Fair value is the amount for which a note could be bought or sold in a transaction between willing parties. The price represents a distillation of historical and expected charge-offs, prepayments, market risks, liquidity and required investor returns. Most consumer loans are not traded, thus accurate portfolio valuation relies on modeling informed by observed loan and financial-market data.
Valuation approaches may vary from simple NAV adjustments to income approaches to complex quantitative methods. One form of the NAV adjustment approach is built into the LendingClub interface and provides a rough cut at portfolio valuation. That approach is described here, and it may not be a bad start for individual retail investors. However, it can be viewed as too limited for professional investors, with their fiduciary responsibility to understand the key factors that drive portfolio performance.
Without proper valuation analysis portfolio performance is commonly based on the following weak measures:
Current Yield: Can be highly skewed depending on the age of the notes, vintage mix, and many other factors.
Yield based on raw NAV: NAV reflects the amount which the borrower has an obligation to pay. The actual payments will be very different.
Yield based on adjusted NAV: Adjusted NAV takes potential losses into account, but ignores the timing of losses and cost of capital requirements.
Coupon rate less expected losses: Ignores the time value of money and amounts to be received from borrowers.
The income approach has become widely accepted as a reasonable middle ground. It is thorough enough to address common concerns about expected cash flows and market risks. And the complexity of quantitative methods may not always be justifiable for traditional unsecured consumer term loans. The types of loans that do require quantitative techniques, such as Monte Carlo simulations, are those where loan performance is path dependent, e.g. mortgages, where values depend on the historical path interest rates took to their current levels.
A typical income approach, or discounted cash flow analysis, projects expected payments from each individual loan based on defaults, prepayments and recoveries. Then these expected future payments are discounted to estimate their present value. The discount rate used is at the core of every income-approach-based valuation, yet it’s highly subjective.
Analytical Strength of Portfolio Valuations
While some observers have noted the limited precision offered by traditional valuation methods, portfolio valuations often provide critical and actionable information. This is because valuation methods can be very unreliable in providing stand-alone point estimates, but shine when it comes to tracking changes in value, especially when value is normalized against observable pricing information.
Most valuations assume that loans are priced fairly, thus providing an opportunity to normalize key inputs such as discount rates. The assumptions are adjusted over time based on observable data such as vintage performance or changes in market rates. When accurately implemented, a drift in valuation model outputs can provide a clear view of portfolio performance.
Strong valuation approaches:
Income Approach: Incorporates all key factors such as expected charge-offs, prepayments, recoveries and market risks.
Binomial Method: Incorporates the same factors that the income approach does, and adds other key drivers such as interest rate volatility.
Monte Carlo Simulation: This method is necessary where loan value is path dependent – think of debt where prepayments are sensitive to movements in interest rates.
Portfolio valuations are fundamental to tracking the investment performance of illiquid securities or reporting the true current financial position of a fund. While the choice of a valuation methodology itself can be subjective, it is important not to choose a too-simple method, which may provide highly misleading results.
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