Approximately 2.1 million Americans get married every year, and that number is continuing to rise. As the economy has improved and the banking industry has recovered from the mortgage meltdown, bank marriages (a.k.a., financial institution mergers and acquisitions) are also now in vogue. The banking industry is feeling pressure to tie the knot and “grow the family” to mitigate the rising cost of regulatory compliance through economies of scale. While there are many issues for banks to consider before taking that big step, perhaps the largest determinant is the health and fair value of the loan portfolio.
Uncover Skeletons and Meet the Parents: Bank Merger Due Diligence
As with any life-changing union, it is important that both parties know who they’re marrying. For the acquirer, due diligence should be performed by qualified personnel to evaluate a target entity’s loan portfolio and determine:
- the expected collectability of the portfolio,
- its fair value, and
- its accounting requirements.
Valuating the loans in the acquirer’s loan portfolio is based on either:
- cost adjusted for probable losses (if included in a pool of similar loans), or
- at the present value of expected cash flows, the market price of the loan, or its realizable collateral value (if a loan is evaluated individually and deemed impaired).
The total allowances for 1 and 2 above are aggregated and reflected as a separate reduction of the recorded value of the loans.
Be Prepared for Changes After the Wedding: Determining Fair Value of the Bank’s Loan Portfolio
Once the business combination — such as a merger or acquisition — occurs between two financial institutions, the acquired loan portfolio is measured and recorded at fair value as of the acquisition date. If the fair value of loans is less than the balance of loans (as most commonly occurs), then a purchase discount is applied to directly reduce the recorded value of loans to fair value.
To determine the fair value of the loan portfolio, segment the portfolio into two sections: performing loans and loans with deteriorated credit quality.
1. Performing Loans
Performing loans are expected to collect all of the contractual principal and interest specified in the loan agreements. Two adjustments will be made to performing loans at the point of acquisition/merger:
- an interest adjustment that values these loans, specifically the difference between the contractual rate and the current loan types’ market rates, and
- a credit adjustment for the inherent risk of the loans.
2. Loans with Deteriorated Credit Quality
A loan is deemed a “deteriorated credit quality loan” when the borrower has had a “change in circumstances” since origination and will not make all contractually required payments. The fair value adjustment at the point of acquisition for this type of loan is the difference in the contractual payment and the expected payment streams for the purchased credit impairment. Of this fair value credit impairment, the expected cash flows that exceed the initial investment is the “accretable yield.” The excess of the total contractual cash flows over the expected cash flows is the “non-accretable difference.”
Settle into Married Life
After the union is official, the bank can group loans that are relatively homogeneous (such as residential mortgage loans, consumer loans, credit card loans, etc.) to compute fair value adjustments and determine purchased credit impairments. For non-homogeneous loans such as larger commercial loans or multi-family residential loans, the computation for the purchased credit impairment is done at the individual loan level.
Loans with revolving terms are not subject to the purchased credit impairment due to the uncertainty of future advances and repayments.
It is imperative to understand and comply with the accounting requirements for acquiring a loan portfolio. The newly combined financial institution should have a supportable position in place to determine the fair market value adjustments for both the interest component and the credit impairment component. Typically, the assumptions for the interest component are easier to determine as current market rates would normally exist for similar loans. The credit impairment is more difficult and has a higher degree of judgment. It is therefore critical and tantamount that the merged institution work with people highly experienced in this area — professionals who know what peer entities’ approaches are and what is typically acceptable to regulators or external auditors.
Plan for Your Future: Consider Implications of the CECL Model
As one can deduce, establishing an acceptable yield discount will result in future earnings to the acquirer. This can occur as the loan portfolio may have average interest rates that are below the current market rates (exit price) due to the actions of the Federal Reserve Bank and improvements in general economic conditions. The non-accretable yield insulates the acquirer from incurring future losses related to credit quality issues that existed at the date of acquisition. Having both of these elements at the highest supportable level may be beneficial to the acquirer.
It is important to note that accounting standards referred to as the “Current Expected Credit Loss” model (CECL) become effective for public entities in 2020 and for nonpublic entities in 2021. The CECL requires that an allowance for purchased credit deteriorated loans that are above an insignificant level is recorded separately from the interest adjustment element. (For more details, read CRI’s article about the CECL model.)
Let CRI Be Your Bank’s Acquisition “Marriage Counselor”
Whether a transaction is being contemplated or is in progress, CRI’s team of experienced banking CPAs are ready to assist you with implementing proper purchase accounting, evaluating the collectability of loan portfolios, or providing other important services to your financial institution. Please contact CRI for “marital” support.