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Can you continue to use the discounted cash flow method to measure credit loss on TDRs?

March 30, 2018
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Continuing our series of questions asked of MST Senior Advisors Paula S. King, Garry Rank, and Dorsey Baskin during the March 13, 2018 webinar “Key Issues and Trends in CECL Transition: A Panel Q & A Webinar”, the panel of allowance experts offers insights into some of the significant changes in disclosures under CECL.

Question:

Can we continue to use the discounted cash flow method to measure credit losses on TDRs?  

Answer:

The regulator FAQs from December 2016 say the following:

“Yes. Although the guidance for determining whether a modification of terms on a financial asset is a TDR will remain unchanged from today’s U.S. GAAP, the new standard makes certain changes to the existing accounting for TDRs. An institution will continue to account for a modification as a TDR if the institution for economic or legal reasons related to a borrower’s financial difficulties grants a concession to the borrower that it would not otherwise consider. However, the FASB determined that credit losses on TDRs should be calculated under the same expected credit loss methodology that is applied to other financial assets carried at amortized cost – in other words, under CECL. This is in contrast to current guidance, which requires that impairment on loans that are TDRs be measured using specific methods applicable to individually impaired loans (e.g., discounted cash flow and fair value of collateral).”

There has been some confusion about the sentence in which the regulators say that the FASB determined that credit losses on TDRs should be calculated under the same expected credit loss methodology that is applied to other financial assets carried at amortized cost – in other words, under CECL. What this answer says is that the methods of measurement of impairment required by current GAAP are no longer applicable under CECL (because the notion of impairment and all the related literature goes away). Thus, TDRs will be measured for expected credit losses using the same techniques allowed by CECL for other loans. CECL does not require specific methods for measurement of expected credit loss, and it allows loans that no longer share risk characteristics to be removed from pools such that the expected credit losses can be measured individually. (See for CECL Example 4). Thus, if the TDR loan no longer shares all the common risk characteristics of its previous pool and is measured individually, the bank may apply any reasonable loss measurement technique, including DCF or collateral fair value, if these fit the circumstances. So, effectively, lenders are still allowed to use DCF and collateral fair value for TDRs.

But, one thing you need to keep in mind, because it may be questioned after the implementation of CECL, is the need for justification for pulling a loan out of a pool (because measuring credit losses using pools is the presumption under CECL) to measure expected credit losses on an individual loan basis.  In other words, let’s say your common risk characteristics are loan type and risk grade. The TDR loan is in a pool defined by loan type and risk grade and it still fits those two characteristics after the TDR.  So, what would be the basis to pull it out of the pool and measure individually?  To justify pulling it out of the pool, it may be necessary to add a third risk characteristic for the pool such as “performing” or “not on non-accrual” or “not a TDR” so that the TDR loan no longer fits in the pool and its expected credit loss can be measured individually. One of the first questions received from a contact at the  FDIC, “Why is the loan no longer in a pool?  What is the basis for taking it out of the pool it was in prior to the TDR?” You will need to be prepared to answer this.

To access a recording of the webinar, click here.

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