Loan Valuation
Contents
Definition
Loan Valuation is the methodology and process of assigning a monetary value to a loan contract.
- Loan valuation (of existing loans) is distinct from Loan Pricing, the determination of an appropriate asking interest rate for a loan product at the time of origination.
- Loan valuation may also be distinct from the accounting value of the loan (e.g., as reported in Financial Statements) when this is not reported under FVPL standards.
- Non-Performing Loan Valuation is a sub-case focusing on the valuation of non performing loans
Loan Valuation is an example of more general model based valuation
Risk Factors
Depending on the nature of the borrower and the type of loan product the following risk factors may be of relevance (must be taken into account) because they affect the scheduled
Credit Risk
- the likelihood of failure to receive timely payments of principal, called Default Risk
- the uncertainty around potential recovery (Recovery Risk) if there is an event of default. After a default event these risk factors acquire more significance and are resolved further in the NPL Risk Factors
Pre-payment Risk
Prepayment Risk is another risk factor affecting Contractual Cash Flows. Prepayment and Credit Risk are Competing Risks (an prepaid loan does not default and vice versa)
Methodologies
There are two broad categories of methodologies that can be applied. The best choice is primarily determined by
- the availability of liquid traded instruments with
- similar contractual characteristics and
- similar credit risk profile
External Benchmarking Method
In the external benchmarking method, reference instruments provide crucial inputs for the valuation. Such instruments and reference prices may be obtained from traded loan markets, corporate bonds or credit default swaps
The process involves the following steps
- Identify the set of external traded instruments that will help construct the benchmark
- Extract a consistent set of key valuation parameters (credit curve, recovery expectation)
- Value the contractual cashflows of the loan using those parameters (and possibly additional inputs)
Internal Benchmarking Method
In the internal valuation method inputs derived solely using internal analysis. The process involves the following steps:
- Assess credit risk characteristics of client / product using internal models (credit curve, recovery expectation)
- Develop an expected loss measure
- Assess diversification risk profile using internal portfolio model
- Develop a risk premium / capital cost measure
- Value the contractual cashflows of the loan using those parameters (and possibly additional inputs)
Issues and Challenges
- Loan contracts are frequently not traded in active markets hence valuation by comparison to similar contracts may carry significant uncertainty due to poor liquidity / wide bid/ask spreads
- The termsheet of a loan contract may contain a substantial number of clauses ( loan covenants) the impact of which in the economic value of the loan might be challenging to establish
- An internal benchmark, while useful as standardized measure across different loans, is ultimately a subjective methodology with substantial Model Risk.
