Looking Beyond the Surface of Credit Discounts
With the softening of the recent credit storm, bankers are enjoying considerable relief from a much stronger economy. But surprises await banks looking to expand through mergers. Establishing a fair value for acquired loans can be a messy and complicated process and result in portfolio discounts much higher than their current allowance for loan and lease loss (ALLL) levels.
The core issue is fair value requirements contained in FASB ASC 805 and ASC 820. For loans acquired through acquisition, fair value means measuring the market value based on credit quality and interest yield. Adding to the complexity of applying the guidance is that most loans in commercial bank portfolios generally have limited or no publicly-available data to guide the creation of credit discounts.
Many large money center banks have extensive statistical packages, credit analysis groups and sophisticated credit assessments that can demonstrate both life of loan losses and market participant characteristics of a credit portfolio. Unfortunately, many regional and community banks lack this capability, making the process complex and more subjective than many accountants and users of financial statements would like. Moreover, many targets have very limited capability to do anything more than demonstrate the reasonableness of their ALLL factors.
This creates a unique problem for acquiring banks as they develop credit discounts. The time to conduct effective due diligence on a large-scale loan portfolio is comparatively short. The standards under which a target’s credits are underwritten may vary materially from the acquirer’s standards. The administrative practices under which the loans are managed usually differ from one bank to another. Add that to an often predisposed management vision on an acquisition and the challenge of developing credit discounts becomes herculean.
In this paper, Guidehouse experts discuss how to meet an enhanced requirement for calculating and documenting a credit discount on an acquired loan portfolio by utilizing a multi-tiered process involving three distinct aspects of credit assessment.