Fair value and expected credit losses: Long-term implications
A critical component of fair value assessment is evaluating and planning for expected credit losses under CECL. In a merger, the acquirer may recognize these losses immediately. The PCD mark can be used to offset a portion of the required CECL reserve, depending on the transaction’s structure.
For loans with credit deterioration, the acquirer can establish a "purchase credit deterioration" (PCD) allowance, reducing the hit to income post-closing. On the other hand, non-PCD assets get hit with a “double count,” as the non-PCD loans have a fair value credit mark at closing and a hit to the income statement after closing for the life of loan CECL reserve calculation. This bifurcation of PCD vs. non-PCD also has implications for ongoing loan portfolio performance and income recognition, since loan discounts get accreted into interest income over time.
FASB is working toward changes that will eliminate this "double count," so stay tuned for a notice of the final rule. Based on the FASB's decisions so far:
- All loans acquired in a business combination would be automatically considered seasoned and would use the gross-up accounting approach.
- For other purchased loans, like those acquired in asset sales or the secondary market, a new seasoning test would determine if the gross-up method applies.
- The gross-up method would continue the accounting used today for PCD assets, where expected credit losses are added to the purchase price to establish amortized cost.
- Credit cards and HTM debt securities would be excluded from these changes.
Integrating forward-looking assumptions: A proactive M&A strategy
Abrigo’s fair value analysis underlines the importance of forward-looking assumptions, particularly around prepayment rates, loan repricing behavior, and PD/LGD assumptions. Initial fair value determinations early in the due diligence process provide numerous benefits. Asset and liability fair value marks directly impact transaction-related goodwill. Having sound analytics early in the transaction process provides executive management and investment bankers key inputs to their merger models in the determination of resulting goodwill, pro forma capital levels, and goodwill earn-back periods under varying purchase prices and transaction structures. Abrigo provides purchase accounting and financial institution valuation services, successfully completing more than 30 buy-side fair value projects the last two years.
Over the past several years, many institutions have found it beneficial to update their fair value marks as regulatory approvals progress and transactions near closing. With the potential for long delays in closing transactions, especially in high-interest environments, institutions that don’t revise fair values may find themselves facing outdated or inaccurate marks, which could lead to unanticipated goodwill adjustments.
A teaching moment: Building a robust M&A framework
As interest rates may have peaked, this may be an opportune time to focus on building an acquisition framework that factors in both current rates, expectations of lower rates, and long-term credit expectations. By so doing, bank leaders can position their institutions for accretive transactions, stronger balance sheets, smoother regulatory approvals, and a more accurate alignment with regulatory and market expectations.
