The fair value of a loan portfolio may need to be measured for many reasons, including two common purposes:

• Recording the fair value of an acquired loan portfolio under Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 805—Business Combinations
• Making a quarterly disclosure of the fair value of financial assets and liabilities under FASB Accounting Standards Update (ASU) 2016-01—Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities

Understanding how to define fair value along with the valuation methods applicable to your loan portfolio can help you be prepared for either purpose.

Defining Fair Value

Under ASC 805, Business Combinations, and ASC 820, Fair Value Measurements and Disclosures, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement  date.

ASC 820 Overview

As a basis for considering market participant assumptions in fair value measurements, ASC 820 establishes a fair value hierarchy that distinguishes between observable and unobservable inputs:

• Observable inputs are based on market data obtained from sources independent of the reporting entity.
• Unobservable inputs are derived from market-participant assumptions and rely on the best information available under the circumstances.

The fair value hierarchy prioritizes inputs to valuation techniques used to measure fair value into three broad levels, giving the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities at Level 1 and the lowest priority to unobservable inputs at Level 3.

Inputs used to measure fair value may sometimes fall into more than one level of the fair value hierarchy. In such cases, the fair-value level should be assigned based on the lowest level input that’s significant to the fair value measurement. Assessing the significance of a particular input requires consideration of the factors specific to the asset or liability.

Loan Portfolios

Loan portfolios fall under Level 3 of the fair value hierarchy because they require pricing models that employ unobservable inputs and estimates of market participant assumptions.

Valuation Methods

Loans are commonly valued using income approaches that model expected future cash flows from the loan at a market participant discount rate. These models allow for the modeling of certain loan characteristics including the following:

• Account types
• Interest rates or coupons
• Timing of principal and interest payments
• Loss exposure
• Collateral type
• Remaining principal balances and terms

In doing so, three important assumptions are made regarding the following:

• Discount rate
• Default and recovery rates
• Prepayment rates

Discount Rate

The discount rate that’s applied to a loan should reflect the rate that would be required by a market participant, given the date of value-interest rate environment for a loan with similar attributes, such as:

• Duration
• Risk profile
• Illiquidity
• Other relevant factors

A discount rate build-up can be employed.

While recent origination rates can provide some information, these aren’t considered market participant assumptions. A notable flaw in recent origination rates is that the originator often receives some type of origination fee that doesn’t benefit the purchaser of the loan.

For variable-rate loans, special attention can be given to the applied discount rate. Adjusting a discount rate to the valuation of a variable-rate loan may mean applying a forward-rate curve or adjusting the fixed discount rate based on fixed and floating rate-swap pricing.

Default and Recovery Rates

The probability of a loan default should be modeled into periodic cash flows. Any expected credit loss models already in place can be used for this assumption. Credit quality ratings assessed on the loan origination date should also be reassessed at the date of value.

Prepayment Rates

While conditional prepayment rates are commonly available for mortgage loans, other loan types will require management to estimate the future prepayment speeds. This estimate can be based on the following:

• Historical experience
• Prepayment expectation models
• Third-party analysis

ASC 805 Overview

Under ASC 805, the fair value of loan portfolios needs to be determined because they’re identifiable and separable assets.

All business combinations must be accounted for using the acquisition method of accounting. Under the acquisition method of accounting, all identifiable assets acquired—including goodwill—as well as assumed liabilities and any non-controlling interests should be recorded on the opening balance sheet at fair value.

Purchased Loans

Purchased loans fall into one of three categories.

Category 1

ASC 310-30, Purchase Credit Impaired Loans, requires separate valuation to account for impaired loans that meet the following criteria:

• Evidence of deterioration in credit quality subsequent to origination
• Probability that the acquirer will be unable to collect all contractually required payments from the borrower

ASC 310-30 then uses the acquirer’s expected cash flows at acquisition as the basis for calculating the loan yield and determining subsequent impairment. This model results in a level yield over the expected life of the loan. Loans with revolving privileges are specifically scoped out.

Category 2

All other loans under ASC 310-20, Performing Loans, require the use of contractual cash flows to determine yield and subsequent impairment. The entire discount or premium is accreted to par, generally over the remaining contractual term of the loan.

Category 3 (Optional)

Loans purchased with a discount due, at least in part, to credit quality. A policy election by an acquiring institution can be made to apply ASC 310-30 by analogy. Once elected, loans in this category follow all aspects of ASC 310-30.

Pooling and Grouping Loans

Performing loans can be analyzed at the individual loan level or by loan pools. While loan-level calculations allow for a greater degree of control for loan-specific characteristics, loans of similar types can be grouped into homogeneous pools and analyzed at the pool level. For example, all performing owner-occupied commercial real estate loans with fixed coupon rates can be pooled.

Loan pools are required to have the following common risk characteristics:

1. Similar credit risk or risk ratings
2. One or more additional predominant risk characteristics—purchase-credit impaired loans need to be evaluated on a loan-by-loan basis

Downsides of Certain Models

If you have current asset liability management (ALM) or asset liability committee (ALCO) models, you might be tempted to use them to calculate fair value. However, fair value requires the use of an exit-price notion, but banks typically build their asset-liability management models to measure based on an entry-price method.

While ASC 820 prioritizes valuation inputs from observable market transactions, finding this for loan portfolios similar to those of a community bank is unlikely. This necessitates the use of a valuation model that would be tailored to specific loan portfolios and considers the following:

• Categorization of loans into pools with similar characteristics
• Contractual cash flows of principal and interest considering maturity, prepayments and repricing features
• Credit losses from potential future defaults net of recoveries
• A discount rate determined from a market participant perspective

We’re Here to Help

If you have questions or would like assistance determining the valuations of your loan portfolio, please contact your Moss Adams professional.