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Adjusting Market Value

02 December 2015

For the record I am not against the concept of mortgage lending value as the basis for loan-to-value calculations. And, despite being British and therefore predisposed to obsess about the property market, I am not a supporter of market values per se.
What I am against is the application of a valuation methodology which is inappropriate for the market in question. More often than not this is the application of a mortgage lending value concept because it is more conservative rather than because it better fits established market practice. I have never seen market value used in a country where banks currently prefer mortgage lending value. 
Yes market values are higher than mortgage lending values but this can effectively be adjusted for in many ways. If done correctly, the one approach is not inherently more conservative than the other.

But how should it be adjusted for?

Broadly speaking there are three ways, via an adjustment to statutory loan-to-value ratios, via supervisor stress tests or via indexation.
A lower loan-to-value ratio as an eligibility criteria for assets in the pool – say 70% of market value as an alternative to 80% of mortgage lending value – is a blunt tool but like all blunt tools it is easy to understand. As an investor I’d feel reasonably compensated: one less conservative value factor is made up for by one more conservative value factor.  It is a static adjustment, not taking into account where we are in the property price cycle but I’m not hugely comfortable with the ability of regulators to quantify the cycle so I’m not going to be too concerned about that.

An interesting alternative would be to let the borrowers chose: 80% if you want to use MLV or 70% if you prefer MV.
A less blunt tool that does allow the supervisor to make a judgement on where we are in the property cycle is to adjust the stress tests on the pool accordingly. This is increasingly an option as these stress tests become more onerous and more relevant to determining total over-collateralisation levels.

Ultimately the regulator could even adjust the stress tests to reflect the difference between the two methodologies. Put the mortgage in the pool on the basis of market value and I will stress test the pool for a decline from current market value to mortgage lending value. This has the advantages that the regulator not a valuer will make the decision and that the rate at which the pool declines to this level can itself be stressed. It has the disadvantage that it is a whole portfolio rather than a line-by-line adjustment.
Finally, the greater risk of market value can be mitigated by indexation. Although not forward looking – an admittedly major drawback - this has the advantage that it is intuitively preferable – mark to market rather than mark to model – and real time.
This is a topic that will become more relevant as property prices rise. Low interest rates have a habit of doing that.

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