Loan Valuation Research Articles

Is COVID Revealing a Virus in CMBS 2.0?

ABSTRACTCommercial loan valuations crucially depend on accurate loan income, but underwritten income on commercial mortgage‐backed securities (CMBS) loans is commonly overstated relative to actual property income. Consistent with these differences being originator‐specific, income overstatement in CMBS 2.0 deals varies widely and persistently across originators, is priced by originators, is related across property types within an originator, is predictable ex ante, and is accompanied by inflation of past financials. Risk retention and associated regulation had no discernible effect on income overstatement. Originator income overstatement is highly predictive of pre‐ and COVID‐period loan distress. Overall, recent market stresses reveal large systemic differences in underwriting standards across originators.

Business intelligence and geographic information systems in the banking industry: A case study of home loan valuation

This case is designed to illustrate how to utilize a business intelligence framework and a geographic information system (GIS) to make better decisions in the banking industry. The case started when Jong, the senior certified analytic professional, and Kampu, the GIS solutions expert were drafting a proposal presentation to help ABC Bank of Thailand improve its home loan appraisal process. The current appraisal process was time-consuming and the appraisal value from the internal and external appraisers were very different as the appraisal process relied heavily on the opinions and judgements from all appraisal staffs. Currently, there was a home loan application pending for Hugo, the appraisal manager of ABC Bank of Thailand, to make the decision on the final appraised value. This was a great opportunity for Jong and Kampu to revisit the current appraisal process and to demonstrate how business intelligence and GIS could aid in the appraisal decision. Additionally, the proposed GIS-based BI dashboard allowed the appraisal team to the analyze data-related to the appraised property in real-time. Eventually, Jong and Kampu had to make a decision on what appraised value Hugo should recommend to the home loan committee members.

Valuation of Non-Performing Loans under Discussion

In March 2018, the ECB published “Addendum to the ECB Guidance to banks on non-performing loans: supervisory expectations for prudential provisioning of non-performing exposures” in which it required non-performing loans originated after 1 April 2018 to be fully written down after 7 years, with unsecured loans to be written offer after only 2 years. In practice, this approach implies the use of a null value: i) after seven years for secured non-performing loans and ii) after two years for unsecured loans, with an accounting provision for an equivalent amount. European Banking Authority (EBA) statistics for 2019 show that provisions for non-performing loans in Europe were 44.9% (Note 1), corresponding to an NPL valuation of 55.1%, which is higher than the implicit value in the prudential provisions recommended by the ECB. The ECB's new guidelines on provision levels and the implicit value of such provisions creates serious doubt about banks' estimated fair values of NPLs, as per what they book in their accounts. This article aims to use the disclosures provided by listed Italian banks in their notes to the accounts from 2009 to 2019 to determine if the fair value for NPLs, as divided between the secured part and the unsecured part, is value relevant and the amount of any discount/premium applied by the financial market compared to the actual fair value that is booked. The results highlight the excessively prudential nature of completely writing off non-performing loans and justify a review of the approach adopted by the European Council and Parliament in August 2019 (and subsequently adopted by the European Central Bank) in which unsecured NPLs should be fully written off after 3 years (compared to 2 years before), NPLs secured by real estate after 9 years (compared to 7 years before) and NPLs secured by non-real estate guarantees after 7 years (confirming the previous approach) for all loans originated after 26 April 2019.

Is COVID Revealing a CMBS Virus?

Commercial loan valuations crucially depend on accurate loan income, but underwritten income on CMBS loans is commonly overstated relative to actual property income. Consistent with these differences being originator specific, income overstatement in CMBS 2.0 deals varies widely and persistently across originators, is priced by originators, related across property types within an originator, predictable ex-ante, and accompanied by inflation of past financials. Risk-retention and associated regulation had no discernable effect on income overstatement. Originator income overstatement is highly predictive of pre- and COVID-period loan distress. Overall, recent marketstresses reveal large systemic differences in underwriting standards across originators.

Regime Classification and Stock Loan Valuation

For traditional perpetual American put options under regime-switching models with positive risk-free interest rates, optimal stopping usually can occur in any regime. Nonetheless, if the risk-free interest rates are allowed to equal zero (the interest rate may drop to zero sometimes in reality), there may exist “continuation regimes” within which optimal stopping can never occur, that is, within which stopping is never optimal. A natural problem is “regime classification,” that is, determination of all continuation regimes. In “Regime Classification and Stock Loan Valuation,” Ning Cai and Wei Zhang develop a unified, fixed point approach to solving this regime classification problem under general regime-switching exponential Levy models with any finite numbers of regimes and general Levy types. Applying this result, they also provide a unified framework for the valuation of infinite maturity stock loans under general regime-switching exponential Levy models.

The impact of ECB loan valuation metrics on third-party loan pricing: A EU firm perspective

This paper delves into the implications for the bank behaviour about firm loan pricing conditions of the new direction undertaken by supervisory and regulatory authorities in the aftermath of the deterioration of the loan portfolio quality that hit EU banks. The 2014 AQR exercise embraces the new direction and extensively uses debt service coverage measures to assess a firm’s loan quality. We, therefore, check whether the DSCR has influenced debt pricing conditions by analysing a panel of 655 listed EU firms from 2009 to 2017. Our findings show that Z-score is unable to discriminate between high and low credit risk firms. The DSCR becomes significant only after 2014, highlighting the incremented importance of this ratio in the bank’s loan pricing determination. Our work contributes to the literature investigating third-party interdependencies with the interplay between lender-borrower relationship and loan pricing and further extends the literature on creditworthiness metrics beyond their mere default-prediction ability (Beaver, 1966; Houghton & Woodliff, 1987). Our results highlight the relevance of the DSCR in the bank’s loan pricing determination and inform firm managers about the drivers that influence the cost of debt thereby enhancing their operational and financial planning.

Securities Lending Strategies, Valuation of Term Loans using Option Theory

We develop models to price long term loans in the securities lending business. These longer horizon deals can be viewed as contracts with optionality embedded in them and can be priced using established methods from derivatives theory, becoming to our limited knowledge, the first application that can lead to greater synergies between the operations of derivative and delta-one trading desks, perhaps even being able to combine certain aspects of the day to day operations of these seemingly disparate entities. We run numerical simulations to demonstrate the practical applicability of these models. These models are part of one of the least explored yet profit laden areas of modern investment management. We develop a heuristic that can mitigate the loss of information that sets in when parameters are estimated first and then the valuation is performed by directly calculating the valuation using the historical time series. This can lead to reduced models errors and greater financial stability. We illustrate how the methodologies developed here could be useful for inventory management. All these techniques could have applications for dealing with other financial instruments, non-financial commodities and many forms of uncertainty. An unintended consequence of our efforts, has become a review of the vast literature on options pricing, which can be useful for anyone that attempts to apply the corresponding techniques to the problems mentioned here. Admittedly, our initial ambitions to produce a normative theory on long term loan valuations are undone by the present state of affairs in social science modeling. Though we consider many elements of a securities lending system at face value, this cannot be termed a positive theory. For now, if it ends up producing a useful theory, our work is done.

Can Loan Valuation Adjustment (LVA) approach immunize collateralized debt from defaults?

AbstractThis study focuses on structuring tangible asset backed loans to inhibit their endemic option to default. We adapt the pragmatic approach of a margin loan in the configuring of collateralized debt to yield a quasi‐default‐free facility. We link our practical method to the current Basel III (2017) regulatory framework. Our new concept of the Loan Valuation Adjustment (LVA) and novel method to minimize the LVA converts the risky loan into a quasi risk‐free loan and achieves value maximization for the lending financial institution. As a result, entrepreneurial activities are promoted and economic growth invigorated. Information asymmetry, costly bailouts and resulting financial fragility are reduced while depositors are endowed with a safety net equivalent to deposit insurance but without the associated moral hazard between risk‐averse lenders and borrowers.

Does the threshold matter? The impact of the monitoring activity on non-performing loans

PurposeThe purpose of this paper is to investigate whether the quality of the credit process is sensitive to reaching a particular threshold level of non-performing loans (NPLs) and, more importantly, whether higher NPLs ratios could make the monitoring activity ineffective.Design/methodology/approachThe empirical design is composed of two steps: in the first step, the authors introduce a monitoring performance indicator (MPI) of the credit process by combining the non-parametric technique Data Envelopment Analysis with some financial ratios adopted as input and output variables. As second step, the authors apply a threshold panel regression model to a sample of 298 Italian banks, over the time period 2006–2014, and the authors investigate whether the quality of the credit process is sensitive to reaching a particular threshold level of NPLs.FindingsThis paper finds that, first, when the NPLs ratio remains below the threshold value estimated endogenously, an increase in the quality of monitoring has a positive impact on the NPLs ratio. Second, if the NPLs ratio exceeds the estimated threshold, the relationship between the NPLs ratio and quality of monitoring assumes a positive value and is statistically significant.Research limitations/implicationsDue to the lack of data, the investigation of NPLs in the Italian industry across loan types combined with the monitoring effort by banks management was not possible. The authors plan to investigate this topic in future studies.Practical implicationsThe identification of the threshold has a double operational valence. The first regards the Supervisory Authority, the threshold approach could be used as an early warning in order to introduce active control strategies based on the additional information requested or by on-site inspections. The second implication is highlighted in relation to the individual banks, the monitoring of credit control quality, if objective and comparable, could facilitate the emergence of best practices among banks.Social implicationsA high NPLs ratio requires greater loan provisions, which reduces capital resources available for lending, and dents bank profitability. Moreover, structural weaknesses on banks’ balance sheets still persist particularly in relation to the inadequate internal governance structures. This means that bank management must able to recognise in advance early warning signals by providing prudent measurement together with an in-depth valuation of loans portfolio.Originality/valueThe originality of the paper is twofold: the authors introduce a new proxy of credit monitoring, called MPI; the authors provide an empirical proof of the Diamond’s (1991) economic intuition: for riskier borrowers, the monitoring activity is an inappropriate instrument depending on the bad reputational quality of borrowers.

Generalization of the Annuity Factor

The well-known Annuity Factor, restricted to constant payments only, can be generalized for time dependent payments. A Generalized Annuity Factor (GAF) broadens the application potential considerably as is shown exemplarily for the valuation of loans and pension obligations. For the first time for such linear and nonlinear payments over time, compressed closed-form formulae for important financial key numbers such as present value, duration, convexity or value at risk can be derived. Moreover, easy computation makes General Annuity Factors a useful valuation tool especially in the field of finance and accounting. As General Annuity Factors can be implemented as User Defined Functions in a spreadsheet program, calculations can also be done in smaller firms or public services. Because of its computational efficiency the new instrument is also suitable for far-sighted economical models such as Asset Liability Management models (ALM) or life-cycle valuation models concerning products or investments.

Stock loan valuation based on the Finite Moment Log-Stable process

The empirical test suggests that the log-return series of stock price in US market reject the normal distribution and admit instead a subclass of the asymmetric distribution. In this paper, we investigate the stock loan problem under the assumption that the return of stock follows the finite moment log-stable process (FMLS). In this case, the pricing model of stock loan can be described by a space-fractional partial differential equation with time-varying free boundary condition. Firstly, a penalty term is introduced to change the original problem to be defined on a fixed domain, and then a fully-implicit difference scheme has been developed. Secondly, based on the fully-implicit scheme, we prove that the stock loan value generated by the penalty method cannot fall below the value obtained when the stock loan is exercised early. Thirdly, the numerical experiments are carried out to demonstrate differences of stock loan model under the FMLS and the standard normal distribution. Optimal redemption strategy of stock loan has been achieved. Furthermore the impact of key parameters in our model on the stock loan evaluation are analyzed, and some reasonable explanation are given.

Securities Lending Strategies, Valuation of Term Loans Using Option Theory (Presentation Slides)

We develop models to price long term loans in the securities lending business. These longer horizon deals can be viewed as contracts with optionality embedded in them and can be priced using established methods from derivatives theory, becoming to our limited knowledge, the first application that can lead to greater synergies between the operations of derivative and delta-one trading desks, perhaps even being able to combine certain aspects of the day to day operations of these seemingly disparate entities. We develop a heuristic that can mitigate the loss of information that sets in, when parameters are estimated first and then the valuation is performed, by directly calculating the valuation using the historical time series. We run numerical simulations to demonstrate the practical applicability of these models. These models are part of one of the least explored yet profit laden areas of modern investment management.We illustrate how the methodologies developed here could be useful for inventory management. All these techniques could have applications for dealing with other financial instruments, non-financial commodities and many forms of uncertainty. Admittedly, our initial ambitions to produce a normative theory on long term loan valuations are undone by the present state of affairs in social science modeling. Though we consider many elements of a securities lending system at face value, this cannot be termed a positive theory. For now, if it ends up producing a useful theory, our work is done.

The impact of guaranteed bailout assistance on bank loan overstatement

Purpose– The purpose of this paper is to highlight how the basic binomial option pricing model (BOPM) might be used by regulators to help formulate rules, prior to financial crisis, that help prevent loan overstatement by banks in emerging market economies undergoing financial crises.Design/methodology/approach– The paper draws on the theory of soft budget constraints (SBC) to construct a simple model in which banks overstate loans to minimize losses. The model is used to illustrate how guarantees of bailout assistance (BA) (to banks) by crisis stricken countries’ financial authorities may encourage banks to overstate loans and delay the implementation of IFRS for loan valuation. However, the model also illustrates how promises of BA may be depicted as binomial put options which provide banks with the option of either: reporting loan values on poor projects accurately and receiving the loans’ liquidation values; or, overstating loans and receiving the guaranteed BA. An illustration is also provided of how authorities may use this representation to help minimize bank loan overstatement in periods of financial crisis. In order to provide an illustration of how the option value of binomial assistance may evolve during a financial crisis, the model is generalized to the Mexican financial crisis of the late 1990s. During this period, Mexican authorities’ guarantees of BA to the nation’s largest banks encouraged those institutions to overstate loans and delay the implementation of (previously adopted) international “best practices” based loan valuation standards.Findings– Application of the model to the Mexican financial crisis provides evidence that, in spite of Mexico’s “official” 1997 adoption of international “best accounting practices” for banks, “iron clad” guarantees of BA by the country’s financial authorities to Mexico’s largest banks provided those institutions with an incentive to knowingly overstate loans in the late 1990s and early 2000s.Research limitations/implications– The model is compared against only one country in which the BA was directly infused into banks’ loan portfolios. Thus, as conceived, it is directly applicable to crisis countries in which the bailout took this form. However, the many quantitative variations of SBC models as well as recent studies which have applied the binomial model to other forms of bailout (e.g. direct purchases of bank shares by authorities) suggest that the model could be modified to accommodate different bailout scenarios.Practical implications– The model and application show that guaranteed BA can be viewed as a put option and thatex-anteregulatory policies based on the correct valuation of the BA as a binomial option might prevent banks from overstating loans.Social implications– Use of the binomial or similar approaches to valuing BA may help regulators to determine the level of BA that will not encourage banks to overstate the value of their loans.Originality/value– Recent research has used the BOPM to value, on anex-postbasis, the BA which appears on the balance sheet of institutions which have been rescued. However, little research has advocated the use of this type of model to help prevent, on anex-antebasis, the overstatement of loans on poor projects.

Stock loan valuation under a stochastic interest rate model

Stock loans are loans collateralized by stocks. They are modern financial products designed for investors with large equity positions. Mathematically, stock loans can be regarded as American call options with a time-dependent strike price. This study is the first in the literature that considers the valuation of stock loans in a stochastic interest rate framework. Based on portfolio analysis, a partial differential equation (PDE) governing the value of stock loans is derived. A set of appropriate boundary conditions, particularly in the interest rate direction, are also proposed to close the pricing system. A sound justification is provided for the proposed boundary conditions mathematically as well as financially. To solve the proposed nonlinear PDE system, a predictor–corrector finite difference method is adopted. Moreover, an alternating direction implicit (ADI) method is used to improve the computational efficiency. Numerical results suggest that the current method is reliable and the stochastic interest rate leads to a higher optimal exercise price of the stock loan in comparison with that calculated from the Black–Scholes model.

Valuation of stock loans under a Markov chain model

In recent years the use of Markov chain models to model stock price movement has received increased attention among researchers. Markov chain models combine the discrete movements of a binomial tree model while retaining the Markovian properties of Brownian motion, thus allowing the best properties of both of these models. In this paper, the authors consider a Markov chain model in which the underlying market is solely determined by a two-state Markov chain. Such a Markov chain model is strikingly simple and yet appears capable of capturing various market movements. By proper selection of parameters, the Markov chain model can produce sample paths that are very similar to or very distinct from a classical Brownian motion, as the authors demonstrate in this paper. This paper studies the stock loan valuation, or the value of a loan in which a risky share of stock is used as collateral, under such a model. Dynamic programming equations in terms of variational inequalities are used to capture the dynamics of the problem. These equations are solved in closed-form. Explicit optimal solutions are obtained. Numerical examples are also reported to illustrate the results.

Semi-analytic valuation of stock loans with finite maturity

In this paper we study stock loans of finite maturity with different dividend distributions semi-analytically using the analytical approximation method in Zhu (2006). Stock loan partial differential equations (PDEs) are established under Black–Scholes framework. Laplace transform method is used to solve the PDEs. Optimal exit price and stock loan value are obtained in Laplace space. Values in the original time space are recovered by numerical Laplace inversion. To demonstrate the efficiency and accuracy of our semi-analytic method several examples are presented, the results are compared with those calculated using existing methods. We also present a calculation of fair service fee charged by the lender for different loan parameters.

Understanding the Fair Value of Bankss Loans

Loans are typically the largest asset class on banks’ balance sheets. So understanding the value of loans is vital to any assessment of the resilience of the banking system. This is not straightforward. The market value of loans is seldom observable. And the nature and diversity of banks’ loans has changed markedly over time: the maturity of loans has increased, on average; banks’ mortgage lending has ballooned; and banks use more hard information in their lending decisions. So it is unlikely that any one valuation technique will capture all relevant aspects of valuation across all types of loans. Recognising this, banks are required by accounting standards to disclose the fair value of their loans in the notes to their accounts. At the end of 2013, the fair value of the major UK banks’ loans was £55 billion less than the amortised cost value.This paper explains loan fair value techniques and compares these to other valuation approaches. Fair value approaches include elements of valuation that are not captured by amortised cost approaches, such as lifetime expected credit losses and embedded interest rate gains and losses. As such, fair value disclosures might provide additional insight into the value of some assets, such as longer-term, fixed-rate loans, like mortgages. But loan fair values, like all loan valuation approaches, come with a number of health warnings. For example, they may capture factors that do not necessarily have a bearing on banks’ resilience. As a result, a loan fair value number on its own is often insufficient, which suggests that there may be benefits to improved supplementary disclosures about the drivers of the fair value of banks’ loans to complement balance sheet values.

The Use of Tax Law from a Macroprudential Perspective: The Impact of Some Recent Tax Measures on Procyclicality and Bankss Stability

A number of recent changes to Italian tax law have important implications for financial stability. The taxation of banks’ loan losses has been revised, attenuating its procyclicality, encouraging the adoption of more prudential loan valuation policies and contributing to the transparency of banks’ balance sheet. For all firms, financial and non-financial alike, the allowance for corporate equity (ACE) system, which reduces the penalization of equity with respect to debt financing, has been reinforced, encouraging capital strengthening. Lastly, changes to the taxation of hybrid capital fund-raising have removed the impediments to issuing subordinated securities.

Valuation of stock loans with jump risk

A stock loan is a special loan with stocks as collateral, which offers the borrowers the right to redeem the stocks on or before the maturity (Xia and Zhou, 2007; Dai and Xu, 2011). We investigate pricing problems of both infinite- and finite-maturity stock loans under a hyper-exponential jump diffusion model. In the infinite-maturity case, we derive closed-form formulas for stock loan prices and deltas by solving the related optimal stopping problem explicitly. Moreover, we obtain a sufficient and necessary condition under which the optimal stopping time is finite with probability one. In the finite-maturity case, we provide analytical approximations to both stock loan prices and deltas by solving an ordinary integro-differential equation as well as a complicated non-linear system. Numerical experiments demonstrate that the approximation methods for both prices and deltas are accurate, fast, and easy to implement.

Valuation of stock loans using exponential phase-type Lévy models

Stock loans are collateral loans with stocks used as the collateral. This paper is concerned with a stock loan valuation problem in which the underlying stock price is modeled as an exponential phase-type Lévy model. The valuation problem is formulated as the optimal stopping problem of a perpetual American option with a time-varying exercise price. When a transformation is applied to the perpetual American option, it becomes a perpetual American call option in an economy with a negative interest rate, thus causing standard Wiener–Hopf techniques to fail. We solve this optimal stopping problem using a variational inequality approach.