Let's Not Compel Commercial Lenders to Mark to Market

The Financial Accounting Standards Board is exploring the costs and benefits of requiring banks to mark their commercial loans to market.

FASB recognizes that, for the vast majority of loans, there exists no "market" in the sense that loans are bought and sold like stocks and bonds.

Indeed, loans are not securities. Evidently, corporate loans must appear "bondlike" to non-bankers. Thus, nonbankers assume that loans can be marked to market the way bonds can be marked to market. However, most loans are highly complex, nonstandard financial instruments.

Unlike most loans, bonds are stand-alone securities. Most often, a commercial loan is merely one strand in a complex product web between a bank and a customer. The value and price of that loan is therefore interrelated with other products such as cash management, balances, lockboxes, swaps, and trust services.

For this reason, it is doubtful that any true market for most corporate loans will soon develop.

In the absence of a true market to provide "mark to market" data, the FASB is exploring the costs and benefits of one or more synthetic valuation schemes.

To produce a worthwhile benefit from this undertaking, the FASB will have to develop and impose bankwide standards in several crucial areas: yield calculation method, credit ratings, applications for market-based loan pricing tools, and loan documentation.

Without standards in these areas, the methods used by banks to comply with the FASB mark-to-market requirements would produce widely different valuation results. Without standards, the whole mark-to-market effort could well result in a costly but empty exercise.

It is thus important to explore the costs of developing realistic standards and to determine the potential benefits accruing from such an undertaking.

Costs and Complexities

The FASB recognizes that this undertaking will impose a significant burden of cost and complexity on banks. To succeed, FASB would have to define a set of standards that banks would use in valuing loans. At minimum, FASB would have to set standards in the following areas:

* Yield calculation. In addition to lending spreads over reference rates like the London interbank offered rate, Prime, CDs, or federal funds, commercial loans include a variety of pricing elements such as upfront fees, annual fees, commitment fees, and special charges.

Because some fees are based on the amount borrowed under the credit line, the utilization or usage rate of the credit facility becomes a key element in the yield calculation. Banks differ on the formula used to calculate loan yield. The FASB could elect to develop and impose a universal loan-yield calculation formula on the banks.

* Credit ratings. Unlike bonds, no universally accepted rating system exists for commercial loans. Bank rating schemes differ widely.

The FASB would have to develop and recommend a universal bank rating system. Complying with this would entail a heavy administrative burden for banks as they redefiend their ratings systems based on FASB guidelines and audited the results for proper compliance.

* "Loan market" prices. Currently, there is about $600 billion of commercial loans on the books of U.S. banks and their branches.

About $50 billion represents loans to visible "big ticket" borrowers like RJR Nabisco, Georgia Gulf Corp., Oryx Energy Co., etc. Perhaps 35 of these loans are actively traded, giving them some level of secondary market-based pricing.

About $150 billion of loans are broadly syndicated, that is, held by several lenders. While these loans have an initial offering price, they are rarely sold once they are syndicated.

For the remainder - $450 billion - absolutely no market pricing exists. These are the "middle market" or core loans, each one uniquely tailored to the needs of the borrower.

It is not credible to extrapolate market pricing from a handful of highly specialized loans to the entire $600 billion universe of commercial loans.

* Loan documentation. In virtually all cases, loan documentation is handcrafted to fit the particular needs and risks of borrowers. This lack of standards is one reason why a large loan-sales market - or market prices for commercial loans - has never developed.

A loan document contains covenants, agreements, and remedies that constitute a complex contract between borrower and lender. The loan agreement is frequently amended as the situation changes.

Consequently, most loan assets are notoriously hard to value - and sell - except for those that are large enough and standardized enough to allow trading.

It is doubtful that FASB seeks to standardize loan documentation. But, without standardized documentation, the mark-to-market scheme will pose an arbitrary structure on loans that is not open, explicit, or reproducible.

Are There Benefits?

In many ways, corporate lending relationships more nearly resemble the complex customer relationships of industrial corporations than the more passive holding of stock and bond investments. Corporate loan relationships are highly active, involving periodic restructuring of the loan across many needs and product lines.

Pricing is different. Unlike bonds, loans are floating-rate instruments. Bond prices are highly variable, in part, because the capital value of he bond fluctuates with long-term rates.

Because most loans are floating rate, fluctuations in the underlying reference rate - Prime, Libor, etc. - keep the loans reasonably close to other short-term yields.

Unlike bondholders, banks can generally get out of a loan at "par" unless there is a credit problem. Presumably, the discount associated with a troubled loan is accounted for in the loanloss provision and, hence, needs no further regulation or disclosure.

Indeed, exercises at Loan Pricing Corp., attempting to develop a mark-to-market approach, show that virtually all nondistressed commercial loans should be valued at par. And for those loans that are seriously underpriced, the entire discount would probably be less than 3%.

There are sound reasons to be conservative in imposing these new burdens of reporting on banks. The proposal to require banks to mark their corporate loans to a synthetic market calls to mind the "inflation accounting" episode of the 1970s.

Inflation accounting was theoretically appealing, but it foundered on practical difficulties. No market prices existed for the bulk of the plant and equipment assets that had to be marked to market.

Appraisal firms sprang up and charged high fees to concoct "prices" for the assets. But each valuation scheme was different and the resulting information contained in the annual reports was of questionable value.

In fact, several securities analysts claimed that the inflation accounting numbers, if anything, confused their efforts to value stocks. After a great deal of expense and effort, inflation accounting was finally dropped.

Commercial banking is a complex business. The braod and deep availability of bank credit to middle-market businesses is an important national asset.

The banking system today is fragile. And, to many securities analysts, commercial loan portfolios appear to be blind pools of risk.

But the problem will not be remedied by compelling banks to report portfolio data based on arbitrary valuation and standardization requirements.

Let's not compel banks to "mark to market."

Mr. Snyder is president of Loan Pricing Corp., a financial data company based in New York. This material was presented to the Financial Accounting Standards Board in Norwalk, Conn., and published in the July 1991 issue of Loan Pricing Report.

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