How is a home inspection similar to the ALLL?

Apr 16, 2015

Migration Analysis


Imagine you’re in the final stages of purchasing your dream home. Location, price and all the intangibles exceed your expectations and the only item remaining is the inspection. The house could either pass the inspection with flying colors, or you could come to find out that another $250,000 worth of work is needed before it is a healthy, stable home.

This inspection is what will ultimately determine how much you should reserve for repairs, structural improvements and any additional unforeseen renovations the house is likely to require. If this inspection is performed by a comprehensive, granular, and objective eye, you will avoid surprises and be much more prepared to assess the general health of the home in its current form.

On the contrary, a poor inspection – or even a mediocre one – can leave you guessing with respect to losses you will incur in the form of needed repairs over the coming years.

The ALLL is very much a similar process; various levels of comprehensiveness exist when assessing the health of your portfolio and determining how much to reserve for loan losses. For repair estimates, you could find neighbors that have homes built in the same decade and ask them how much they’ve spent on maintenance. You may get a reasonable ballpark figure upon which you can base a decision. However, it is unlikely that the neighbors’ homes are constructed of the same material and have the exact same nuts and bolts inside them as your potential new home. Your decision may not be entirely informed.

If you have access to the home – or if you have a loss history – you should have the inspection done to assess its condition. The accuracy of your forecasted repair budget is contingent upon the comprehensiveness of your inspection. Let’s examine two approaches.

Approach A: Historical Loss

Your inspector examines the home and all of its components by segment. It was built in 1990 so he bases his assumptions on his experience with general repairs needed after 25 years: 1990 bathroom, 1990 attic, 1990 kitchen, etc. He spots the glaring items that need to be fixed and accounts for those individually. Based upon what he’s encountered in the past, he estimates that in another 5 years you’ll have to replace the air conditioning unit and replace part of the deck. Total repair: $22,500.

Approach B: Migration Analysis

Your inspector examines the home, its segments, and the components that make up those segments. He is aware that it was built in 1990, but inspects the individual health of each component of the home. He uncovers the same glaring items, but then notes that your metal roof is in need of repair, your pipes are showing signs of deterioration and your flooring may need to be replaced in a few years. He also notices that your air conditioning unit is in perfect shape and your deck can withstand another 15 years. Total repair: $45,000.

With the latter approach, you are able to see the health of each individual component and account for that in your forecasted budget. Most metal roofs and pipe systems last 50 years, but yours are in substandard condition. This would not have been factored into your budget using Approach A. It’s helpful to know that most bathrooms generally require $3,000 in repair every ten years. It’s more helpful to know that your electric work is in good shape and that your sink is starting to leak, and how much you should set aside for the sink repairs specifically.

Metaphors aside, the accuracy of your portfolio assessment is fundamental to the ongoing health of your bank. Graduating to a methodology that subsegments your portfolio by risk level and tracks migration to loss gives you significantly more insight into the health of your portfolio now. In addition, migration analysis is widely viewed as a more accurate and comprehensive process by examiners; it validates or uncovers inefficiencies in your loan rating process, it requires institutions to improve their data gathering practices, and it gives you the ability to perform loan portfolio stress testing based on pro forma migration analysis under different scenarios.

There is a strong correlation between comprehensiveness of portfolio analysis and the accuracy of the output. Migration analysis accounts for the various risk levels that may be present within a given pool and measures the likelihood of those various risk levels migrating to loss. As opposed to looking at an aggregate 3.28% loss experience for “CRE: owner-occupied,” you may have “CRE: owner-occupied – pass” at 1.04%, “CRE: owner-occupied – special mention” at 2.94% and “CRE: owner-occupied – substandard” at 14.39%. Thus, as the CRE environment changes and you adjust your risk ratings, you will have a more predictive model of future losses than your aggregate sum of historical losses.

Many institutions have already begun this shift, but it is not something that can be done overnight. For a statistically viable migration analysis methodology, it is recommended that institutions capture loan-level data for a minimum of four to eight quarters. The data requirements for migration analysis appear to mirror those of the FASB’s CECL model, so institutions that graduate to migration analysis benefit from both a more comprehensive loss methodology as well as a more favorable data gathering process with respect to the new accounting standards.

For more on the topic, access the complimentary whitepaper, “Migration Analysis: The Way Forward for an Effective ALLL.”