Collateral is an asset pledged by a borrower, to a lender (or a creditor), as security for a loan. Borrowers generally seek credit in order to purchase things – it could be a house or a car for an individual, or it could be manufacturing equipment, commercial real estate, or even something intangible (like intellectual property) for a business.
If loan exposure is supported by collateral, it’s said to be secured credit; if it is not secured by collateral, the exposure is said to be unsecured.
While collateral will make a sound borrowing request more secure, having collateral available does not serve as a substitute for other risk management and loan underwriting best practices.
Collateral is an asset that’s been pledged as security against credit exposure.
Secured loans are supported by collateral; unsecured loans are not.
Taking collateral does not make an otherwise bad borrower a good one.
How Does Collateral Work?
An asset becomes collateral security when a lender registers a charge over it, either by using a fixed or a floating charge. These charges are also known as liens.
Examples of fixed charges include a collateral mortgage over a specific property or the registration of a charge over a unique identifier, like the serial number of a specific vehicle. Once a security charge is registered over a physical asset, the borrower cannot sell that asset without the lender first discharging its security interest.
A floating charge is very common with business borrowers and is often registered using something called a General Security Agreement (GSA). A GSA covers all the assets of a borrower not otherwise named in a specific security registration (like our property or vehicle examples). GSAs allow lenders to take otherwise difficult-to-identify assets (like inventory) and use them as collateral to help backstop credit exposure.
Charges are filed with a public registry, which varies by jurisdiction. The public registry allows stakeholders to see and understand who has claims over which assets and in what order those claims were filed.
In general, charges that are filed first usually have “higher priority” than charges registered later (or “behind”) them. They are often referred to as “higher ranking” claims or claims that are more “senior” than those below them.
Understanding Collateral Value
There are two ways to think about collateral “value.” The first is its relative desirability; the second is its monetary value – although both are subject to market forces.
How “Desirable” is the Asset?
A useful tool to help conceptualize the overall desirability of collateral is the MAST framework. MAST stands for Marketable, Ascertainable, Stable, and Transferable.
If an asset is marketable,it implies an active secondary market for the asset. Things like stocks and bonds are great examples, as there are global exchanges used to trade these instruments. Fine art, on the other hand, is somewhat less marketable as it appeals only to a niche audience.
Ascertainable asks how easy it is to quote or quantify a price (or market value); this is often achieved using an appraiser (like commercial real estate), although stocks and bonds are also highly ascertainable since they trade in real-time in public markets. Intellectual property, on the other hand, is much harder to value and much more open to interpretation.
How stable is the asset’s value? While marketable securities have both an active secondary market and their prices are marked-to-market, stocks (in particular) can be unstable, which makes the actual value of the collateral potentially quite volatile. Commercial real estate, on the other hand, tends to be much more stable day-to-day.
Is the asset transferable? A logging company may wish to pledge inventory as collateral, but much of its inventory may be located in a remote location that’s difficult for third parties to access – the costs associated with transferring this collateral can be very high. Real estate, on the other hand, requires only the discharge (and the subsequent re-registration) of a collateral mortgage agreement over the subject property.
Collateral assets that score highly against these MAST criteria tend to command more flexible loan terms, like longer amortization periods, lower interest rates, and higher loan-to-values (LTV).
What is the Asset Worth?
An asset’s monetary value could mean a number of things. Book value is one measure that’s commonly used to understand what inventory or accounts receivable are worth for the purposes of extending credit.
If a business is acquiring fixed assets (like property, plant and equipment), it would be common to use the purchase price as the “value” when calculating loan-to-value. For used equipment, a third-party appraiser is often hired to assess that asset’s value. Equipment appraisers will often provide three “values” when preparing a valuation report. These are:
Fair Market Value (FMV): FMV is an estimate of an asset’s “price” if timing were not of the essence and if multiple informed parties were involved in a standard bidding process.
Orderly Liquidation Value (OLV): OLV provides an estimate of “price” if time were of some priority and the asset was to be sold in an “orderly” auction process.
Forced Liquidation Value (FLV): FLV asks what “price” an asset might fetch if time were of the absolute essence and a creditor needed to sell this asset without the benefit of an orderly auction process.
What is Collateral Used for?
Once a creditor’s full loan exposure has been repaid (either by the borrower making payments or through refinancing by a different lender), the original creditor’s claim is “discharged” by its legal counsel.
If a borrower defaults on a loan payment to a lender, however, and the credit exposure cannot be refinanced with another firm, that lender can sell the asset (or assets) over which they have a charge in order to recover outstanding funds, plus any accrued interest. As noted earlier, assets are seized and liquidated in the same order of priority that the security charges were made.
In some liquidation scenarios, collateral assets are sold at auction for more than is owed to the creditors. In this case, surplus funds beyond the balance of outstanding credit plus accrued interest would be distributed to common stockholders of the business.
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