February 2025 - The CECL Effect
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In this month’s edition of The LoanStreet Beat, we dive into CECL and the impact it has had on credit union participation decisions. In particular, we describe how properly evaluating CECL reserves can help buyers achieve higher loss-adjusted returns. In addition, we recap an active economic news cycle and share our observations on the current loan trading market. Enjoy, and please comment and share below!
LoanStreet Market Commentary
The latest inflation data points to moderate price pressures consistent with forecasts. The December Personal Consumption Expenditures (PCE) index, Fed’s favorable measure, rose 0.3% month-over-month (MoM) and 2.6% year-over-year (YoY), both in line with estimates. Core PCE, which excludes volatile food and energy categories, increased 0.2% MoM and 2.8% YoY, again aligning with expectations. On a three-month annualized basis, the core PCE price advance of 2.2% is the lowest since July. These findings echo the December Consumer Price Index (CPI) data, which showed core inflation rising 0.2% MoM and 3.2% YoY, both 0.1% below estimates. The biggest driver of the CPI index continues to be shelter. After showing progress last month, shelter prices remained at 0.3%, the same as last month. The two components which go into the shelter cost calculation, rent of primary residence and owners’ equivalent rent, both ticked up by 0.1%. (https://www.bls.gov/news.release/cpi.t01.htm)?
Meanwhile, the labor market continues to outpace projections, underscoring economic resilience. The December job report posted a robust gain of 256k, well above the forecasted 155k, pointing to stronger hiring than anticipated. Further, consumer spending rose 0.4%, above the 0.3% estimate. One area of concern is the savings rate, which has dropped to 3.8%, a two-year low. This suggests that most of the spending is fueled by consumers pulling funds from the savings accounts instead of strong wage growth.?????
Loan Trading Trends and Implications
Driven by a slowdown in loan origination volume, buy-side loan demand remains strong. Buyers continue to maintain a strong preference for super-prime credit and a tight buy-box, even at the expense of their overall return. After adjusting for losses, the differences in spreads above the applicable Treasury can be as large as 100bps between and among competing auto deals, depending on how narrow the buy-box and perceived risk associated with the selling institution. This means sellers with strong financials with a history of peer-group outperformance are able to take advantage of the market’s preference for their assets by selling at materially tighter spreads. From a buyer’s perspective, buyers who are able to dig deeper into what is driving losses for a given seller and are comfortable buying from institutions who have underperformed peers, are able to purchase loans with favorable pricing.?
Outside of auto, residential loans have been doing well. There is a strong preference for ARM loans over 30-year fixed. Buyers are heavily focused on geography and prefer to avoid some of the usual concentrations of Florida, California and Texas. Because of this, Midwest loans are selling at tighter spreads, this geographic preference is also true for auto. Second lien fixed and HELOC pools have also been in demand, although supply has been limited. Given the potential for prepayment risk associated with long term residential loans, buyers remain sensitive to high premiums. Given this term aversion, a pool with pricing near par, but a higher servicing fee, would generate better overall return to the seller while clearing the market to the same buyers.?
Deep Dive: The CECL Effect
Loan participations have always followed a cyclical pattern, largely influenced by liquidity. In times of excess liquidity—such as 2020 and 2021—strong demand for loans drove down yields, making trades more competitive. However, the landscape shifted in 2022 and 2023, when tighter liquidity forced sellers to offer deals at historically high spreads to attract buyers.
While liquidity remains a key factor, the introduction of the Current Expected Credit Loss (CECL) model has added a new layer of complexity. Now, buyers are not only evaluating market conditions but also adjusting their strategies based on the CECL reserves required for a given asset class. As the market continues to evolve, understanding these driving forces will be critical for navigating loan participation opportunities effectively.
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The CECL model requires financial institutions to estimate expected credit losses over the lifetime of a financial asset at the time of origination. Before CECL, the incurred loss model was used, which only required recognizing credit losses when they became probable. CECL shifts this approach by requiring an estimate of lifetime credit losses from day one based on historical data, current conditions, and reasonable forecasts. (FASB.org)
What does this mean for participations? Read our full article on CUInsight here: CUInsight
Monthly Economic Data Summary
This article was authored by Matt Rudzinski, VP of Capital Markets
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