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How to calculate value

17 November 2014
Richard Kemmish

I am indebted to the Estonian Bankers Association who produced a wonderful slide pointing out that there are eight ways to calculate the value of a property in use in European covered bond legislations. These eight methods are either single malt (a method to calculate a value), or blended (a combination of more than one of those methods typically via an either/or mechanism).

The most prevalent system is of course market value - what price did the borrower pay to buy the house? Possibly with a generic revaluation based on an index of property prices since the transaction took place. The revaluations always have an inherent conservatism – the value is adjusted by some of the upside but all of the downside.  

In the opposing corner, the mortgage lending value, as championed by, for example, pfandbrief regulations. According to these regulations the mortgage lending value is an attempt to strip out non-sustainable parts of the market price. 

According to Fitch the average difference between the two methods is 12% (for residential mortgages, more for commercial). But what I would really love to know is whether this 12% is a stable number over time or if it varies over the course of a cycle? If the latter then effectively sustainable market value methodology is just a haircut – or stress test if your prefer - on market value.

If it varies over the cycle - maybe this is an iconoclastic question – could it ever go negative? In my previous life in the securitisation market (it was a long time ago and I’ve already apologised), I once saw a “theoretical value” for a property that was greater than the market value. The borrower was trying to argue that the former, not the latter was the appropriate basis for the loan-to-value calculation. It would be unfair of me to say which country that was in but the theoretical value was based on such details of which arrondissement the property was located in.

OK, so the regulator in every country is entitled to define the valuation methodology that they think is most appropriate for the dynamics of their property market.  This is however, yet another argument against a greater harmonisation of covered bond laws.

It is even an argument against harmonisation-lite. The EBA said that covered bonds should as a minimum standard always have over-collateralisation, but they didn’t say how much. There will of course be calls for an EU wide floor on o/c in covered bonds, which should be rejected. More worryingly, there is already implicitly a floor in the definitions used in the LCR definitions. If the method of calculating o/c is based on a market value calculation of the underlying property it is hardly fair to apply the same o/c in a jurisdiction using the mortgage lending value.

And I haven’t even started on the other six valuation methodologies.

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