Toxic Bank Asset Valuation Principles

Many of these questionable loans encounter repayment trouble because the real estate collateral fails to perform as expected, the borrowing entity fails to perform as expected, or any other of a myriad of problems that find their way to loans these days.

Other more arcane assets, such as high-risk tranches (or “cohorts” for those of you opposed to using French terms) of commercial mortgage backed securities (“CMBS”), collateralized debt obligations (“CDO”s) and other incarnations of securitized loan products often find their way into the troubled asset category.

When any these situations occur, the result

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is what has become known as a “toxic asset,” that is, one that is worth less than the indebtedness it secures. Then, the question becomes, “How much is this asset worth?”

Toxic Real Estate Assets

Usually, this is not an easy question to answer, but there are enlightened methodologies that can be implemented in approaching the problem of valuing a troubled real estate property:

● Keep in mind that the value of any financial or real estate asset has to do with the cash flows that can be expected to flow from the asset. These cash flows can be regular or irregular cash payments from the asset, capital sales from the assets, or a final sale of the entire or remainder of the asset.

● In effect, a feasibility study has to be performed for a real estate asset or a portfolio of real estate assets being valued as toxic assets. The feasibility study must consider and make supportable assumptions regarding the future performance of the real estate market and the particular segment of the real estate market that encompasses the subject property. A realistic schedule and timetable of anticipated cash flows from the asset must be established based upon realistic and supportable future market scenario assumptions. These factors are important considerations in estimating when cash flows will occur and the size of the cash flows.

● A realistic estimate and schedule of any foreseeable cash outflows that will be required to achieve the cash inflows must be established. The potential outflows may include items such as repairs, taxes, insurance, management fees, and many other items.

● Due to the time value of money, the estimate of the timing of these cash flows is critical in establishing a credible value for the asset.

● The cash flows must be net present valued to the correct date in order to establish a credible value.

● A realistic and supportable discount rate must be used in these calculations.

As you can see, there are many factors that have to be considered, estimated, and incorporated into the valuation analysis for an individual toxic asset or a portfolio of toxic assets.

Toxic Financial Assets

Here are several helpful methodologies that can be implemented in approaching the problem of valuing a financial asset such as CDOs, CMBS, residual interests in loans, or other asset-backed security toxic financial assets:

● Completely read and understand the documents that create and describe the particular security you are valuing. These assets vary greatly in how they are structured. Do not rely on assumptions based upon past experiences.

● A feasibility decision has to be made regarding the likelihood of the success or failure of the financial asset, or a portfolio of assets, being valued as toxic assets. The feasibility study must consider and make supportable assumptions regarding the future performance of the underlying market that generates the cash flow on which the particular financial asset relies. Then a realistic schedule and timetable of anticipated cash flows from the financial asset must be established based upon realistic and supportable future market scenario assumptions. These factors are important considerations in estimating how much cash will be available to make payments to investors and when.

● If any of the assets are covered by credit default swaps (“CDS”), make a realistic evaluation of the ability of the seller to make good on their guarantee. This is more involved than you might think since an analysis has to be made of the total level of CDSs that the seller has outstanding, the likelihood that the seller will be called on to make good on its guarantees, what volume of CDSs will the seller most likely be called on to fund, and the seller’s ability to meet its obligations.

● Due to the time value of money, the estimate of the timing of future cash flows from these assets, including any proceeds from CDSs, is critical in establishing a credible value for the asset.

● The cash flows must be net present valued to the correct date in order to establish a credible value.

● A realistic and supportable discount rate must be used in these calculations.

Summary

Valuing toxic assets is quite a different job than straight business valuation or accounting exercises. The job involves several skill sets that are difficult to find in one place. There are multiple steps to the process, and each one has its own challenges.

This copyrighted article may not be duplicated, altered, distributed, saved, incorporated into another document or website, or otherwise modified without the author’s written permission in advance.

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ABOUT THE AUTHOR: Don Coker
Don Coker is an experienced banker, mortgage banker manager, consultant, and banking regulator who has successfully managed and marketed hundreds of millions of dollars of distressed and foreclosed properties nationwide as well as partnership and corporate debt. His background includes experience with Citicorp and entities that are now Bank of America, JPMorgan Chase Bank, and Regions Financial. His valuation training includes a Certificate in Business Valuation from the Harvard Business School. Mr. Coker has been engaged numerous times by the FDIC, RTC, IRS, and other governmental entities. Sixty banks worldwide, including 8 of the country’s top 10 banks and 12 of the world’s top 45 banks, as well as 33 of the country’s top 250 law firms, have called on Mr. Coker for advice. Widely published in finance. Mr. Coker serves clients worldwide from his northern metro Atlanta-area office.

Copyright Don Coker

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.