The progression towards commercial banks marking their loans to market seems almost inevitable, says Sophie Roell in New York. A new tool from Moody’s KMV can help banks to price loans and, more importantly, could help them with value management.
Ask fund managers how much their assets are worth and the answer will come quickly. In the fund management industry, marking assets to market every day has long been the norm. Not so for banks, however, whose loan portfolios constitute a kind of black box of assets, which are unlikely to see the light of day except in the case of a disaster. Ask loan officers what their portfolio is worth today – or even last quarter – and they would be hard pressed to say. Jeff Bohn, managing director at Moody’s KMV, is trying to change that.
With its newly-developed CreditMark tool, the credit risk measurement company hopes to prod banks into measuring the value of their loan portfolio and mark their loans to market on a regular basis. “With CreditMark, you now have the technology to do that,” says Mr Bohn. “The technology allows you to move much more to an asset management mindset.”
Value calculation
CreditMark pulls together data from various markets – like spreads in the credit default swap market or in the corporate bond market – and combines that information with a Moody’s KMV-developed credit measure known as Expected Default Frequency (EDF), which uses the equity market to proxy underlying credit risk. The resulting valuations are close to what the bank loans trade at in the secondary market, when they do trade.
In a comparison with prices indicated by Loan X, a provider of loan price data, Moody’s KMV found that just over 70% of loans valued using CreditMark came within two points of the bid/offer spread.
Mr Bohn attributes the product’s successful development to a convergence of more sophisticated ways of modelling default probability, expected recovery, liquidity and the risk premium (the result of years of research not just by Moody’s KMV but also by others) at the same time as the greater access to different credit markets, such as the credit default swap market.
“Putting the two together and then having an organising framework that is really what we are trying to do, creates the ability to do this kind of modelling,” he says.
No excuse
Banks’ argument that regular loan valuation is impossible in practice given the lack of liquidity in the loan market is clearly weakened by tools such as CreditMark. So the progression towards commercial banks marking their loans to market, perhaps ultimately even on a daily basis, seems almost inevitable. As investors and regulators demand greater transparency about the value of banks’ loan books, pressure may grow for banks to give a clearer idea of what their loans are worth.
So far, however, the overwhelming response has been resistance. For example, Donna Fisher, a director at the American Bankers Association (ABA), argues: “We agree with fair value accounting if an item is to be traded, or if an item is being held for sale. But if they are not, loans should not be marked to market.” She says that the Canadian Bankers Association, the Australian Bankers Association, the European Federation of Banks and the Japanese Bankers Association share this view. The group “unanimously agrees that loans should not be marked to market”, she says.
Early converts
The formal adoption of mark-to-market principles in banks’ accounts may not be imminent, but Mr Bohn already has some converts, including Bank of America (BOA). John Walter, senior vice-president of risk capital and portfolio analysis at BOA, says the bank has been using CreditMark “for more than a year now, to run weekly valuations of portions of our commercial and middle market loan portfolios and to communicate the results to portfolio managers. They appreciate having a single site where they may view their portfolio valuations, browse data from multiple markets and run scenario analysis to understand the drivers of loan value better”.
BOA is trying to move its lending business from an originate-and-hold model to an originate-and-distribute, so keeping an eye on market valuations of its loans is expedient. In the developing market for secondary loan trading, the CreditMark product has been welcomed as a source of independent third party pricing, supplementing indicative prices offered by dealers. Participants say that in the long-term, more objective valuations, such as CreditMark potentially provides, will allow banks to become more comfortable trading with each other, boosting liquidity in that market.
Value management
In its broadest application, CreditMark is not so much about pricing loans that a bank might want to sell as it is about managing value, a job that Mr Bohn suggests commercial banks do not do very well. He is particularly critical of banks for incentivising loan originators on the basis of volume – leading to the accumulation of huge, concentrated portfolios – rather than looking at the risk-adjusted return of each loan. “It’s all about encouraging people to evaluate loan price,” he says.
For example, some companies get cheaper funding because banks tend not to price in the possibility that the company will pre-pay and borrow again at a lower rate. CreditMark can put a price tag on that prepayment option. “This option to pre-pay has some value associated with it. Most bankers when I talk to them say: ‘We don’t really think about that.’ What I’m suggesting is that those banks start either adding in some extra spread to account for this option (that would be one strategy) or, if they don’t think they can do that because of competitive pressures, at least when they’re evaluating the overall profitability of a particular customer they can take that into account,” says Mr Bohn.
Vital knowledge
This focus on the profitability of a particular customer is key. In a deteriorating market, where some borrowers may be facing difficulties, keeping abreast of the value of loans can be especially vital. With faster access to better information, the idea is that banks will be able to mitigate risk by selling a loan, hedging it or taking some other action.
That does not necessarily spell the end of relationship banking, according to which, in one view, part of a bank’s role is to see companies through the tough times, eschewing the fickleness of the public markets. “It’s not that you necessarily exit the relationship when the value of the loan is deteriorating. It’s just that you need to figure out a way to hedge it. And to the extent that you’re earning other types of fees from that client – then you’re still in good shape – that’s just a cost of doing business,” says Mr Bohn.
He argues that CreditMark could help to expand relationships with some companies to which a bank has a lot of exposure. It could, for example, encourage the bank to hedge risk in the credit default swap market (if that looks relatively cheap) as an alternative to cutting off lending altogether.
With credit portfolios managed more efficiently, banks can focus on service and on building up the more profitable, fee-based business. “A lot of value can be unlocked in the commercial banking business if they come around to this paradigm,” says Mr Bohn.
“But there’s a lot of resistance,” he says, warning that this could, in the long term, result in a situation in which everything a bank does is done better by other types of firms. “One idea to think about is taking a service firm, for example Microsoft, to provide the technology to do the servicing (for example, to write cheques or get mortgages) and if they hooked up with an asset manager like Fidelity, then potentially you have a more cost-efficient approach to manage the credit portfolio on the one side [by an asset management firm] and then build the service business on the other side,” suggests Mr Bohn.
