Defining Collateral Valuation - a New Way of Thinking
Recent events in the financial markets bring to mind the final scene of Shakespeare’s The Merchant of Venice: No-one can remember the amount of interest charged for the loan, but everyone remembers that the collateral was in the form of human flesh. In business, as in the play, it is collateral, not the interest rate or the value of exchange, that determines the basis of a transaction.
The financial crisis is forcing financial professionals to discard one of their most important tenets – interest as a medium of value creation. For many asset classes, in these times of uncertain liquidity and reduced opportunities for market-making, there are few benchmark price points available to measure and quantify risk. This evaporation of market-making for certain asset classes, together with a changing risk premium definition for many derivative instruments, has raised new challenges in valuing collateral and defining interest rates to determine cash flow. In this context, risk premium is reaching heights that make it difficult for the firms to seek credit lines without impacting their own return on investment (ROI) calculations.
What we are seeing today, with eroding portfolio values and the volatility this poses to cash flows defined through a series of interest calculations, is a shifting of the debate from market risk management to liquidity risk management. In classical financial theory, liquidity ratios provide insight into a firm’s abilities to meet its short-term financial obligations. In layman’s terms, current assets need to be higher than current liabilities. However, if one looks into today’s unfolding crisis, these ratios are working against the viability of many firms in the long run. Many of these firms have sound business models, great customers and, in the long term, will probably add to the value creation of an industry. They, therefore, feel their long-term growth story is intact. These firms are likely to further invest to protect their turf in expectations of better days, further eroding liquidity and quality of assets. In fact, unless they address this quickly by unwinding leverage and recognising the losses on the book, these firms may be unable to change impending events.
Reflecting this volatility, the pledged collateral, which is initially equivalent in value to the amount owing, will be subject to change against the benchmarked price points. Pressing for higher value payment protects the lender’s risk exposure but can’t be viewed as a rational approach in all market conditions. The lender’s practice of discounting the initial value of collateral has its consequences in the presence of a liquidity crisis. In this context, a higher ‘haircut’ is not synonymous with lowering the long-term risk of an exposure.
Although in normal market conditions a higher haircut lowers the risk of exposure, the same can’t be said to be true in all circumstances. A high haircut often creates undue pressure on the firm’s business, which is a going concern, and even more so if the collateral is the base for the business. In this context, it is in the lender’s interest to ensure collaterals are meaningfully measured and valued before the margin calls are pressed. Although value at risk (VaR), additional VaR and expected shortfall measures provide some framework to understanding the risk and risk exposure, their application needs sound rational and business thinking. In an extraordinary situation, where liquidity is key for the survival of a firm, it is important from the lender’s perspective to ensure the firm – if it has a sound business – survives and its working capital needs are met and supported.
Even the demise of long-standing organisations, such as Lehman Brothers, stems from liquidity problems. Lehmans was unable to raise enough money to redeem its obligations to its investors, which resulted in the firm being caught off-guard on the value of the underlying collateral in its collateralised debt obligation (CDO) portfolio. The industry is just now arriving at a consensus that it would have served the finance world better if it had saved Lehman’s through a support mechanism to ensure its collaterals were held for a longer period of time. Pressing for collateral liquidation and market-to-market loss-based margin calls have contributed significantly, to the untimely demise of Lehmans as an institution. It may be a stretch of the imagination, but the similarity to The Merchant of Venice is clear.
Across the globe, traditional theories of risk measurement and management have focused on the VaR at any given point of time. This has led to the very peculiar outcome of valuing the collateral on a daily basis. Since many of the assets that are offered as collateral do not have any reference pricing points and moving market indices are not much help, assessing the value of a collateral has become irrelevant. The only security many lenders have is that these collaterals are of importance to the firm. This hypothesis, too, does not give much comfort to the lenders. In light of this, many lenders are increasingly looking at their fund commitments to the firm’s projects and reversing decisions where they don’t have contractual obligations to fund. Absence of new fund commitments can kill many businesses and further deepen the slowdown or recession.
Economists are afraid of these outcomes. While economist may be somewhat discredited right now, the fear is real and governments globally need to take a measured approach to help firms unwind asset leverage and ease the liquidity situation. Since most lenders are asking for collateral – and valuing those on a real-time basis to press the margin call – assets created by these firms are not hugely helping to ease the liquidity crisis. As in Shakespeare’s play, lenders are not looking at the possible interest earning but at the pound of flesh. Avoiding this scenario should become the priority for the policy response to the current crisis.