Loan sale adviser DebtX published a white paper advocating for the incorporation of mark-to-market (or fair market) loan valuations in bank stress tests.
The new test would project losses on loans with declining asset values, giving financial firms a truer picture of stressors that could face banks in the future.
Marking these trends early on is another critical step in recognizing and solving a potential liquidity squeeze if existing loans are losing their financial value, DebtX suggested.
The proposal comes at a time when the Federal Reserve is busy constructing bank stress tests that will eventually be used routinely to evaluate risks contained within banks holding $10 billion more in assets.
So what's the difference between DebtX's proposal and stress tests as they currently exist?
"Mark-to-market stress testing is a more accurate predictor of a portfolio’s performance in times of duress or prosperity," said DebtX CEO Kingsley Greenland.
"DebtX believes the nation’s financial system will be stronger and better equipped to manage a systemic shock if mark-to-market valuations are used in stress testing."
Greenland told HousingWire the added benefit of mark-to-market valuations is banks can "look at assets and say which ones are losing more value than others." This will give them time to evaluate coming risks in their portfolio and to make business decisions, like a loan sale, to shield the company from losses on the mortgage.
At the present time, "banks are required to report something similar to mark-to-market, which is fair value", Kingsley said. DebtX outlines the difference between the two in its report, saying "fair value accounting rules allow banks to deviate from true market prices," especially in periods of market instability. Mark-to-market evaluations calculate the price 'as-is', giving financial firms a chance to detect and mitigate potential losses on loans that are losing their true market price.
Kingsley said he's not advocating for the test to replace the current stress testing model, but sees it as a viable add-on.
Still, he believes the addition of mark-to-market valuations should remain internal since the extra information could "create the problem of putting it all out there, leading to fluctuations in portfolio values." Under this scenario, he believes publicly displayed mark-to-market figures would lead to "distortions in how lending is generated."