What is Quality of Collateral?
Quality of collateral is related to the overall condition of a certain asset that a company or an individual wants to put as collateral when borrowing funds from a lender (e.g., bank). Collateral secures the lender’s funds if the borrower faces bankruptcy. Alternatively, quality of collateral refers to how well a lender can collect on the economic benefits of assets used to secure a loan in case the borrower defaults.
The overall condition of an asset includes:
- Physical condition (for tangible assets)
- Estimation of the asset’s liquidation value
- Liquidity (the extent of the asset’s ability to be converted into cash within one fiscal year or less than a 12-month period)
- Magnitude and nature of the asset (scale and type)
*Note that since different types of assets can be pledged as collateral, the criteria and methods for assessing the collateral’s quality vary.
What is Collateral?
Collateral is simply a pledge for a loan (debt). In other words, it is typically an asset or property being offered to a lender (e.g., a bank) by a borrower (e.g., an individual or a company) as security. In the event the borrower defaults on the repayment of the debt, the lender is entitled to foreclose the collateral or to repossess the asset or assets that were pledged as collateral to secure the loan.
The lender then sells the repossessed asset(s) in the open market to recover the borrowed funds. During adverse market conditions, such as recession or market crash, it is possible that the lender does not recover 100% of the borrowed funds by selling an asset but is compensated only partially.
John decides to open his own bakery business after working for several years as a baker at the local bakery shop. John approaches a bank to borrow money for operations and the construction of the actual bakery (building). After performing some financial analysis, he estimated costs of $40,000. He would also need to hire some employees for more efficiency, and the salaries would equal $3,000 on a monthly basis. The bakery would need an inventory worth approximately $10,000.
John also pledged collateral to secure the loan. In this case, it was his 3-bedroom flat not far from the bakery, which was assessed for $105,000 at the time of the loan initiation.
After a thorough due diligence process by the bank, they’ve decided to lend John a sum of $100,000 for ten years.
After three years of amortized debt repayments, an economic recession happens, negatively impacting John’s business. After a while, he becomes insolvent, and his business fails to generate enough cash to sustain the operations, leading to loan repayment delays. Since the economy is getting worse, John defaults on the loan, and the bank forecloses the collateral.
Given a recent significant decline in the property market, the bank cannot sell the repossessed flat at $105,000 now, but only at $90,000. Therefore, the bank ultimately loses $10,000 (spread between $100,000 and $90,000).
Of course, such economy recessions and market crashes do not happen often. However, they do happen, as it did back in 2008 when the world’s financial markets collapsed, leaving many organizations out of business.
Types of Collateral
There are many types of collateral, and their nature is fully dependent on the types of loans. For example, taking a car loan or a mortgage, the car itself and the property (e.g., house or flat) will serve as collateral in such types of loans.
The different types of collateral also include:
- Intangible assets
How to Value an Asset
Typically, there are two main methods of value estimation of a collateral asset:
- Comparable market analysis (CMA)
- Consultancy with an expert in the type of collateral asset (Qualified Assessor)
While estimating the value of collateral, lenders do their due diligence conducting market research or comparable market analysis related to the collateralized asset. It provides a close estimate of its fair value (market value) by identifying the prices of similar assets traded in the open market.
The lender would also want to know the intrinsic value of the asset by using the services of professional assessors who examine the condition of the asset and then assign value to it. It is especially widely used in the real estate industry to come up with property values.
Studies on Quality of Collateral
According to a study on collateral quality and loan default risk in the transition economy of Vietnam, the researchers, after analysis of 2,296 internal loan accounts in the country, conclude that a high-quality collateral not only implies a more credible borrower but also stipulates a stable proper behavior while using the loan, such as making repayment installments on time and overall excellent borrower’s commitment to the repay the debt.
Therefore, it enables banks to mitigate risks of adverse borrower’s selection and the problem of moral hazard. A moral hazard occurs when one party starts to be involved in risky activities knowing that the other party will incur the associated costs if the risks arise.
Quality of Collateral and Probability of Default
Quality of collateral tests are performed to get a deep understanding of whether the underlying asset of collateral meets all the lender’s criteria.
Stable companies with a low probability of default will typically pledge strong collaterals (high-quality assets), thus making the loans cheaper because they bear a lower interest rate. Therefore, there is a straight correlation between the quality of collateral and its value.
The value or quality of assets is a very crucial indicator of potential credit risk a lender will bear by initiating loans. Therefore, credit analysts pay a lot of attention to the accurate value estimation of an asset and, thus, its quality.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: