In our Q4 2016 Securitization Tracker, we noted the increased pace of ABS issuance, heightened rate volatility, and the emergence of deals with seasoned collateral which require consistent valuation methods amongst market participants.

Given this backdrop, market participants are eager to understand the pricing and valuation of loans. We discuss this topic below and explore further on the valuation panel at Context Summits’ Alternative Lending Summit on January 30 & 31st at the Fontainebleau Hotel, Miami Beach.

This week we will deliver our newsletter in two parts. Today, in Part I, we summarize regulatory framework for valuation, review existing valuation approaches, and introduce key principles of the PeerIQ valuation framework. On Sunday, in Part II, we will address quantitative and technical implementation. 

Regulatory Framework for Valuation

In 2010, the Financial Accounting Standards Board (FASB) introduced more rigorous requirements for fair value measurements and disclosures in ASC Topic 820 (formerly known as FAS 157). The FASB Fair Value Hierarchy in ASC 820 categorizes assets across three levels based on inputs to valuation techniques used:

  • Level 1 assets have actively traded markets; and valuation inputs are direct quoted prices for identical assets or liabilities. 
  • Level 2 assets include valuation inputs other than quoted prices that are observable for the asset, either directly or indirectly. Examples of Level 2 assets are privately placed bonds whose value is derived from a similar bond that is publicly traded, corporate bonds, collateralized mortgage and debt obligations, and high-yield debt securities.

  • Level 3 is the most unobservable level and requires many assumptions and estimates. Since a two-way market is not available, fair value is often based on models in which there are few, if any, external observations. Examples include nonpublic private equity investments, retained interest in securitizations, and mortgage servicing rights. 

Under ASC 820 guidelines, the fair value of an asset reflects the exit price that would occur in an orderly market.

Current Alternative Pricing and Valuation Approach

Prices of non-tradeable or illiquid loans are generally only observed when they are issued. Asset managers employ a number of informal approaches to valuation – several of which have limitations.

Amortized Cost: This approach values a loan at its outstanding balance at purchase price plus accrued interest. It may overstate loan price during the early period of the loan’s life, as it does not account for loan status (e.g., delinquency). 

Haircut Matrix: Loans are valued at outstanding balance plus accrued interest, with haircuts applied to loans based on their stage in the delinquency queue. The size of the haircut is calibrated to historical loan performance. The haircut-matrix approach improves on an amortized cost approach by incorporating loan status, yet still suffers from major deficiencies ignoring A) changes in a borrower’s credit profile at loan level, B) seasonality of loans, and C) credit spread and interest rate risk premium, and D) a forward-looking view on cashflows.

Loan Loss Provisions: Banks holding loans in the hold-to-maturity book create a provision or accrued liability based on expected losses on the pool. This approach is not applicable to hedge funds offering liquidity as it leads to “stale” and smooth loan prices that do not reflect fair value.

Asset managers can no longer rely on informal processes to value illiquid securities. A consistent and transparent valuation framework is necessary to promote investor confidence, market integrity, improve comparability of returns, and meet fiduciary and regulatory obligations. 

The need for a fair value approach is further heightened for asset managers that perform liquidity transformation (e.g., enabling investors to subscribe or redeem a fund at net asset value). The net asset value must be marked as accurately as possible to ensure existing and future redemptions are treated fairly.

Key Principles of Robust Valuation Approach

The PeerIQ pricing and valuation framework adheres to the following key principles: 

  • Transparency: A repeatable, documented methodology, with exposition of inputs and other assumptions.
  • Fair value: If the valuation inputs are not readily observable, ASC 820 requires a derived fair value based on a consistent modeling framework that factors in both unobservable and observable valuation inputs from similar assets.
  • Sensitive to major risk factors: The pricing framework accounts for risk factors including default risk, prepayment risk, and credit spread risk.
  • Forward looking: Loan valuations are driven off of expected future cashflows, with such cashflows a function of the borrower’s attributes, macro conditions, loan performance, and seasoning.
  • Loan-level: The pricing framework operates on a loan-level to address granularity in credit risk of loan.

Stay tuned for Part II of our newsletter on Sunday where we will illustrate PeerIQ’s valuation in detail. We welcome friends to join us in Valuation Methodology session at Context Summits’ Alternative Lending Summit on January 30 & 31 at Fontainebleau Hotel, Miami Beach.