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Incorporating New Fixed Income Approaches into Commercial Loan Valuation

Scott Aguais and Anthony M. Santomero

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: Growing competition, convergence of the loan and capital markets, and the greater complexity of commercial loan structure have heightened the need for banks to manage their loan portfolios in a more sophisticated way. This is true for the management of individual transactions and for the loan portfolio as a whole. In order to do so, each and every loan must be valued more accurately to account for the credit risk imbedded in the loan, loan migration, its structure and subsequent periodic fees and repricing agreements. In short, loans must be priced in a much more dynamic and complete way than is the case today. To do so, however, requires that banks acquire a deeper understanding of loan valuation and apply the newer techniques of the bond market to the loan market. Specifically, the new standards to credit analysis require the following steps to be taken: Loans must be accurately rated, monitored, and tracked through time. This history will prove important, not only for the existing loan, but also for all subsequent loans that can benefit from the migration pattern that is unique to the specific institution. A. The credit officer must more accurately value the underlying pricing conventions built into the loan market. These are often neglected when loans are priced as bonds. The existence of a repricing grid, a periodic fee structure and various repricing techniques are often neglected in favor of the assertion that loans are merely small bonds. B. Structure must be more accurately priced. Towards this end, it is necessary for the individual institution to recognize that structure has value. It should be quite apparent that the options imbedded in the loan portfolio have value; we have known the value of options imbedded in bonds for some time. As the derivative market has expanded, we trade these options that are part of the collective loan agreement in isolation. It is incumbent upon the banking community to more accurately price these options and to incorporate them into the pricing of loans that have imbedded options. To do all this would result in an improvement in the ability of banking institutions to value their loans, define their required spreads, and to both aggressively and accurately compete. It is often the case that structure and repricing are powerful tools to be employed in the competitive financial community. At the moment, however, structure is often given away and options are often neglected in competitive bidding. Banks can compete more effectively for their customers and have higher yielding loan portfolio to the extent that they have the ability to price the value of these options, to use the repricing of the credit spread and to know the migration of credit quality that is specific to the credit portfolio of their particular bank. There is no question that the market for credits is under severe competitive pressure. In such an environment, knowledge of the underlying portfolio and its value is the only true weapon for successful competition. Those that lag behind will be gamed by competitors and gamed by their customers. They will find they are subject to what academics call "the winner's curse." They will lose the good deals and win the bad ones. In today's world, information about the underlying lending relationship is the only adequate defense for a successful banking firm.

Date: 1997-12
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