Gone Concern Valuation

From Open Risk Manual

Definition

Gone Concern Valuation of a Non-Performing Loan refers to the collection of valuation methodologies that assume that operational cashflows from the debtor (obligor, borrower) cease and any available collateral is exercised[1]

Methodology

The approach involves estimating the underlying risk factors (uncertainties) and / or structural elements

  • Expected time to liquidation (T)
  • Total Liquidation Proceeds and
  • Total Liquidation Costs
  • Collateral Share
  • Discount Rate

Formula

The Recoverable Amount of the collateral proceeds at t=0 is therefore defined as follows:

 
\mbox{Recoverable Amount} = 
\mbox{Collateral Share} \, (\%) \times \sum_{t=0}^{T} (
\frac{\mbox{Liquidation Proceeds}_{t} - \mbox{Liquidations Costs}_{t}}{(1 + r)^{t}})

Liquidation Proceeds

Total Liquidation Proceeds are the cash inflows during the liquidation process. These inflows are estimated for each year of the liquidation process taking into account both income generation of the asset (e.g. rent) and proceeds from sale (including consideration of whether collateral perfection will allow reasonable execution of collateral in a realistic timeframe).

Proceeds from sale should be based on market value. Market values should be determined as described in the Collateral Valuation, though also include expected falls (but not rises) in market value in the time between observation and sale. To take into account expected falls in market values, forward-looking indices can be used.

Account should also be taken of the recoverability of insurance and guarantees, considering fully what outcome is most likely on each policy/protection – pay or not pay. As a rule of thumb, unfunded credit protection eligible under CRR, where the provider of the protection is rated at Credit Quality Step 3 or above should be acceptable.

Liquidation Costs

Total Liquidation Costs are the cash outflows incurred during collateral execution and the sales process. Estimates of these outflows are required for each year of the liquidation process. These costs should include law enforcement, other sales costs as well as haircuts to market value. The market price haircut will reflect liquidity of the market and liquidation strategy. It need not reflect fire sale conditions unless the anticipated liquidation strategy involves a fire sale.

If the plan is to sell with vendor finance, then the present value of the discount given to the client on financing (vs. market rates) should be included in the liquidation costs. The market price haircut can be zero for liquid and non-distressed collateral types but is expected to be at least 10% in the following cases (If no market price haircut for liquid and non-distressed collateral is made, one needs to substantiate that the collateral is really liquid and non-distressed and that no costs for the sale are to be expected. Ideally, the bank already has a binding offer from a third party to acquire the collateral):

  • The collateral will be sold by Auction
  • The collateral was foreclosed 2 years ago and has not been sold; and
  • The collateral is sold involving vendor finance reflecting the NPV loss from the provision of cheaper than market financing.

Collateral Share

The lien structure determines the Collateral Share. The Collateral share reflects the claims of other parties on the same collateral e.g.:

  • If another creditor has a preferred claim on the collateral (i.e. the significant bank’s claim is only second lien), greater than the recoverable value Collateral Share is set to 0;
  • If the bank’s claim is first lien but pari passu with other creditor’s claims, the Collateral Share equals the contractually agreed share of the claim. If there is no such agreement and national insolvency law does not provide explicit guidance, the significant bank’s share of exposure towards this collateral will be used;
  • The collateral share may be also influenced by legal issues associated with collateral where these are material to the individual impairment and provisioning review, such as the strength of collateral claims.

Discount Rate

  • In accounting valuation, the present value of the cash flows is estimated by discounting the proceeds with the original effective interest rate of the exposure (EIR)
  • In a market transaction the sale price determines an implied risk premium


  1. AQR Manual