Thursday, January 27, 2011

The 2 C’s of Lending: Credit and Character but what about Collateral (Asset Value)?

The news broke this week that the FASB has codified and made permanent temporary measures designed to go easier on banks using valuation measures instituted during the height of the 2008 financial crisis. The eased valuation rules give banks a great deal more discretion in the way asset values are established. To boil it down, the guidance says two of the C’s of lending are important, the third, not so much. Borrower credit and character will be weighted most heavily as summarized in Accounting Today:

“The “plain vanilla” assets that would be eligible for cost accounting would be “those instruments where the entity has a relationship with the borrower and the purpose is to be repaid with the collection of interest and fees,” said FASB chairman Leslie Seidman during a webcast Tuesday.”

“While mark-to-market can be very useful for a business that trades financial instruments, the most appropriate accounting measure for a loan portfolio is the loan balance minus impairment.”

“According to a summary of the board meeting, FASB decided that financial assets for which an entity’s business strategy is managing the assets for the collection of contractual cash flows through a lending or customer financing activity would be measured at amortized cost.”

(MICHAEL COHN, “FASB Reverses Course on Fair Value”,, JANUARY 25, 2011)

Mark-to-Model, Hold-to-Maturity

Fair values for loans will based on a discounted cash flow methodology (or a modeled approach) that is called a “level 3 valuation in the fair value hierarchy”. Put very simply, level 1 and 2 methods in determining fair value use actual asset sales in very active and somewhat less active markets, respectively.

Level 3 valuation was used in inactive markets or nonfunctioning loan markets like we have had since 2008; valuations are not solely based on asset sales or trades. Fair value requires the bank to make estimates about discount rates, market conditions, expected cash flows and other future events that are based on evaluation borrower credit and are highly subjective in nature and subject to change. Adverse changes in the model assumptions result in a loan impairment deducted from book value.

Investors most assuredly would like to know about the value of the underlying collateral backing the loan too, not rely on discretionary financial modeling alone. After all, if credit and character fail to support the loan, the collateral that is trade-able and liquid matters a lot. Whether the price data is found in the body of the financial statements or hidden in the footnotes, collateral values is what investors will want to focus on. And investors don't want to have been misled by overly smoothed value estimates only to find out it is too late to react.

CRE, The Worst is Over?

CRE may indeed be coming out of the woods as an increasing quantity of non-crisis CRE trading data is becoming available. Use of arms-length trading data as a valuation guide means many more eyes and extensive ‘at-risk’ due diligence that comes to bear on the determination of asset values. Discretionary internal models, as we have seen in events leading up to the crisis, may diverge from (and possibly overstate) values compared with those derived from true, 'at-risk' positions.

There is little to fear about current distressed debt pricing. Between loss sharing arrangements that have locked $200 Billion of failed bank loans away and out of view for many years to come and FDIC structured sales of distressed debt that have inflated prices through FDIC low cost financing, everything possible has been done to prop up distressed debt prices today.

Yes the markets for financial assets are volatile. Yes markets overreact in crisis. CMBS is an example of just such a vital, reactive, volatile and liquid arms-length market: investors trading in these securities are striving to get behind the façade and assess the collateral (cash flow) as well as the credit in order to price the securities.

We think too that de-emphasizing external data and valuation in favor of internally driven models will make the already impossible job of regulating and monitoring of the banks' condition even more difficult. Level 3 accounting is obscure, to say the least. Market-derived data points are a very necessary component of the valuation mix.