By Will Mercer, Managing Director of Analytics
The great statistician George Box is known for his many accomplishments and a certain quote about data-driven models. One variation is particularly germane to fair value calculations in times of economic turmoil:
“Since all models are wrong, the scientist must be alert to what is importantly wrong. It is inappropriate to be concerned about mice when there are tigers abroad.”
As the nation’s largest provider of loan level fair value to banks, insurance companies, funds and government agencies, DebtX is thinking a lot about George Box’s tigers. It might seem that we could easily guide our clients through the pricing jungle given our access to unparalleled amounts of new origination and trade data from our various internal platforms.
In fact, it’s quite the contrary. Rarely do we see what is needed to capture the desired quarry. Instead, we see stale loan data, and that is a big hurdle in terms of knowing what may be lurking in the shadows.
Inaccurate credit characteristics are particularly troublesome in times of economic stress. Many lenders do not update important data like LTV, DSC, DTI, etc., post origination. Some only update annually. As a result, we are currently seeing retail and hospitality loans showing debt service that logically does not exist. Further, it is not just a few lenders here and there. It’s a systemic problem.
Fair Value and Stress Testing
Calculating fair value without updated loan information will not reflect the performance of the credit. Certainly, spreads will be much wider in any modeling exercise during times of tumult, and prices will change around the margins. However, the downside can be muted as underlying rates have concurrently declined quite a bit.
Thus, if management teams are not currently stress testing and looking hard at loan-level credit factors, they are missing the bigger potential downside. To maintain a firm grasp on risks to capital, it is essential to make realistic estimates about collateral performance. And why not formulate a plan now, before regulators focus on the issue?
Many of the larger financial institutions have done just that. Their reported results under CECL have resulted in some very sizable reserves. The fairly stunning numbers really reflect future stress at the loan level. However, if your institution is not subject to CECL as yet, we recommend at least some basic sensitivity analysis of key metrics that have changed or will change in the near term.
What To Do? Call DebtX
DebtX has proven solutions to help institutions better understand their portfolios and save time and money.
In addition to traditional stress testing, DebtX’s Credit Default Analytics solution (DXCDA) is a fully outsourced solution that calculates a loan portfolio’s expected losses with loan-by-loan granularity. It provides an immediate view about any potential capital impact from shifting credit and market characteristics.
DebtX runs all calculations and provides outputs in the format that best fits each bank’s accounting platform. DXCDA leverages the most robust historical data set in the market for both performing and non-performing loans. DXCDA can also be used for your firm’s CECL calculations.
To get a portfolio analysis from DebtX, click here.