LOAN VALUATION USING PRESENT

VALUE ANALYSIS

William ThomasU.S. Department of TreasuryOffice of Technical Assistance

   

 

OVERVIEWThis presentation covers loan

classification and present value calculations used in the valuation of loans. Loan valuation is used for analyzing decisions

regarding performing, sub-performing and non-performing loans.

Present value calculations, which include the analysis of risk and the time value of money, are required when asset disposition decisions have to be made.

   

 

Suggested Policy

Proper credit decisions require the evaluation of collection alternatives on a comparable basis. Therefore, it should be the policy of LPS to employ present value techniques to assist in determining courses of action most advantageous to LPS in the liquidation of closed bank loans.

    

What is Present Value Analysis?

Net present value: NPV compares the value of a dollar today to

the value of that same dollar in the future, taking inflation and returns into account.

If the NPV of a prospective collection exceeds the involuntary worst-case scenario, it should be accepted.

If NPV is negative, the offer should probably be rejected because cash flows are less than the worst case.

What is Present Value Analysis?

Present value: The current worth of a future sum of money or stream of

cash flows given a specified rate of return Future cash flows are discounted at the discount rate, and

the higher the discount rate, the lower the present value of the future cash flows.

Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.Also referred to as "discounted value".

Put simply the basis is that receiving $1,000 now is worth more than $1,000 five years from now, because if you got the money now, you could invest it and receive an additional return over the five years.

What is Present Value Analysis?

Time value of money: The concept that money available at

the present time is worth more than the same amount in the future due to its potential earning capacity. 

This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. 

 

Loan Classification

Determining loan status Is the loan performing, sub-performing or non-

performing? Performing Loan

Paying as agreed (less than 30 days past due) Expected to pay in full under the terms of the note No serious past delinquency or file documentation

problems Sub-Performing Loan

The borrower is presently performing but is ultimately projected to default due to a severe negative event in the future

Maturity with balloon payment due Major tenant move-out Loss of other major customer

    

 

Loan Classification

Non-Performing 30 days or more past due Past the note or modification maturity date Regardless of whether the borrower is making

payments

    

 Valuation of Performing

Loans

Valuation Usage Normally the first step in establishing a reserve price when

selling to the secondary market. Also used to get borrowers to refinance by creating a

discounted value. Refinancing should be encouraged for performing loans with

extended maturities that are not readily saleable or when the market for a particular type of loan is limited.

Market Value Performing loan value is calculated through a Mark-to-Market

process in which the remaining payments are present valued using current market yield requirements for similar loans. The result of this discounting is called the Market Value.

    

 Valuation of Performing Loans

Market Rate Performing loan market value is calculated by using a current

market yield for similar types and quality of loans. The current market yield is comprised of a base rate, which is

the rate for good quality, market-standard loans, adjusted for the characteristics of specific loans.

Base Rate May be well defined for loans such as residential mortgages. An estimation may be required for loans with unique terms. May be determined through recognized publications or

through surveys of local lending institutions. These surveys should be recorded and updated periodically.

    

 Valuation of Performing

Loans

Adjusting the Base Rate Specific loan factors can affect the base rate. These

are determined by reviewing the loan file (due diligence.)

Past delinquency history Documentation deficiencies Geographic location if the base rate does not reflect local

lending practices. The current market yield is the result of adjusting the

base rate for any of these factors.

    

 

Valuation of Performing Loans

Adjusting the Base Rate Here are some sample standardized adjustments used by the

FDIC in valuing performing loans:

Missing Documentation Adjustments

Original note/credit agreement 200bpFinancial statement 100bpCredit file (including F/S) 300bp

Credit

More than 30 days delinquent 2 or more 200bptimes in the past year

    

 Valuation of Performing

Loans

Adjusting the Base Rate

Curable documentation deficiencies, such as a missing appraisal, should not be included in the standard adjustments.

Sometimes it is more advantageous not to cure such deficiencies, though in this case, yield adjustments should be made.

Adjustments for curable deficiencies should not exceed 100bp.

    

 Valuation of Sub-

Performing and Non-Performing Loans

Present Value Methodology Net Present Value of the Estimated Cash Recovery (NPV-

ECR) Based on a liquidation scenario Established by estimating, over time,

Cash recoveries Direct expenses Payment of any prior liens

Estimated net cash flows are then present valued using an appropriate discount rate

This rate reflects the risk associated with: The sources of the ultimate collection The estimated timing of the cash flows

   

 Valuation of Sub-

Performing and Non-Performing Loans

Liquidation Scenario Decisions on a compromise, restructure or sale are

based on the same established value. Broadly defined as the cash flows from:

Foreclosure/repossession, holding and sale of collateral. Collection through litigation from identifiable assets of the

borrowers or guarantors. For sub-performing loans, NPV-ECR may also include

projected principal and interest payments until default occurs.

   

 Valuation of Sub-

Performing and Non-Performing Loans

Analyzing Alternatives The liquidation scenario is essentially the worst-case

scenario It should be used as a base-line in comparing other

options, particularly a cash offer by the borrower to compromise the debt.

The cash offer should have present value analysis performed at a realistic discount rate, factoring in down payment and perceived risk factors.

This helps provide for a realistic counter-offer to the borrowers proposal and ultimately to justification for accepting the settlement for less than payment in full.

    

 Valuation of Sub-Performing

and Non-Performing Loans

To calculate the NPV-ECR: Project quarterly cash flow estimates for the first two

years, and annually thereafter. Project cash flows starting from the time the estimate is

made. First quarter recoveries are those estimated to occur

within 90 days, second quarter between 91 and 180 days, etc.

Discount all cash flows quarterly, even if they are beyond the first two years.

PV calculations assume all cash flows occur at the end of the period in which they are estimated.

ECR cannot exceed total principal and interest due.

    

 Projection of Cash Flows

Sources of Recovery When estimating cash flows, consider all potential

sources of recovery, including: Collateral

Based on current appraisals Recognized publications Should be based on current values and not factoring in

projected or expected future market changes Other attachable or recoverable assets of borrowers and

guarantors More subjective and should be very conservative Based on:

Financial statements Credit reports Asset searches and legal depositions

    

 Projection of Cash Flows

Sources of Direct Expenses Type and amount vary by sources of recovery and

collection laws For NPV-ECR, direct cash collection expenses include

items such as: Legal fees Advances to protect asset (property tax, insurance, etc.) Payment of prior liens Foreclosure costs Selling expenses Appraisal fees Operating Expenses Management fees Other direct expenses not listed here

    

 

Projection of Cash Flows

Indirect Expenses

No deduction should be made for indirect expenses such as the LPS’s internal overhead or administrative costs of doing business.

    

 Timing of Cash Flows

The timing of estimated cash recoveries and expenses depends on:

Repossession and foreclosure law Litigation and bankruptcy scenarios Estimated selling time for foreclosed collateral Example:

If the foreclosure takes 3 months and holding period is six months, then the recovery is projected in the third quarter

The cash recovery is listed at the time of sale, not the time of foreclosure

Expenses should be placed in the periods in which they are expected to occur.

LPS could standardize certain time frames, such as foreclosure, repossession and holding periods for different types of collateral

   

 When to Get Legal

Assessment

When a projected recovery is based on the questionable outcome of a court decision:

The NPV-ECR should reflect counsel’s assessment of probable success

An outcome is questionable when the probability is less than 75%

The probability of success percentage provided by counsel should be applied only to those cash flows resulting from a successful outcome

It would not affect any recoveries or expenses prior to or unrelated to the court decision

If the probability is 75% or greater, no adjustment should be made

    

  Documentation

The documentation required to estimate recoveries depends on the size and type of loan:

For very small loans, estimated recoveries may be based on existing information and credit information

Certain mortgage loans may only require an appraisal to calculate NPV-ECR

For larger loans efforts should be made to obtain documentation to establish the recovery estimate

Collateral appraisals, asset and lien searches, credit reports, financial statements, etc.

The collector’s personal feelings about the debtor or collectibility should not be factored in

Obtaining such information can often increase the valuation of the loan and outweigh the cost of gathering the information

    

 Discount Rates

Measuring Risk Discount rates used to present value the NPV-ECR

measure the potential risk associated with: Sources of recovery The timing of the projected cash flows An appropriate return on investment to LPS or a purchaser

For example: Less risk should be associated with estimating recovery

on a performing mortgage loan with a current appraisal than on an unsecured loan without current financial information.

   

  Discount Rates

Discount Rates for NPV-ECR Here are some sample discount rates used to present

value the NPV-ECR that were utilized by the FDIC:

Sources of ECR Discount Rate

At least 20% of total ECR from Prime + 5Real Estate Collateral

Less than 50% of total ECR from Prime + 7Real Estate Collateral

ECR entirely from sources other than Prime + 10Real Estate Collateral (includes Unsecured loans)