for credit unions significantly exceeded the prior year-end balance of the ALL, an indicator of ALL understatement. This was especially evident in the sand states of Arizona, California, Florida, and Nevada. Based on a combination of publicly available financial data, as well as empirical data observed in my consulting practice, the following lessons help to explain this condition and are critical for those charged with governance in credit unions to understand. Overreliance on Historical Loss Ratios, Failure to Consider Q&E Factors Many credit unions relied too heavily on historical loss ratios for the GVR component of the ALL. Since loss ratios by definition are retrospective, the quickly changing environmental conditions that gave rise to impairment (rising unemployment combined with rapidly declining real estate values) were not reflected in the loan loss analytics. Lesson Historical loss ratios alone are a poor indicator of impairment during periods of economic volatility and can lead to ALL understatement during deteriorating cycles, as well as overstatement during improved cycles. Credit unions must consider appropriate Q&E factors (see further discussion below) to supplement the historical loss ratios. Credit unions with large residential real estate portfolios, especially in the sand states, must understand the relationship between current loan balance and underlying collateral value in order to properly assess portfolio impairment. Also, it is critical to select a look-back period (one year, three years, etc.) that is reflective of current economic conditions. Generally, a one-year look-back period supplemented by appropriate Q&E factors is common (and appropriate) for credit unions. 30

Failure to Properly Account for TDRs When a borrower is unable to make their contractual loan payments, lenders often reduce the interest rate or forgive some portion of the loan in order to lower the amount of the monthly payment. When this occurs, the loan is classified as a TDR and requires specialized accounting. This is one of the more complex areas of credit union accounting, and it requires an understanding of estimating and discounting future cash flows on an ongoing basis (see further discussion below). Lesson Many credit unions didn t have adequate controls in place to properly identify TDR loans, and they also didn t understand the proper accounting for such loans. This breakdown of internal controls in many cases led to an overstatement of earnings and net worth. Also, many credit unions lack automated systems to properly identify and prospectively account for TDR loans. Failure to Properly Account for Business Loans on an Individual Loan Basis Many credit unions originate and hold member business loans, which typically have large balances and do not meet the homogenous portfolio definition. Such loans need to be evaluated for impairment on a loan-by-loan basis, with consideration given to impairment characteristics such as current collateral value, current borrower financial condition, and underlying business cash flow assessments. Often, member business loans have deteriorating characteristics that would require an ALL reserve component well in advance of such loans becoming reportably delinquent. Lesson Many credit unions have not implemented adequate monitoring and assessment methods to properly evaluate impairment on member business loans. Further, these loans are often serviced by third parties, and credit unions often fail to determine the reliability of the servicers and the timely receipt of impairment data. Outdated ALL Policies Although GAAP for recognition of loan losses have not really changed, many credit unions didn t understand how a severe economic downturn could impact the ALL, and their allowance policies and procedures were reflective of ongoing strong economic cycles. 31

Members of the board and supervisory committee often lacked the technical insights required to monitor the reasonableness of the ALL, and therefore auditors and examiners were often the first to question the resulting understated balances. Lesson Ongoing efforts should be made to update all critical accounting policies. The board of directors should ensure not only that these policies are updated regularly, but also that there is an ongoing educational process in place to ensure compliance with accounting and regulatory reporting standards. 32

CHAPTER 6 Final ALL Considerations No report can address every facet of ALL regulation and management. This final chapter offers guidance on some of the most common challenges in today s confounding ALL environment.

A Word About Timing of Charge-Offs Care should be taken to ensure that loans are charged off when routine collections efforts have been exhausted and the loan is deemed to be uncollectible, and when the credit union has properly acquired title to the collateral, if any, securing the loan balance. It would be improper to delay a charge-off until the last possible dollar of expected payments had been received. A loan should be charged off if the asset (or portion thereof) is considered uncollectible and of such little value that its continuance on the books is not warranted. Failure to charge off loans in a timely manner often results in significant understatement of the ALL balance, since historical loss ratios will be understated, and often the loans in question are not properly identified in the SVR calculation. One of the outcomes of the Great Recession is the significant delay experienced by many credit unions throughout the country in being able to execute a foreclosure on residential properties. The delays are often the result of backed-up judicial processes, as well as the large volume of real estate loans pending foreclosure, especially in the sand states. During this period of delay, delinquent real estate loans continue to escalate, even though the loss exposure on these loans should be fully reserved in the SVR component of the ALL. A question often arises as to when the loan can be charged off, thereby reducing the delinquency ratio. If the credit union is in physical possession of the property, the credit union should charge off the estimated loss portion of the loan and transfer the remaining balance (fair value less costs to sell) to other real estate owned (OREO). It should be noted that if a residential property has been abandoned by the borrower, the credit union is likely considered to have physical possession. However, if the property has not been abandoned, the balance of the loan should not be transferred to OREO. 34

What Do NCUA Regulations Say About the ALL? NCUA Rules and Regulations Part 702.402(b) states in part, The financial statements of a federally- insured credit union shall provide for full and fair disclosure of all assets, liabilities, and members equity, including such valuation (allowance) accounts as may be necessary to present fairly the financial condition. Part 702.402(d)(2) further clarifies this requirement by stating, The allowance for loan and lease losses established for loans must fairly present the probable losses for all categories of loans and the proper valuation of loans. The valuation allowance must encompass specifically identified loans, as well as estimated losses inherent in the loan portfolio, such as loans and pools of loans for which losses have been incurred but are not identifiable on a specific loan-by- loan basis. The NCUA s position on the ALL is summarized in Interpretive Ruling and Policy Statement 02-3, issued in May 2002 (www.ncua. gov/resources/regulationsopinionslaws/irps/2002/irps02-3. html), and Accounting Bulletin 06-1, issued in 2006 (www.ncua. gov/geninfo/guidesmanuals/accounting_bulletins/2006/06-01alll. pdf). This regulatory guidance addresses key issues of importance to credit union management and officials, and should be reviewed regularly for compliance. One last regulatory point of confusion regarding TDR accounting: For call reporting purposes, a restructured loan must continue to be reported as delinquent (based on the original contractual terms) until six months of timely contractual payments under the restructured terms have been received by the credit union. Thereafter, the TDR loan is no longer reported as delinquent unless another payment is missed, in which case the delinquency reporting would be based on the restructured terms. Many credit unions have confused the delinquency reporting requirements with the TDR accounting requirements, which, as noted earlier, are based on the present value of future cash flows. Lesson The absence of TDR delinquency status does not alleviate the need for the discounting of future cash flows over the remaining term of the restructured loan and for classification of the loan as a TDR. 35

Why Do Internal Controls Impact the Determination of the ALL? An appropriate system of internal controls is critical to properly evaluating the reasonableness of the ALL. The accuracy of the aging of delinquent loans, the timely foreclosure and repossession of collateral, and the timeliness of charge-offs are but a few examples of critical internal controls that management must be able to place reliance upon. Management must be able to demonstrate and represent to the board of directors that such controls are operating effectively, or the board may face harsh criticism over potential and material misstatement of financial statement accuracy. The following is a partial listing of key internal controls that are appropriate for most credit unions. The supervisory/audit committee of every credit union should satisfy themselves that the credit union has identified the appropriate controls surrounding the ALL and that such controls are operating effectively. Delinquency reports are generated from each major loan system at month s end and are considered in the determination of the ALL balance. There is an effective loan review system in place to ensure that loans originated are in compliance with underwriting policies. Controls are in place to identify problem loans in a timely manner. The CFO performs a formal review of ALL analytics on at least a quarterly basis. This review is documented and signed-off on by others with oversight responsibility, including the CEO, chief lending officer, and COO. A review of the ALL methodology and its application is performed by a party that is independent from the ALL estimation process on at least an annual basis. There is a process to ensure the timely charge-off of uncollectible loans. The board of directors and supervisory committee meet with management on at least an annual basis to review ALL methodology and key analytical trends. For commercial loans, if any, there is an appropriate loan grading system that is updated at least annually, and loans whose credit quality has deteriorated are individually reviewed for impairment on at least a quarterly basis. Loans recommended for charge-off are approved by the board of directors. 36

Actual charge-offs are reconciled to authorized charge-offs. The credit union s internal audit staff reviews the effectiveness of the above controls on at least an annual basis and reports the results of this review to management and the board of directors and supervisory committee. ALL Analytical Expectations Those charged with governance in credit unions should develop expectations of reasonable ALL analytics and should regularly compare those expectations with actual ALL metrics. The following chart provides an example of expectations that should be considered by all credit unions; this example should be customized and updated as appropriate. Figure 7: Analytical Expectations Analytic tool 1. A comparison of current-year charge-offs to the prior year-end ALL balance. This is sometimes referred to as a look-back test. 2. A review of delinquent loan and charge-off trends. Note: Consideration should be given to calculating both the delinquent and chargeoff ratio using total loans and also stripping away real estate loans from the numerator and denominator of both fractions to calculate a consumer only delinquent and charge-off ratio. 3. A review of the trend in the severity of delinquency (for example, if there is a higher amount and/or percentage of loans that are over six months delinquent this year versus last year). 4. A review of the balance of delinquent loans as a percentage of the ALL balance. 5. A review of the balance of the ALL as a percentage of loans outstanding. 6. An assessment of the impact that overdrawn share-draft accounts could have on the ALL. Expectations/Concerns Generally, current-year charge-offs are less than the prior year-end balance of the ALL. When current-year charge-offs exceed the prior year-end balance, this indicates a possibility that the ALL methodology is not adequate, and the ALL could be understated and earnings overstated in the current period. Reality Test: How does the current balance of the ALL compare to expected charge-offs for the next 12 months? If expected charge-offs exceed the current ALL balance, this may be an indicator of an inadequate ALL. If the current balance of the ALL significantly exceeds the 12-month expectation, the ALL may be overstated. Generally, rising delinquent loan balances are indicative of the need to increase the balance of the ALL. Rising delinquencies may be indicative of untimely charge-offs. An increase in charged-off loans could indicate the credit union should be using a shorterterm loss ratio (for example, a one-year loss ratio as opposed to a three-year loss ratio). If delinquent loans are increasing in severity of delinquency, it could be indicative of a higher required ALL balance. Increasing severity of delinquency could also be indicative of the credit union not charging loans off in a timely manner. As delinquent loan balances become a larger percentage of the ALL balance, the possibility exists that the ALL is inadequate to absorb losses on loans that might not yet be in the reportable delinquent stage. Changes to this percentage should be consistent with recent loan trends. For example, if the ALL balance is a significantly lower percentage of loans this year versus past years, the expectation is that there has been an improvement in loan quality. For ALL purposes, an overdrawn share account is considered the equivalent of a loan to a member. Therefore, the balance of overdrawn accounts must be reviewed for collectibility. 37

Putting It All Together: Five Questions to Help Manage the ALL During periods of economic stability, determining the reasonableness of the ALL is comparatively easy and the risk of material financial statement error is minimal. However, during highly volatile economic times such as we ve encountered over the past few years, oversight of the ALL becomes a critical concern to credit union management and officials. The following list is provided to help those charged with governance ensure an appropriate ALL balance: 1. Is there a process for reviewing and updating the ALL policy on an annual basis, and is the updated policy appropriately documented, consistently applied, and approved by the board of directors? 2. Is there an annual assessment of the adequacy of internal controls surrounding the ALL? Is the operating effectiveness of critical controls tested on a regular basis, and are the results of those tests monitored by the supervisory committee and reported to the board of directors? 3. Has the credit union developed reasonable ALL expectations, and are actual results compared to these expectations each period in order to identify developing trends in a timely manner? 4. Is the calculation of the GVR based on appropriate segmentation of the loan portfolio by loans with common risk characteristics? Is the historical loss ratio look-back period (e.g., one-year loss ratio) appropriate and reflective of current economic conditions? Does the GVR component properly consider appropriate Q&E factors as a means of supplementing the historical loss ratios? Does the credit union appropriately consider the decline in residential real estate values as part of the Q&E evaluation? Are uncollectible loans charged off in a timely manner? 5. Does the calculation of the SVR consider the following? Is the present value of future cash flows discounted at the loan s original interest rate for loans specifically identified as impaired as of the measurement date? Are appropriate assumptions regarding re-default risk and prepayments made for TDR loans? Do re-default assumptions provide for higher loss estimates for loans with comparatively high LTV ratios? Are the present value calculations updated on a regular basis? Is there a reliable process for identifying other known losses, such as pending short sale loans, bankruptcies, and foreclosures, and are these known losses accounted for at their estimated value less selling costs? 38

Endnotes 1. FASB ASC, 310-10. 2. Historically, loan charge-offs in credit unions have averaged 0.5% of average loans outstanding. During the Great Recession, charge-offs increased to approximately 1.1% of average loans. Despite the increased level of charge-offs, the vast majority of loans originated by credit unions pay all principal and interest due according to the contractual provisions of the loan agreement. 3. The terms loss event, loss event indicator, and loss confirmation are all noted in the accounting standards and are very descriptive of the sequence of events applicable to ALL theory. 4. AICPA Proposed Statement of Position (SOP), Allowance for Credit Losses, 2003, Par. 25. 39

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