Good morning, welcome to First Horizon IBERIABANK Investor Community Information Session. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I'd now like to turn the conference over to Ms. Ellen Taylor, Head of Investor Relations. Please go ahead.
Thanks so much, Nick, and good morning, everyone. We really appreciate you joining us today. I'm so excited to be a part of the First Horizon team. Needless to say, this has been quite a challenging year, and certainly CECL implementation has been an additional factor that added to those challenges. Given that the First Horizon IBERIABANK MOE is one of the first transactions under CECL, we thought it might be helpful to have some experts provide some additional clarity. As a result, we're really pleased to have Greg Norwood and Jonathan Prejean from Deloitte with us today. They are planning to provide some prepared remarks and then they will open it up for questions. You can find the presentation they'll be referencing on ir.fhnc.com.
I, of course, need to remind you that this presentation is not intended to cover anything related to our MOE or any historic or pending transactions. Deloitte will not address any questions specific to any past or pending transactions. With that, I'm going to hand it over to Greg Norwood.
Thanks, Ellen. On behalf of Deloitte, and especially Jonathan and myself, thanks to First Horizon and IBERIABANK for hosting this session. We are happy to share some thoughts about a key aspect of CECL. Let's turn to slide two of the deck we provided. Today, we will look at PCD accounting or purchased credit deteriorated by reviewing first the definition and ways of identifying such loans. We will also look at the accounting at closing. We will look at what the expected future impact could be based on consummation assumptions. Finally, we will look at how measurement could change based on changes in the future. As Ellen said, we will go through the slides with prepared remarks, but we'll leave ample time for questions at the end.
Before we get into the discussion, let me be clear, our comments today are not reflective of any specific transaction, and examples are for illustrative purposes only. The amounts in the example are purposely simple and not intended to portray any real-life examples of measurement. They are simple examples to highlight the basics of the accounting measurement and how they can change in the future, and the impact to key financial statement reported amounts. I will walk you through the definition of PCD loans and some possible selection criteria. Jonathan will take you through the accounting construct and highlight the impact of gross-up and double count, terms you've certainly heard in the marketplace. I will walk you through how the accounting can affect the reported allowance, provision, and NII, given how the future may play out. With that, let's move to slide three.
Before I start, much has been said about why didn't FASB just treat all acquired loans as PCD. Given where we are today, I will not try to speculate. I will move directly to what the rule does say. First, we should remind ourselves that CECL is a principle-based standard, not prescriptive. FASB developed CECL using broad concepts and no detail, quote, "how-to requirements," and that is certainly true in their guidance for PCD accounting. While FASB was clear in the accounting and the financial statement geography for PCD, they did not give rules on how to identify PCD versus non-PCD. Let's focus on the definition, and importantly, what's not in the definition. The definition is more than insignificant deterioration in credit quality since origination. Let's start with credit quality, which is the measurement criteria. Credit quality is a relative concept.
PCD is not trying to identify bad loans, which is why FASB did not define the identification concept as expected loss or risk of loss or some other concept of loss measurement. Importantly, FASB went out of their way to say PCD was not the same as legacy PCI definition, which for shorthand was probable default. A simple way to think of credit quality is on the consumer side. For example, two borrowers with FICO scores of 790 and 690 may both meet the definition of a PCD loan if their credit quality declines since origination. When we think about PCD loans, they could be both high-quality credit or lower quality credit, and the classification is determined by the degree of change. Now let's look at the degree of change required to be PCD, defined as greater than insignificant. This is highly judgmental.
FASB provided no guidance as to how to define the level of change. Like other areas of CECL, banks may come up with different thresholds. It's clear FASB said that PCD should be a much bigger population than PCI. Now let's talk about the accounting geography. Let's start at the end. All loans, whether PCD or non-PCD, will have an allowance based on CECL principles after consummation in day one accounting. Going forward, all changes in expected loss estimates for both types of loans will be reflected in the provision line on a quarterly basis, just like originated loans. If credit improves on the acquired book, the benefit will be reflected in a lower provision expense in future periods. Also, charge-offs for PCD and non-PCD loans will go through the allowance just like originated loans.
In the end, FASB wanted all loans, whether originated or purchased, to be treated the same. Now let's talk about the charge for the consummation and day one allowance is reflected in the financial statements, as well as interest accretion. For PCD loans, the allowance amount is grossed up, and what this means is there is no charge in the income statement. Rather, a CECL allowance is recorded at consummation, and the difference between the total fair value mark at consummation and the CECL allowance is accreted into interest income in the future. For non-PCD loans, the amount of the CECL allowance is charged through the buyer's income statement in the period of closing, which is referred to as the double count, and the entire fair value mark, both interest and credit components, is accreted into interest income in the future.
Jonathan will emphasize the accounting also when he goes through the examples, which will help put a picture to my words. Now let's move to slide four. The PCD selection process has two discrete steps. First is to identify a bank's view or processes for assessing credit quality. This would likely vary by bank and could include many different processes. Slide four lists some possible credit quality triggers or buckets. For reference, FASB included an example of criteria and other perspectives in standard. For those so inclined, it is example 11. FASB's obvious criteria included non-accrual loans and delinquent loans, but also included loans that have been downgraded or whose credit spreads have widened since origination. The second step is for each criteria identified, the bank must determine the threshold for measuring greater than insignificant. This threshold can differ by category and by relative origination credit quality.
What I mean by that is that each one of these buckets may have a different measurement and a high quality, like in our example of FICO, there might be different measurements for changes relative to individual borrowers. Before I turn it over to Jonathan, let me highlight one last perspective in determining PCD loans. Like any credit quality assessment, both idiosyncratic factors and the general economic environment can cause borrowers to suffer credit quality, and both should be considered in this process. I will turn it over to Jonathan, who will begin on slide five.
Thanks, Greg. If we move to slide five, this is not an accounting class, so we don't want to get too accounting technical with you, but we think it's helpful for you to see how these transactions would be recorded, so that you fully understand what Greg was talking about when it comes to the day one accounting and then the impact on the subsequent accounting. The first example on slide five shows the accounting for PCD assets. In this example, we have a $10 million balance is outstanding. There's a 2.5% rate mark, so that's referred to as a non-credit discount. Then we have an allowance, which is determined under CECL and will approximate the credit mark associated on with the fair value calculation.
As you can see here, they talk about a gross up, the standard talks about a gross up, really what you're doing is if you paid $9.25 million for this portfolio of loans, a component of that discount is the rate component or the non-credit component, and the other component is the credit component. As you record it, you'll split it out. It'll actually be recorded on your balance sheet. For those who remember the PCI calculation, the old SOP 03-3 calculation, that credit mark or the part you don't expect to collect would not be recorded in the financial statements, thus, any charge-offs associated with that $500,000 in our example, would not flow through as a charge-off in the bank's credit metrics going forward.
With the introduction of PCD accounting, that $500,000 will be recorded as an allowance and will act as an allowance going forward, thereby any improvements in credit will be a reduction in the allowance. Any deterioration in credit will be an increase in the allowance through the provision. Of course, any charge-offs will flow through the credit metrics of the organization. If we move to the next slide, this is where the accounting for the non-PCD assets. As Greg mentioned, there's a uniqueness to this one because there's a so-called double count associated with this one, and I'll explain what that means. In our example, we have the loans with a balance of $5 million, unpaid principal balance, and the fair value is $4.9 million.
That fair value is comprised of $25,000 rate mark or non-credit discount and a $75,000 credit mark. As you'll see on this one, it is not identified as an allowance, because on day one, when you acquire the loans and through purchase accounting, you would record that the combination of the $25,000 and the $75,000 or $100,000 would be your discount that gets accreted up over the life of the loan. On day one, we'll refer to it as day one and a half. Upon acquisition, you would also establish a CECL reserve. In our example, the CECL reserve in line four and five approximates the fair value credit mark.
The establishment of that allowance will go through the provision expense, so it will be a P&L impact on day one or day one and a half of the acquisition. You can see the double count. You have the CECL allowance of $75,000, along with the credit mark of $75,000. This is different than what was historically done prior to CECL, where the credit mark was booked similarly, but you didn't have to book the additional $75,000 CECL allowance. You wouldn't book an additional allowance until your estimated losses actually exceeded the purchase discount. The other component is the full $100,000 will be accreted through income, so that $75,000 will come through over the life of the loan and, although not at the same time, will offset the $75,000 initial impact to retained earnings through the provision expense.
If we move to slide eight, very basic, the allowance that had discounts associated with the portfolio will be removed. The loans, both the PCD and non-PCD, will be initially recorded at fair value, where the difference will be is that on the PCD assets, you will have the fair value broken down between a credit and non-credit component. For those following along, this is on slide seven. You'll have that broken down between a credit and non-credit component with no further impact to tangible book value. On the non-PCD side, you will initially record at fair value. The combination of your credit and non-credit mark will be your loan discount, which will be accreted in the future, and then you will record an additional allowance, associated with that portfolio. That will be another impact to tangible book value. That's how it's set up on day one.
Greg's going to walk through what happens both from your expected performance of the portfolio and then when your expectations change so that you can see how that happens. The one thing I do want to point out is that after this initial recording of the loans, whether they're PCD or non-PCD, they will be accounted for in the same manner going forward. There will not be a distinction between acquired PCD, acquired non-PCD, and originated loans. All will look the same going forward. Greg, you want to go through the P&L impact?
Sure. Thanks, Jonathan. Moving to slide eight. Again, we tried to get this very simple so that we could focus on the geography of the accounting and how that can change rather than the actual numbers themselves. As you can see on the top of page eight, the total discount of $350 is the sum of the numbers from the prior page. The charge-offs, again, are the sum of the expected credit mark, assuming that there is no change. As you see on page eight, the accretion is fixed over the life of the loan, and as we see in other examples, only changes relative to prepayment, and this is different than the PCI accounting. As you can see, the quote double count is reflected in the $75 mark that's on day one and in year one.
This basically shows that the accretion of the total 350 will be recognized over the life of the loan, and that the allowance, in this example, assuming perfect foresight, is reduced each year by a pro rata share of the charge-off. That is the basic construct of what the portfolio would perform if all of management's assumptions prove out perfect and there's no changes in overall credit quality. Let me now turn to page nine, where we have two examples to try to very simply identify what can happen in different forms and different fashions and different timing. The top half of the page is faster than expected prepayments. The same kind of activity in years one and two, but in year three, at the end, you've experienced the proportionate charge-offs for that period, but all the loans prepay.
What happens then is you accelerate the accretion from years four and five at the time the loans prepay. Because there's no future losses, the remaining allowance for loan loss under CECL is reversed. You can see that that can have significant impacts, and that prepayment, importantly, will impact both the accretion timing as well as the provision/benefit. If we go to the other type of example, is where credit deterioration happens post the balance sheet date of recording the acquisition. Here you see in year three, the company has concluded that this portfolio needs an additional provision of $25. As you can see, the accretion remains the same in years four and five, but because of the higher expected credit losses, you'll see charge-offs increase to absorb what is now a $600 estimated loss against the portfolio.
Again, two examples to really try to highlight that the prepayment assumptions, and the reality of how loans prepay or charge off will impact both the accretion and the allowance balance, and changes in credit quality of the portfolio, or importantly in CECL, changes in credit quality of the environment or the reasonable and supported forecast can both impact future provision and expense. With that, Ellen, let's turn it back over to you, and happy to answer any questions relative to the concept of PCD accounting.
Sure. Operator, can you give the Q&A?
Yes. I now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. At this time, we'll pause momentarily to assemble our roster. Again, if you have a question, please press star then one. Our first question comes from John Helfst , Voya. Please go ahead.
Hey, guys. This is a really stupid question, but what's the advantage of having non-PCD and PCD? It seems like, couldn't it be easier just to have one classification? It's almost like we're driving with metric and miles per hour. I don't understand. I feel moronic asking this question, but what's the added advantage to having both technology or both classifications?
That's a great question. I assume you're meaning from a FASB's perspective as to why they wanted two different classifications.
I don't want to point fingers, but from a user standpoint.
Yeah
It seems more complicated, right? I'm actually following you along, if I tried to turn around and explain this to someone, I know I couldn't do it very well. That means I don't really understand it as well as I would like to.
Yeah.
What's the added benefit to the user of having the two buckets in your mind? Again, I'm not trying to blow FASB out of the water here, right?
Yeah.
What is the advantage? Thanks.
That's a fair question. And I would say, I wouldn't say there's an advantage to having two separate classifications other than historically we've had two separate classifications. Although admittedly, what we're looking at today is a lot different, right? Because historically, you were purchasing credit-impaired loans. Now we have credit-deteriorated loans. I would say the benefit of what happened was the day two accounting is the same. We could debate whether or not we need the two separate classifications, and we have what we have. I think the benefit, however, is that going forward, the accounting is the same, whereas in the past, you had to understand, on the PCI side, what wasn't expected to be collected on day one. If that improves, how does that impact interest income, et cetera.
Now, after the acquisition is booked, the accounting for any portfolio, whether it's originated, acquired PCD, or acquired non-PCD, that accounting will be the same. You're really looking at what's the impact on credit that's going through the allowance/provision, what's the impact on interest income relative to speed of prepayments, et cetera. I think the benefit is really the day two that they've aligned on a go-forward day two accounting, as opposed to the initial classification, which I understand your point. I guess they wanted to keep something of old. Still wanted that to align on the day two accounting.
I think, again, one person's opinion when you think about it is when I talk about idiosyncratic events causing PCD classification, I think if you look at a portfolio that would be non-PCD, a lot of those would be very recent originations, and recent relative to the environment. Also, if you think about it, if it's a relatively newly originated loan, in which case there's just not enough time for it to deteriorate, those would be reflected as a debit in the income statement, just as though the buyer had originated. There's an element of, if it's something that's newly originated or just very recently originated with no change, then they wanted that to mirror originated account. Again, I said there was a lot of debates about this back and forth, FASB just continued to believe this was the right measurement standard.
One of the things that we think is important is to try to demystify this, is to just really understand how the numbers flow through the provision line, how they flow through capital, and how they flow through the NII line.
Okay. I get the day two elegance, but I would just think you could solve, just reclassify everything day one and just flush it.
Yeah.
I don't know.
Yeah.
Honestly, I've gone back in time and read FASB bulletins like ASC 001, 002, 003, and frankly, the old accounting is confusing to me as well.
hating on CECL. I'm just hating on the whole accounting construct that it's unnecessarily complicated, I feel like. Thanks.
Thank you. Our next question comes from Will Nance, Goldman Sachs. Please go ahead.
Hi. Thanks for taking my question. Could you maybe talk a little bit about the PCD versus non-PCD selection process and what kind of delineates the two? You touched on it a little bit, but I guess particularly in an environment like we're all in, where you would think every loan in the industry has deteriorated somewhat. How do you set that demarcation about what qualifies as PCD versus non-PCD? How much flexibility is there to do more classification as PCD versus non-PCD? It would seem like accounting incentives, given the double count, would kind of incentivize you to do more PCD versus non-PCD if given the option. I'm just kind of curious about how much flexibility there is to kind of toggle between the two when there has been some kind of exogenous event like we're all living through.
Yeah, great question, this is Greg Norwood. When I think about it, maybe a way to kind of layer through that is there's a lot of flexibility to address one of your premises, and banks will do it different. It certainly does look at what are the processes that the bank uses either in benign times or in times that we're facing today relative to monitoring credit quality. As a bank looks at this, we would expect that they would really focus on what are the management routines within the organization. How are they looking at it? If management routines are heightened because of an environmental concern across the macroeconomics, those factors would be something that would make sense perhaps to consider.
Even on slide four, where we talk about modified loans or loans in forbearance, watch list loans, those types of heightened monitoring, those types of things might be ways that a bank could look at whether or not credit quality has declined. What we've seen is really looking at the routines that management uses and then both trying to identify idiosyncratic, which often banks are very good at, right? That's what they do. They look at their credits. Also looking at the more macro environment and looking at other factors that might say credit quality has deteriorated. I think an important part that we tried to hit is this is credit quality, right? It doesn't mean that a loan has to be perceived as bad. It's just a relative measure of where it was at origination versus where it is at consummation date.
I guess to summarize, a lot of flexibility, looking at the way management looks at credit quality and monitors it. If there are events at a macro level or a geographic level, or in a particular asset class, all of those would be factors that I think a management team would look at to consider the buckets for a PCD determination.
Got it. Appreciate that. That makes sense. Just maybe a separate kind of related answer. I'm guessing the credit mark is determined on the day of the close. Can you just talk about how you would look at determining that credit mark on the day of the close, and then how does the flow-through of a larger credit mark in a deteriorated credit environment when a deal closes, how does that roll through to impact tangible book value dilution and accretion? If the mark ends up being larger than you may have expected, I would assume that's more book value dilution and more accretion down the line. Can you just kind of help flesh out a couple of the moving pieces there?
Just for clarity, you're talking about in general, are you talking about a PCD determination?
I guess across either asset classes, if a deal is announced and there's some sort of expectation of credit quality. Upon deal closing, credit quality is generally deteriorated across the industry. How does that flow through to metrics such as tangible book value dilution and earnings accretion, and what's the trade-off between the two?
Yeah. I'll start on the PCD side. Well, actually on both sides. If I announce and I have a fair value estimate of my loans, and then I close, call it 6 months later, and that fair value estimate changes, obviously that impacts your tangible book value, accretion, et cetera. On the PCD side, when you have the fair value and you have that credit mark, you have the day one establishment of your PCD portfolio, which includes your allowance. The size of the credit mark relative to the total discount will impact future accretion. Because basically what you're doing is you're splitting out that discount on your fair value between the CECL allowance and the non-credit discount. The more credit mark associated with that discount will reduce the future accretion. The tangible book value impact would be based on the fair value of the asset.
You won't have a day one impact beyond the fact that you have your fair value. On the non-PCD, you're going to have an impact from the day one provision, right? In addition to booking the fair value of the loans on day one, or as I mentioned, one and a half. I mentioned one and a half because it goes through the P&L, and it wouldn't go to goodwill. So that would be an additional impact to tangible book value because you're now establishing that CECL allowance on day one and a half. In our example, the credit mark and CECL allowance are the same, so you would have that similar impact, an additional impact to tangible book value from the credit mark. Any changes in your estimations along the process prior to close are going to impact it.
At the close, the fair value at the close, you're going to have additional impact because of that CECL allowance on the non-PCD assets.
Yeah.
Any impact. Sorry, go ahead, Greg.
I was going to say, another perspective relative to this is kind of in the CECL environment, right? The allowance and the fair value mark of a transaction that was closed in 2018 or 2019 would have one construct under a CECL environment. Obviously under CECL now, you could have the exact same number of loans in a non-PCD category, right? They haven't suffered any deterioration. If you looked at CECL and what CECL might project to happen a year from now, you could see where that day one allowance that would go through P&L as a double count could get larger, not because there are more loans, but just because there's a worse outlook under CECL. That day one dilution, again, that it creeps back over, in our example, five years. At the end of five years, you're back to zero.
On day one, a worse CECL outlook could cause that number to increase. Relative to what Jonathan's saying, from a fair value mark, the same would be true for your PCD classification as well.
Got it. That's helpful. I'm going to attempt to go for three here, and see if I don't embarrass myself. I think under the old accounting policy, when you had, I believe it's acquired non-credit impaired loans that had a credit mark against them, when those loans would either refinance or pay off, you would have a lot of accelerated accretion. In a refinance scenario, you would have to actually reestablish an allowance. You had this scenario where banks that would announce an acquisition, they would have some ongoing level of accretion, and a relatively depressed level of provisioning. As loans would refinance, you would have accelerated accretion. Net interest income ends up being higher than expected, but that reestablishment of the reserve upon refinance would end up elevating the provision.
It seems in your scenario, as you're going through and in your accelerated prepayment scenario, there's an acceleration of the accretion and there's a releasing of the reserve. It doesn't seem like the drivers of the provisioning are the same under this. Can you talk to that, and am I getting those moving pieces right?
Let me see if I can break it down. There's a couple of things going on that caused that prior to CECL. One was when I bought loans, and at a discount, right? When I looked at my provisioning and my allowance determination, I was able to take full credit for that discount. For example, I bought a $100 loan at a $10 discount, so I paid $90 for it. I had that $10 discount. If I calculated my allowance and through my normal process and I said, "Well, my allowance should be $2," I wouldn't have to record any allowance because I was still covered with a discount. First, CECL takes that away. You can't take full credit for that discount. In my example, I would still book an allowance. I'd book the relative 2% of $90, call it. That's one component.
The whole refi, if it's determined to be a new loan, and we don't need to get into accounting, but if it's a new loan and you refinance it, you would have the same phenomenon that you had under prior accounting. Meaning, if I refinanced a loan into a new, quote unquote, "new loan," I would release whatever discount I have, and whatever provision I have on that loan, and establish a new provision. Now, you would expect it to be very similar, so those may net out effectively. You would get that income statement, that accelerated accretion and the provision establishing the new allowance under the loan. You would have the same phenomenon. I think part of the depressed provisioning was because of the discount associated with the acquisition, and so therefore, the allowance, we called it accrete to impair, right?
You would accrete up until you don't have enough discount to cover your allowance, then you'd start booking incremental allowance. I think that was some of the phenomenon of why you had lower provisioning. That's gone under CECL because you're not allowed to, quote unquote, "accrete to impair" under CECL. You may not see that as much. You would have the acceleration of accretion if it's refinanced into a new loan. Does that make sense?
Got it. I think so. The accretion still accelerates, but because you already have an allowance against that loan when you do the refi, the kind of rebooking of the provision is not as pronounced under the new system.
Yeah. I mean, obviously that's fact and circumstances dependent, but generally speaking, yes.
Got it. Thanks for taking all my questions.
Sure.
Thank you. Again, if you have a question, please press star then one.
Next question comes from Steve Covington of Stieven Capital . Please go ahead.
Hi. Thanks for doing the call and taking the question. Have you heard any will or desire from the FASB to fix the double counting piece of the standard? That seems like an obvious and simple thing to fix. Have you heard anything from them?
This is Greg. I guess what I would do is recap history. Letters were written prior to the standard, and comments were made that did not result in a change, and letters were written and comments were made subsequent to the standard, and there was no change. I don't hear folks talking about it, frankly, at all. Jonathan, I don't know. From your vantage point, what are you hearing?
I agree. Last fall, it was put on the list of potential agenda items to remove it, and the FASB didn't take it up. Unless something significant changes going forward, I don't see them revisiting. It's been asked numerous times.
Okay. Appreciate that. One quick follow-up. I've asked this of a number of CEOs that I've been meeting with. In a normal environment, assuming we ever get back to a normal environment, I ask them, could they sell an at-the-market rate loan at par? Most of them say, "Yeah, we could sell new production at the market at par easily, and sometimes at a premium." If that's the case for a non-PCD loan, could a management team argue that there really isn't any necessary credit mark because you could sell it at par, especially in an environment where you have to put up a date, kind of this add CECL double count same time?
Well, let me take a stab. One way to think about this is the allowance is a CECL expected loss measurement. For a lot of assets in particular or certain economic times, that may line up with a fair value measurement as well. There are some differences to the techniques used in commercial loans is the example people look to because a commercial loan for CECL only goes out to the contractual life, whereas a market participant might look at the renewal probability and the value of that renewal. The other is, again, an expected perspective from a management team may or may not be a fair value number, and you could look at that in today's environment, right? There's a lot of different nuances that are pretty significant in how to look at valuing assets, whether it be under market participant exchange or under CECL.
I also think consistent with what your premise of your question is, FASB expected the non-PCD category to be rather small. If you haven't had any deterioration in credit quality, not only would the population be small, but it would be logical that it wouldn't have a significant provision, perhaps. A lot of that comes into the facts and circumstances of the portfolio as well as the environment for which the measurement assessment has to be done.
Yeah. I'll just add that if you're selling it at par, I get from a fair value perspective, you may argue that there's either no or minimal credit mark, right? Because the interest rate's covering it. The challenge is you may be able to argue that, but from a CECL front, you wouldn't be able to. The reason being is that that argument was put forward that why should we record an allowance on day one under CECL? We don't need to rehash CECL, but that argument was made because a newly originated loan, I priced it to cover the risk of loss, it's covered, and so forth and so on.
FASB acknowledged that, still said that their position was that they wanted to get full expected losses on the balance sheet on day one, regardless of how it came in over time and the fact that you're getting paid to cover it. I think even from that point, even if you were to argue there was no credit mark in my fair value, you would still have that day one CECL allowance for non-PCD assets.
Okay. Thank you.
Yep.
Thank you. Our next question comes from Catherine Mealor of KBW. Please go ahead.
Thanks. Good morning, thank you so much for doing this. It's a really helpful call. My question is, it kind of piggybacks a earlier question, but I just want to kind of confirm that I'm thinking about this right. When you're on slide nine, that looks at what day two looks like for the provision, then the accretion. In the scenario where credit is better or there are earlier payoffs, it looks like both the accretion and the provision release, if you will, are both accelerated. If we kind of over-mark, then in periods after that, we're going to see lower provision, and we're going to see higher accretion kind of at the same time. That's kind of question one. Question two is then, in a scenario where credit is worse, it appears that the accretion doesn't change.
I just kind of want to confirm that, in that accretion stays the same, but the only difference then is that we see a higher provision. Is that a correct way to think about it?
Yeah, I think so. Go ahead, Jonathan.
Yeah. I was going to say, and these are simplified examples, but yes. Even though you're booking an allowance, as long as the loans are still performing and not on non-accrual, you would still have the same accretion, right? If we wanted to dive down in here and say, well, that $25 is because we put loans on non-accrual or something like that, you might see it, but the accretion would continue as long as it's an accruing loan. It's just, we may have had a-
Oh, I see.
change in forecast.
If they go non-performing, then in that credit deterioration scenario, you could actually see less discount accretion.
Yeah. If your loans go on non-accrual or something like that. That's right.
That makes sense. You should assume that in a scenario where there's credit deterioration, most of these probably will be non-performing, especially if they have charge-offs.
You-
I think that's a great nuance to the question because the CECL component, if we just assume on slide nine, the $25 in the bottom example was all forecast. Like today, not a lot of charge-offs, not a lot of change in non-accruals for whatever reasons, and that's another discussion. You could see where you're not seeing charge-offs, you're not seeing non-accrual, your accretion would go forward. You believe unemployment is going to peak at a higher level in the second quarter than the first quarter, then that $25 would come in and you wouldn't have, quote, a lot of loans going non-accrual, the accretion could continue.
That's right.
Got it. Okay. In theory, these loans are still going to act very similarly, I guess outside of the discount, but just from the kind of provision cadence as your legacy non-acquired book from a CECL perspective. As you think your losses are higher, you'll take a big catch-up kind of provision in that quarter. As you think losses are lower, then you'll release some of your allowance, kind of all at once in that quarter. Is that a fair way to think about it?
Yeah, that's really the big change with the PCD accounting, is that historically, when you had improvements in credit, you would take that in over time through yield. Right?
Yeah.
Now, under CECL, you just take it in immediately through provision.
Got it.
The yield stays.
That makes sense. Okay, great. Very helpful. Thank you.
Thank you. Our next question, Steven Scouten of Piper Sandler. Please go ahead.
Hey, good morning. Thanks y'all for this information here. I'm curious just if you could, maybe going back to your illustration, if we could frame this up in the way probably a lot of us are used to seeing it. I know you didn't want to talk about specific company examples, but a lot of times when we see these in presentations when a deal is announced, we'll see, okay, here's the credit mark, here's the breakdown, the PCD and the non-PCD, and then here's the CECL adjustment. If I think about your example that way, am I doing this right when I say there's a $575,000 credit mark, $500,000 of which is PCD, $75,000 of which is non-PCD? Is that correct in a top level?
That's correct.
Okay. When I think about that, and then there's a CECL adjustment of the $75K. When I think about that cumulatively, does that mean that entire $650,000 would go into the loan loss reserve on day one?
That's what I was just about to clarify.
Okay.
You're right, okay, that you've got a $575 credit mark for your fair value. What happens is, when you look at slide six, and you've got the rate fair value mark, credit fair value mark, right, $25 and $75. That $75 that's in line 2B, that actually gets accreted. What we're looking at from an allowance perspective is the $500 from slide five, plus the line 5 on slide six, $75, right? You're going to accrete the $75,000, quote unquote, credit mark of the non-PCD assets. You're not going to have $650 as an allowance. You'd have $575 as an allowance.
That's where you're showing on slide eight, you're showing that coming through in year one. Why does it come through immediately in year one and not over the life of the loan?
On day one, you have to establish an allowance for non-PCD assets, and you establish that allowance through the provision. What we're showing on slide eight, that day one, where we say day one, that $75, that's establishing that allowance for the non-PCD assets. In total, you would have $575, which is the combination of the non-PCD $500,000 and this $75 day one adjustment to establish the allowance for non-PCD.
While this is extremely detailed, maybe this would if you look at slide six, what you're seeing in the example is the provision is line four. Right? You're seeing that in the provision. The 75 on line 2B, the double count has to be eliminated, has to be put back into capital. By accreting the 100, over time, that line 2B is going in as increased NII. It's being recharacterized in the financial statements as NII versus a credit component, and by doing that, it basically de facto offsets over time the line four provision expense. I don't know if that helps clarify it, but it's basically the.
Not really. The presentation just doesn't tie it together very well or reference the numbers. That's neither here nor there, I suppose. My main question is, on day one, the reserve would be $575, not the $650.
Correct.
Then I guess from a P&L impact, it would be $150,000 that would run through the P&L, right? The credit mark on the non-PCD and then the CECL adjustment?
Credit? No.
No?
No. The $75 from line 2B is accreted into NII over the life of the portfolio.
Okay.
I see. The 150-
I can't track how it's going. It's fine.
Sorry, I apologize. I think I see. The $150 just happens to be the $75 and the $75 combined. Now that I look at it, we probably could have put a different number. You don't take the full 2B through income on day one. That goes in over the life of the loan like any other discount would. The only thing you take the full amount to P&L on day one is the $75 of provision.
Yes.
Okay.
This is Ellen.
Thanks for the time, guys.
We probably could have taken the discount accretion on spot A and split it between the two.
Yeah.
Bye.
Thank you. Our next question is from Jacquie Bohlen of KBW. Please go ahead.
Hi, everyone. It's Jacquie Bohlen. Thank you very much for doing this call. I have a question. To a certain extent, I think maybe you alluded to this when you said that, if I understand you, it sounds like you said, FASB intent was that the non-PCD portion was expected to be rather small. At least for the limited number of transactions that I've seen under CECL with PCD, that has not been the case. My question is, given the flexibility that a company has to mark a loan as PCD, why wouldn't you try to mark everything you possibly can as PCD because it would avoid the day one provision and the double counting?
I guess I would just reiterate what FASB said relative to their belief of the outcome of the standard is that PCD would be a smaller portfolio, and thus the double count would be less significant to the financial reporting. I think as management goes through and makes their determination, it is important to understand, particularly in a principle-based standard, what the objective was. The PCD categorization was clearly expanded. The definition was changed during the process of developing the standard. I do think as management looks at it and it looks at how it monitors credit quality in any given particular environment, I think management teams will assess what does classify as PCD. As that evolves, the focus of FASB saying it should be a larger PCD category and a smaller non-PCD category, I think we'll see that play out.
Am I correct in my interpretation that from an accounting standpoint, obviously it impacts your goodwill creation and everything, but there's an advantage to the PCD mark, which, if I understood earlier comments correctly, doesn't imply that those loans are necessarily bad, just that there's been even a small piece of deterioration since origination. It avoids a large provision on day one, and it limits some of that double counting and the accretion back in through income. It makes for cleaner financial statements going forward, right?
Well, I think you hit two points there. One is that the categorization should be a larger number. I think the struggle to one of the earlier questions is why didn't they just have one category? I think as an investor and an analyst, the key here is, yes, the numbers for the double count may be smaller, but depending on how you look at your modeling, there would still be kind of a look-through to tangible book value to say, "Okay, how do I think about tangible book value dilution versus the day one entry and then the accretion back in?
How do I want to assess that in my modeling? Unfortunately, it might be smaller, but it still creates kind of a requirement to assess what goes through the income statement on day one and then how that's reflected back into the NII on day two through the life of the loan.
Okay. Thank you.
Thank you. Next, we have a follow-up question from [John Halse] of Voya. Please go ahead.
Okay, thanks. Maybe one question, one statement. I feel like the extra provisioning that we have, if we're a bank buying another bank that's got banged up credit, prior bad credit performance, you're going to have a massive provision upon closing, which to me then jams up all your valuation metrics that sticks for the history of mankind. It's actually, to me, I don't know how to think about it, like non-core, but it adds less user value. It obfuscates the core profitability of that company. I know probably everyone's been complaining about that, but anyway. My other question, that was a statement. You can comment on that. Maybe I'm wrong. My question then is with this whole COVID, we're in a period of forbearance, and then I think we're going to move to modification before year-end under the CARES Act.
Can you walk us through what we should be expecting in terms of, we've seen out of Banner, I know we're not supposed to name names, that they had some forward CECL outlook for 2Q, and some of it was driven by loan downgrades, and that was helpful for me understanding the process of what to expect going forward. I would think in a normal environment, we have that, but now we have CARES Act, which may actually limit the amount of Probably loan downgrade should be the same, but then we may have less charge-off experience with the modification process and TDR accounting. Am I crazy or am I onto something? Thank you.
Well, let me separate those into what I think was two questions. The first one, somebody buys, I think your words was banged up credit.
Yeah.
If you buy a troubled bank, so to speak, let's just say for arguments, virtually all or all the loans would be PCD, and therefore there would be no non-PCD and no debit through the day one income statement. You would basically record it at fair value, book the allowance, and if your assessment of the banged up credit was perfect, you would not have any income statement impact in the future. I think that example leans towards what FASB was saying, is that would be recorded on day one. You wouldn't see it in the income statement because it was banged up credit. The dialogue around COVID and forbearance, I think what I would just say there is it really focuses on the difference between deterioration in credit quality and measuring the risk or the expected loss.
That's probably one of the most fundamental issues here is CECL is estimating expected losses. What PCD classification is trying to do is find those loans where you've had deterioration in credit quality. A borrower that's asked for forbearance arguably has perceived his or her or the company's credit quality is changing, and that might be a factor that a management team may consider. To your point, a year from now, the stimulus may have kept that from ever being an actual charge-off, but that's a different measurement than whether or not the credit quality of the borrower has deteriorated since origination.
As a purist philosophy major, I should be downgrading my loans depending on the cash flows of my assessment and my quarterly cash flows of my borrowers, and therefore booking a larger CECL provision or just provision in 2Q, 3Q. Another question would be cash flow accounting is, do these loans charge off in 2021 or not? Is that what you're saying? Thanks.
What I was trying to say is how you measure CECL is a risk of measuring expected losses. That is fundamentally different than how do you classify a loan that's had greater than insignificant deterioration in credit quality. Those are totally different measurement paradigms.
I don't mean to argue with you. I was a lender, and you put loans on a risk rating of one to nine, like nine is highly doubtful, right? One is gilt-edged . Bell-shaped curve three, four, five. If cash flows are deteriorated, you're going to downgrade them. That's like a Moody's triple B to a double B. How is that not a greater than a significant expected loss? Are you saying really you're looking at the bottom like seven, eight, nine? Is that what you're saying for the CECL?
Well, I think an example might be even if you use where stimulus might help a particular industry, that industry may have a deterioration in credit quality, but because of the stimulus, a company may conclude that the risk of loss ultimately is not as great as you might think. That doesn't mean that that industry hasn't had a deterioration in credit quality. Again, I think in the slide we used, PCD is not a distinction of good loan or bad loan. Even someone said, who knows when the normal comes back, but let's just say two years from now you have a transaction, and you could be looking at this and classification of PCD doesn't mean you think that's a bad loan.
You could have a grade 1 commercial loan go to a grade 4, still a pass grade, and have a bank conclude that that's a greater than insignificant deterioration. It's still a pass grade loan.
Yeah. Meaning no additional reserve?
Correct.
Thank you.
Very modest. Again, that's why we said even high-quality borrowers can have a greater than insignificant deterioration in credit quality.
Shades of gray.
Welcome to CECL.
Thank you. Our final question comes from Dan Mather of Citadel. Please go ahead.
Thanks for taking my question. This relates a little bit to Catherine's, but just to confirm, with prior accounting provided a measurement period where you could adjust, with credit deterioration that didn't flow through the income statement but was an adjustment to goodwill. The example in your presentation is kind of year three, but is there a measurement period now, or is it just, it's kind of stuck at day one, so any deterioration, even in the first few months would flow through the income statement?
CECL doesn't change the purchase accounting guidance, which provides for the measurement period. CECL doesn't provide for a subsequent measurement period, and so you should have your day one established reserves, and then anything after that would fall under your normal CECL process. If you have deterioration post the next month or two months later, after close, that would just be part of your normal provisioning process.
Okay. That makes sense. Just wondering if CECL accounting has a potential to impact whether an acquirer books a bargain purchase gain versus a negative goodwill or a contra equity. Like in a hypothetical situation, of course, like an all-stock deal where the seller is below tangible book value, but the buyer is very close to tangible book value. What's the relevant measurement period for tangible book value for the buyer? I'm just wondering if CECL would have an impact on that on a lower tangible book value, kind of post-close versus pre-close.
Yeah. When you get into that kind of discussion, it really gets very fact and circumstances relative to the different accounting measurements across all types of asset classes, be it securities, be it loans, be it unfunded commitments. It's really hard to really walk through how that might play out.
Fair enough. Well, stay tuned.
This concludes our question and answer session. Now I'd like to turn the conference back over to management for closing remarks. Thank you.
Well, just wanted to say thank you to you all for joining us again today. Hopefully, and thank you so much to Greg and Jonathan and the whole team at Deloitte. We really appreciate their finding time to help walk all of us through this, and certainly, we hope it was useful, and I don't pretend that we've potentially answered every question, but, certainly, we'll stand ready going forward to help provide additional assistance and thank you so much.
Conference is now concluded. Thank you for attending today's presentation. You may now disconnect.