Second, the underlying value of the pledged asset is estimated. While this is typically straightforward for marketable securities, loan valuations are not quite as easily observed.
Two general sets of criteria are used to evaluate loans: 1) a discounted cash flow analysis that looks primarily to fixed-income dynamics and 2) the underlying property value that looks primarily to credit dynamics. Functionally, one or the other will likely dominate the valuation depending upon the economic environment. These valuations are made quarterly as of the second month of the quarter (February, May, August, and November).
Due to the combination of elevated property values and materially higher interest rates in the past year, cash flows are dominating valuation estimates. Like other fixed-income instruments, the rapid increase in rates has put downward pressure on fixed- and adjustable-rate loans with longer reset frequencies.
Beyond nominal interest rates, wider market spreads can also affect asset valuations. As with higher nominal rates, higher spreads also increase the discount rates used in present value calculations, which would result in lower valuations, all else equal.
At other times, however, declining property values may push the asset valuation lower based on market dynamics. If interest rates decline or stay the same since a loan was booked (increasing the discounted cash flow valuation), but the credit environment has deteriorated to the point that real estate prices decline significantly, the overall asset valuation could still be lower. Geography and property type are also contemplated in the credit-oriented valuation process.
While precise changes will be idiosyncratic to the particulars of pledged loans, in general, if interest rates are at or near multi-year highs in a declining real estate market, asset valuations are likely to be low. The inverse is true, too; if interest rates are at or near multi-year lows in a benign or strong real estate market, asset valuations are likely to be high.
Importantly, in no event can the asset valuation exceed the underlying book value of the loan. Even if the discounted cash flow analysis implied the equivalent of a bond price above 100 in a market with strong real estate price appreciation, the asset valuation would not exceed the nominal value of the loan.