By Will Mercer, Managing Director of Analytics
As we get closer to year-end, we continue to face unprecedented economic and market uncertainty. Determining fair value for loan portfolios typically involves overcoming imperfect data in the best of times and making assumptions to fill in those gaps has become increasingly difficult in the current environment.
Of course, it is precisely at these times of market flux when management and stakeholders have the greatest need for accurate and transparent information. There are a number of factors that will bring fair value into much greater focus for the financial year-end.
Insufficient Real-Time or Market Information
As noted above, even in “normal” times, most financial institutions have insufficient insight into a borrower’s financial condition or the status of underlying collateral. For a variety of factors, many institutions have difficulty updating loan information after origination, and often updates are not a requirement. During the pandemic, operational cash flows have become unpredictable and market values of underlying loan collateral were undoubtedly impacted. Thus, loan data supplied even six months ago is of suspect accuracy.
Using commercial real estate loans as an example, one intuitively knows that stated debt service coverage and loan to value are inaccurate unless there has been real-time re-underwriting. While loans in forbearance may have garnered extra scrutiny, many other problem loans are looming out there, balancing on the precipice. Given this lack of current intelligence, many professionals will not feel confident making fair value judgments.
Higher Scrutiny Around Year-End Financials
For public entities, it is quite normal that the year-end audit would drive higher scrutiny than the quarterly review reports. Assumptions are likely to be challenged and judgments may be second-guessed. Outsourcing fair value could help streamline and clarify follow up discussions between auditors, regulators, senior management, and risk oversight teams. Additionally, board members get an extra level of comfort that potential risks have been reviewed, measured, and addressed.
Given the events of this year, there are already expectations that auditors and regulators will apply this higher level of scrutiny for this year-end cycle. For public filers, the SEC has already questioned some of the disclosures for fair value accounting as evidenced by comment letters. The questions raised in those letters were around the valuation techniques and key inputs used to determine the fair value, as well as the quantitative information provided for significant unobservable inputs used in Level 3 fair value measurements.
Most institutions recognize that fair value measurement should not be purely a financial reporting exercise and it is short-sighted to treat it as such. As the economic environment continues to be volatile, banks and financial institutions need to take stock and assess the true picture of their portfolios and exposures in order to get ahead of potential risks earlier. Portfolio management groups often look beyond their own internal experience and leverage the expertise and market data of third parties in order to identify potential exposures early and minimize their impact.
Focus on Time/Resources
Finally, in addition to a higher degree of objectivity, utilizing expert third parties for fair value of loan portfolios is more time and cost efficient. Expertise, time tested models and access to unique market data allow third parties to complete fair value of portfolios in a much more efficient manner, plus they have experience and documentation auditors require in order to validate results.