Collateral (often referred to as collateral security) is when an asset is pledged to a lender, by a borrower, in support of a credit request.
If a loan cannot be repaid or refinanced, a lender may take enforcement action against the borrower’s assets in order to recover the outstanding loan principal plus accrued interest.
Some assets are physical “things” like equipment (i.e., vehicles, inventory, or real estate), while others are “intangible assets” (like intellectual property or customer lists).
Assessing the quality of collateral involves understanding an asset’s condition and its overall desirability.
Key measures include how easily identified (and how stable) an asset’s value is, how active its secondary market is, and how easy it is to transfer the title.
An appraisal is commonly employed to support estimates of an asset’s value and to provide commentary on its condition.
All things being equal, higher quality collateral tends to support more flexible credit terms.
Understanding Collateral Quality
There are a few ways to think about collateral “quality.” These may vary slightly based on whether a lender is looking at current or non-current assets.
Collateral quality may be assessed based on an asset’s liquidity – meaning how easily it can be converted into cash. In general, the closer to the top of a company’s balance sheet an asset appears, the more liquid it is.
Cash (at the very top) is the best since it’s already cash, followed by short-term investments, accounts receivable, and inventory. Of course, these are all current assets, which are supposed to be converted to cash within 12 months.
For non-current assets (like property, plant, and equipment), collateral quality can be measured in part based on its condition. For example, are we talking about a relatively new real estate asset that’s never been tenanted, or is it a 5-year-old chemical holding tank that’s been exposed to winter weather and is now oxidized and rusty? Obviously, the former should be in much better “condition” than the latter.
Collateral “quality,” however, can also be assessed based on the asset’s overall desirability. Certain assets are inherently much more desirable as collateral security than others.
All things being equal, more desirable assets are more easily converted to cash than less desirable ones. While desirability is somewhat subjective (and subject to market forces), there are some general dimensions against which an asset may be measured.
A useful framework for this is MAST.
The MAST Framework
MAST stands for Marketable, Ascertainable, Stable, and Transferrable. Assets (current or non-current) that score highly against some (or all) of these criteria tend to be considered much higher quality collateral.
Marketable assets are assets that other parties want. In other words, there is an active secondary market. In that sense, intellectual property may not be high quality collateral, since it’s only valuable in the hands of a management team that can monetize it. Real property, on the other hand, has a very active secondary market and is often considered to be much more desirable as collateral.
The ascertainable question asks how easy it is to understand the asset’s market value. Stocks and bonds, for example, are marked-to-market in real-time during trading hours, and, therefore, would score very highly against this dimension. The market value of fine art or jewelry, on the other hand, is very subjective and much more difficult to ascertain.
Assuming an asset’s value can actually be ascertained (as above), the next question to ask is how stable will its value remain over the course of the credit exposure? High quality collateral either retains value well over time or, at minimum, depreciates at a predictable rate.
While stocks are certainly ascertainable, they are not necessarily stable (which is why we see margin calls). Manufacturing equipment, on the other hand, tends to have a relatively predictable rate of depreciation, and credit is usually structured so that the loan exposure reduces in tandem with the declining collateral value.
The degree to which an asset’s title is transferable should also be considered. In general, “yellow iron” (like dozers and dump trucks) has an active secondary market, and it tends to depreciate at a predictable rate. But if the borrower is a mining company and the site where the assets are located is on another continent and in a remote area, physically repossessing and/or transferring the title of those assets could be very difficult and very expensive.
Commercial real estate, on the other hand, can be foreclosed upon, and the title can be transferred with a simple lien discharge followed by reregistration with the local land title office.
An appraisal is a third-party expert’s estimate of an asset’s value. When an asset is not marked-to-market (like stocks are), then an appraisal is typically used to assess its value.
Let’s look at real estate as an example. We know that real estate is marketable; it’s also ascertainable (if an appraiser is employed). Its value tends to be stable and it’s transferable. But those are general rules – what if the specific building in question happens to be 75 years old and in complete disrepair?
Appraisals have the dual benefit of providing commentary around the asset’s condition, too – which we know is an important consideration. Appraisals don’t just offer an estimate of value but should also provide specific feedback about the asset’s condition.
High Quality Collateral
In general, tangible assets (meaning real, physical things, as opposed to intangible assets) that score highly against the 4 MAST criteria are usually considered higher quality collateral than those that don’t.
Having said that, assets should also be in excellent physical condition, and bonus points if they happen to be more easily converted into cash.
All other things being equal, higher quality collateral tends to support more flexible loan terms, including higher LTV‘s (Loan-to-Value), longer amortizations, less restrictive covenants, and longer interest terms.
Thank you for reading CFI’s guide to Collateral Quality. To keep learning and developing your knowledge base, please explore the additional relevant resources below: