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Market Values & Asset Quality

Do market values of financial instruments indicate asset quality?

Yes. A market value is the price a willing buyer and a willing seller would offer and accept, to trade an item owned, for cash or equivalent, in a free and open market ("at-arms-length"). Presumably a willing buyer expects normal quality, will pay a premium for good quality and will require a discount for poor quality.

The quality of a financial instrument is indicated by the credit worthiness of the maker, the length of time until principal is to be repaid, estimates of prepayment speeds, the rate of return, the structure of the interest rate contract (i.e. fixed rate, floating or adjustable) and timing of interest rate changes. Of the above, credit quality is the most important.

Asset quality, as suggested by market values, of a commercial bank is reflected in three items: the market value of its investment securities; the fair value of its loans; and the fair value of its deposit premium (the recorded value less the calculated economic value of deposit liabilities).

For traded financial instruments, such as investment securities, active markets with published prices provide an independent source of information for market values.

The major difference between a loan contract and an investment security is the absence of a trading market to set prices "at-arms-length". None-the-less, a fair value (the financial world’s substitute for market value) can be estimated.

Like loans, deposits of most commercial banks are not traded in any public market on a daily basis. The next measure, Net Charge-Offs, represents loans actually charged-off, net of recoveries. The current amount and trend of charge-offs is an indication of prior credit decisions and management’s balance sheet philosophy. A steady amount of charge-offs at a low level indicates that some bad debts are simply a cost of doing business. Large swings in charge-offs are an indication of surprises and the possibility of less than adequate credit approval procedures.

Finally, Loan Loss Provision is the current loss expense recognized for the lending and credit function. When viewed in comparison with the charge-offs over time, the provision indicates whether the expense provision is required to build reserves for a growing loan portfolio or is required to absorb the bad and charged-off loans in excess of the current reserve position.

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