This summer, the business of providing and investing in credit was hit with a headwind that could eventually make lending more volatile and almost certainly more confusing. This time, no subprime predators or cowboy bankers were in sight. This time it was the accountants.
The Financial Accounting Standards Board's new approach to measuring forward-looking credit was described by the American Bankers Association as the biggest bank accounting change in 40 years. It stands to make the highs in the credit markets higher and the lows lower, and it risks putting a cloud of uncertainty around credit reporting. Credit consequently may become easier to get when borrowers need it least, and harder to get when borrowers need it most. And cloudy credit reporting could lead lenders to compensate by charging higher interest rates.
The new rules try to fix a problem that accountants, regulators and investors saw in the aftermath of the 2008 financial crisis. Banks, insurers and others with risk on the books could only report losses either when they occurred or were highly probable. But the crash of the U.S. housing market made it clear for almost everyone to foresee that years of likely losses – while not registered under the previous accounting rules – were in banks' future. Investors and especially regulators wanted to know what those ultimate losses might be. But the accounting rules left no place for lenders and insurers to report those distant expected losses and set aside reserves. Banks had to wait until losses rolled more immediately into view.
In June, after working on a solution since December 2012, FASB published a new and final set of accounting rules for credit risk called the Current Expected Credit Loss model, or CECL. The intent of the new standard is good. Everyone wants to see good estimates of future risk. But the potential for unintended consequences is large depending on how the rules are interpreted. The difference between the right and wrong accounting standard for credit risk can be summed up by adapting a famous Mark Twain quote about word choices in writing. Twain was quoted as saying, "The difference between the almost right word and the right word is … the difference between the lightning bug and the lightning."
The new rules require lenders to estimate losses expected over the life of a loan and then subtract those losses from current income on the day the loan is booked. But the income that lenders get for taking risk on the loan – income that could far exceed the projected loss – only shows up on the books over years. That's a big mismatch. The cost of providing credit under the new rules gets loaded all upfront, but the return only gets captured over time. Therein lies the problem.
If every loan that a lender makes comes with a hit to today's income, then lenders will find it easier to makes loans when income is strong and harder to make loans when income is weak. When home prices are rising and defaults go down, for instance, surging income will make it easier for lenders to make even more mortgage loans. And when home prices are falling, lenders will find it harder. The riskier the loan, the steeper the rollercoaster ride.
CECL, in what is almost surely an unintended consequence, stands to magnify the credit cycle. Borrowers on the edge of the credit markets – borrowers with poor credit or borrowers taking out longer auto loans, student loans or mortgages – should feel this more than most. After years of work by regulators to bolster financial stability by eliminating things that magnify credit cycles, CECL looks likely to roll back some of the tide.
The credit cycle could also get a little spin from the complexity of the new forecasting. CECL properly encourages lenders to weigh credit history along with current and future circumstances. But in making forecasts, as Nobel laureate Daniel Kahneman and others have found, most people, even sober statistical modelers, tend to bend their views toward recent events. Strong credit markets will likely bias lenders toward rosy views of the future, and weak markets toward gloomy. Reserves will likely fall in good markets and rise in bad. The cycle will rise and fall a little further.
It is also likely that different lenders will assign different loss estimates to loans that look, for most purposes, identical. Reasonable people will differ on the right estimate, but those differences could raise concerns that lenders and investors have returned to the accounting practices that occasionally made headlines in the 1990s before the current regime for reporting losses. Lenders then could set aside general reserves against potential losses and occasionally were accused of adding to or releasing those reserves to smooth out income – known as cookie jar accounting. The complexity of estimating CECL could be too sweet for some to resist, putting a cloud over credit quality.
The new rules for credit clearly have the best of intentions, and the accounting industry should be commended for that. Lenders, regulators and investors need clear, thoughtful estimates. But a likely amplification of the ups and downs of the credit market was probably not part of the plans behind CECL.
The accounting board has set up a group to take feedback and guide the profession toward implementation of CECL, starting with 2020 financial statements. But the accounting profession should go back to the board, literally, and ask for a solution that better matches the cost of extending credit to the reward for taking the risk.
There is lightning in the new CECL rules, but there's also a bug.
Steven Abrahams is a co-founder of Milepost Capital Management and former head of securitization research for Deutsche Bank.