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CECL Methodologies: Loss Rate Model and Cohort Analysis

Sohini Chowdhury PhD| Senior Economist & Director, Moody’s Analytics

August 2019

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Agenda

1. What is Cohort Level Analysis?

2. What are Loss Rate Models?

3. Examples Showing ECL Calculation

What is Cohort-Level Analysis?

Different Types of Analysis

Historical time series of performance variables is available

The performance variable is linked to macro variables

Aggregate levelLoan age is included in the model

Adding loan age makes it a more granular approach relative to aggregate level model

Cohort levelAll available borrower attributes are included in the model in addition to loan age. The most granular approach

Loan Level

Aggregate vs Cohort Level AnalysisPD rate for first mortgages – Aggregate vs different vintages

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0.20%

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PD

Calendar time

Vintage 2004 Vintage 2005 Vintage 2006 Vintage 2007 Aggregate

Pros and Cons of Different Types of Analysis

Simple data cleaning

Easy to implement

Could be inaccurate if loan characteristics are changing thru time

Aggregate levelMore complex than aggregate level model

Vintage differences are captured

Still easy to implement

Cohort levelMore thorough data cleaning is needed

Very complex in terms of estimation

More accurate by including all loan attributes

More applicable to different types of portfolios

More difficult to implement

Loan Level

Pick Cohorts by Similar Risk Characteristics

Like:

» Product type

» Vintage

» Risk score

» Geography

» Collateral Type

» Materiality

» Term

» Historical or Expected loss Patterns

Too granular cohorts can result in too few loan counts and statistically insignificant results

What are Loss Rate Models?

Models which predict future loss rates based on historical loss data

Loss Rate Model Pros and Cons

PROS CONS

▪ Transparent calculation. Simpler data requirements.

▪ If sourced from a statistical model, it can capture the effect of key risk drivers such as credit rating, loan age, size, industry, and other loan characteristics

▪ Can incorporates the dependence on macroeconomic scenario

▪ Possible to calibrate losses to institution’s historical experience

▪ Does not incorporate the cash flow schedule

▪ Does not separate default risk from recovery risk

▪ Cannot incorporate prepayment as a separate input; must be factored into the loss rate or remaining life

Modeling Loss Rates

Common Drivers of Loss Rate Models

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Delin

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ate

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0 20 40 60 80Age-on-books (months)

Life CycleThe age of loans

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2010m1 2012m1 2014m1 2016m1Date

EconomyConditions every month

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Del

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rate

(%)

0 20 40 60 80Age-on-books (months)

Pool Quality Parallel shifts

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810

Del

inqu

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rate

(%)

0 20 40 60 80Age-on-books (months)

Interactions Quality & Life-cycle

Incorporate R&S Future Economic ConditionsInclude both national and regional forecast economic factors:

» Economic Performance

GDP Growth, Disposable Income Growth

» Labor Markets

Unemployment, Job/Wage/Salary Growth

» Demographics

Population, Number of Households, Migrations etc.

» Real Estate Markets

Home Prices, Home Sales, Housing Starts, Permits

» Financial Markets

Federal Reserve Interest Rates, Equity Mark Indexes2

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Unemployment rate, %

Baseline Consensus

S1 S2

S3 S4

S5 S6

S7 S8

Capture Local Economic Conditions

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Unemployment rate, %

National State

Metro

2019Q3 F

2019Q3

Which metro area has the LOWEST unemployment rate?

Which metro area has the HIGHEST unemployment rate?

Using Loss Rates in CECL Calculation

Using Loss Rates to Calculate ECL

» Unpaid Principal Balance = $1,000,000

» Amortized Cost = $ 986,732

» Remaining maturity = 5 years

» Fixed Coupon Rate = 5%

» Effective Interest Rate = 5.5%

» Amortization type = Linear

» Payment Frequency = Annual

» Annual Prepayment Rate= 5%

Loss Rate Annualized Approach

Assumptions Formula Output

» Amortized Cost = $ 986,732» Remaining maturity = 5 years» Fixed Coupon Rate = 5%» Amortization type = Linear» Annualized Loss Rate = 0.25%

Allowance= EAD X

Annualized Loss Rate XRemaining Lifetime

Allowance = 986,732 x 0.0025 x 5= 12,334

Loss Rate Lifetime Approach

Assumptions Formula Output

» Amortized Cost = $986,732» Remaining maturity = 5 years» Amortization type = Linear» Lifetime Loss Rate = 4.2%

Allowance= EAD X Lifetime Loss Rate

Allowance = 986,732 x 0.042= 41,443