Beany & Cecil was a cartoon. The Current Expected Credit Loss accounting rules, better known as CECL, which the FASB is insisting will go into effect at the beginning of next year for publicly traded banks and lenders and a year later for all other GAAP reporting entities is not. Now, heaven forfend that I suggest that the work of the Financial Accounting Standards Board is cartoonish, but there’s a parallel in this pairing of harmless and obscured menace worth noting.
Beany & Cecil, an animated cartoon from the early 1960s, while surficially a kid show, had a subliminal dark and adult subtext. The world is very scary, the Cold War could get hot in a heartbeat, and the Commies are making us sterile by introducing fluoride to our drinking water. So here’s Beany & CECL 2.0; innocuous and perhaps even sensible on its face, safe enough for little kids, wholesome and benign. But there’s a baleful underbelly here, recklessly constructed and dangerous, which should indeed trouble us. And it’s arriving in 9 short months. (Okay, I’m being a little dramatic here and the Beany & Cecil conceit is a bit of a stretch, but stick with me).
For those of you with something better to do than study the arcana of the proceedings of the highly academic accounting types housed in the intellectual (self-described) environs of FASB headquarters in Norwalk, Connecticut, what’s this CECL all about? It’s about how a lender books a loss under GAAP because a loan may not be collectable in full. CECL will take the place of the Incurred Loss Model that has been the rule of the GAAP road for generations. As the eponymously-named Incurred Loss Model suggests, this requires a lender to book a loss when there’s evidence that a loss will be incurred. Sounds commonsensical, doesn’t it? CECL arises from the notion that the Incurred Loss Model doesn’t recognize losses early enough and embraces the notion that losses in financial assets can be, to some degree, anticipated or predicted long before actual evidence of a loss can be discerned (note that this will also apply to lease losses under the new rules that require that all leases be treated as capital leases and will impact held for investment and held for maturity portfolios which will undoubtedly suppress investor appetite for the securities that underlie a significant part of CRE capital formation). Sticking with the cartoon motif here, we all know that Wile E. Coyote will be obliterated (temporarily) by the falling boulder long before the rock gets its squash on. So, if we knew that there are real losses in the portfolio even though there is no real evidence that they will occur, then to ignore that is to overstate the health of a lender’s balance sheet. Obvious, right? Those who support CECL also observe that the Incurred Loss Model was pro-cyclical because, as losses often accelerate when the economy turns down, booking losses at that point in the business cycle constricts lenders’ ability to continue to lend, just when the economy needs it the most.
CECL is a big thing. It is going to impact earnings, reserves and capital. Moreover, models being models where outputs are based on complex inputs, it will become more difficult for investors to compare lending platforms latitudinally as folks will make different “guesses” around macro trends and about how they model (non-existent) losses. Don’t we have enough capital already without turboing losses in lending activities? I saw a note from KPMG recently that suggested that CECL will cause a 10% to 50% increase on reserves. Yikes!
There is very little clarity as to how one “does CECL” at this point. How does one model anticipated losses over the life of the asset? With tongue only slightly in cheek, one might observe that if you could do that, you should get out of banking and raise a billion dollars just to run a long short hedge fund. Trepp, (see: www.trepp.com/cecl-solutions) among others, has been developing models to assist lenders, but the modeling will, certainly, be complex and whether many lenders will have access to the type of data to provide all the input, even for its own historical performance, is not clear. And remember, this is also a huge macro guess (err, sophisticated analytical assessment, I mean). So where’s the economy going? Who’s paid to fill in those blanks in these models? Does every lender have to hire a suite of top flight economists? Do they all take guidance from one or two consulting firms offering macroeconomic guesses to the marketplace? If they do the latter, doesn’t that sort of bring with it its own set of problems in terms of the quality and accuracy of these models?
Call me a cynic, but I have to ask; is CECL entirely a technical response to a perceived technical flaw in accounting policy? Maybe, but it feels a bit like the accounting patriciate, doing its bit for the social engineering favored by the zeitgeist of the coastal cocktail party set where the self-identified best people meet and tut-tut over the excesses of the banking community. It has a certain odeur of a political expression that the lending community should, at best, be treated as recalcitrant children and at worst, as bandits in business suits, in either case, in need of more and better instruction and now our accountants will provide it. Shouldn’t financial accounting’s role be reporting what business does and not driving change in business practice? Isn’t driving such a change the purview of our prudential banking regulators or perhaps, God help us, our elected lenders? Okay, they were prodded by the apparatchiki, but why voluntarily carry policy water when it’s not their job? In consequence, this effort has a certain fetor of illegitimacy.
FASB was asked this past week to delay the implementation for CECL for small lenders, which will struggle mightily to meet these complex CECL requirements. But wrapped in the dignity of academic certainty, FASB rejected the proposal out of hand, so we continue to stare at CECL conversion for all public companies in January. According to some sources, there are over 15,000 reporting entities in the United States in which CECL conversion will be necessary.
Assuming the promise of CECL can be achieved, that it will deliver a better and more accurate assessment of the loan book, a conclusion I for one am not prepared to embrace, two negative externalities will flow in the real world from CECL. The first, and maybe the most consequential, is the enormous investment in time and energy and money to be expended by the banking and lending community figuring out how to do CECL (crystal balls are in short supply). Under CECL, we are supposed to discern what the anticipated expected loss over the life of a financial asset will be as of the date when the financial asset is created. Moreover, this is a dynamic process and lenders will be required to revisit this complex analysis quarterly. That is a daunting task. Staff will have to be added, more tail to go with less teeth. How’s that for a great thing for the economy? Lots of time, money and energy will be consumed chasing this El Dorado City on the Hill of perfect loss accountancy.
And it can’t be said too often: these are models. Do we have certainty that they will be right or even probative, or even directionally correct? Will it make us smarter? Is it a cure for lack of transparency in the financial statements? Will it better reflect reality? Are we really okay with having our lenders book losses that may or may not have any real connection to actual outcomes?
Like what would happen if you could merge Fox News, CNN and MSNBC, let’s be fair and balanced. Europe has a version of CECL that’s been in place for a couple of years. It is IFRS 9. It applies across the European Union and apparently a whole bunch of other countries to boot. Is it working great there? Not really. First, it generally only takes into account model losses over the first twelve months of the term of a financial asset and that’s going to mediate the scale of any potential front-end loss recognition as frankly, early losses in financial assets are relatively rare, it’s the tail losses that matter. Is this putting the rabbit in the hat? Under the existing US GAAP Incurred Loss Rule, one already looks forward for 12 months to determine whether credit losses are expected in any event! That lines up very nicely with the European version of CECL but is very different from what US CECL will actually require. Second, it’s Europe where EU banking rule bending by national banking authorities appears to be a competitive sport, leading one to wonder how meaningful this new disclosure regime actually is. And let’s face it, Europe is not exactly a model of robust capital formation. I’m not suggesting that IFRS 9 is the root cause of that anemic capital formation system, but, I’m just saying.
Moving on, beyond the practical complexities, the cost and expense of predicting future losses of loans when the loans are closed, what is this going to do to pricing and credit availability? More capital means less lending. That’s pretty straightforward. Also, if under existing guidance I need 200 BPs over the relevant index to make my loan pencil out, what will I need if I have to book 100-200 BPs or more loss of principal on day one? It will consume more capital and that by itself will put downward pressure on capital formation. I don’t know, but it seems to be effectively a tax on capital formation to pay for a misguided adventure in accountancy. And since, let’s face it, these will be mathematically larded guesses, when all goes casters up, this will be more grist for the mill for those populist critics of banking that are already shocked, shocked by everything banks and lenders do each day to create and deploy capital.
But the bottom line is, if your team hasn’t developed a CECL response yet, it better get started ASAP. Now it’s possible, or indeed, if one is inclined to be a bit Pollyanna-ish, make that probable, that this will get delayed or even might all go away. CREFC and other trade organizations in our orbit have all weighed in with the SEC making compelling arguments in favor of a delay or an actual rethink of the whole damn thing. This has begun to attract some attention on the Hill as it might negatively impact lending activity everywhere across the country. This makes this not a Wall Street issue, or a big bank issue, attracting the ire of those of our elected representatives who are making a career out of bashing banking and lenders, but an important issue for Congressmen and Senators, from the left and the right, who have to worry about the health of their districts back home.
I wish I could tell you to take a deep breath and ignore this, but I can’t.
Accountancy sometimes seems unhinged from its core function of assisting business people in running successful companies and assisting investors in understanding the companies in which they invest, but that’s too big an issue for the moment. Right now, the problem is that CECL is coming and coming soon to a theatre near you. I sort of liked Beany & Cecil, back when I was a mite, and I’m thinking that just about no one is going to like Beany & CECL 2.0.
