Quality of Collateral

What is The Quality of Collateral?

The quality of the collateral is the value and reliability of an asset guaranteed to secure a loan. It is greatly influenced by the condition of the asset, market demand for the asset, and the type of asset.

Collateral is used as security for a lender and may be liquidated in case of default. The quality of a collateral asset depends on several factors, such as the desirability of ownership and convenience in liquidation.

Collateral is used as insurance for a lender in the event of a borrower default, such as when a borrower does not make payments in full or defaults by taking action that is against the terms outlined in the agreement.

A collateral is an asset pledged to the lender by a borrower for the duration of the agreement. The lender is allowed to liquidate the collateral in the event of default.

Assets come in a range of sizes and forms, some more valuable than others. Therefore, there is a difference in the quality of assets. The following are the two broad categories of assets:

1. Tangible Assets: Tangible assets, such as land, equipment, furniture, property, and inventory, can typically be touched and felt. Given their associated value, this category also includes securities such as cash, stocks, and bonds.
2. Intangible Assets: Intangible assets are those without a real physical substance but with an identifiable monetary value. Some examples include brand value, patents, logos, copyrights, data, software, and goodwill.

As you can imagine, collateral assets are usually desired to be tangible, given their transferability and clear ownership. Hence, you will find that high-quality collateral usually comprises desirable physical assets such as property.

Why is The Quality of Collateral Important?

Let us highlight the perspectives of both the lender and the borrower concerning collateral quality. This section will highlight the many benefits lenders and borrowers have concerning desirable collateral assets.

A lender wishes to issue debt on terms that reduce risk as much as possible while creating sizable returns. In this case, collateral assets would provide insurance for the lender by providing a recoverable amount in a default situation.

In case of default, the borrower can simply liquidate the collateral asset(s) to fully, or at least partially, cover the loan amount. Further, based on the structure of the debt, the lender may or may not have permission to pursue the borrower for repayment further.

Even so, high-quality collateral reduces the lender's fear and risk of default. Therefore, the lender may be less reluctant to issue a loan to a borrower offering high-quality collateral than to a borrower with no or low-quality collateral.

Ultimately, collateral can provide significant value to a lender by mitigating risk. Thus, collateral quality is of importance to lending firms and private lenders.

From a borrower's perspective, providing a lender with high-quality collateral means that the borrower can create an agreement with more favorable conditions, such as lower interest and flexibility.

Moreover, offering higher-quality collateral will show that the borrower is confident in meeting payments, even in a worst-case scenario, as the collateral will only be pursued in case of default.

Of course, a borrower will need to accurately judge their payment-making ability by forecasting various scenarios with different sentiments to understand their risks of default.

Overall, high-quality collateral assets give borrowers negotiating power and allow them to secure low-cost financing at flexible terms. They also give lenders confidence by creating a baseline for a recoverable amount.

For instance, lenders may be willing to offer the following for high-quality collateral:

• Less restrictive covenants
• Lower interest 
• Flexible payment schedule 
• Longer amortizations
• Better Loan-To-Value (LTV) terms
• Negotiation flexibility 

Hence, it is imperative to recognize that collateral quality is of importance in a loan agreement as it impacts both parties. Given these reasons, it is of utmost importance to recognize and judge the quality of a collateral asset for both parties.

Here is a paper from the International Monetary Fund (IMF) that highlights the power of collateral through several examples.

Judging the Quality of Collateral

Given the importance of collateral due to the benefits it brings to both lenders and borrowers, there are clear incentives for borrowers to try to pledge a desirable asset to lenders for the duration of a loan. This will convince the lender to create favorable conditions and provide leeway.

Hence, it is important to judge the quality of an asset that is pledged as collateral for both parties. This section will explain how to judge the quality of an asset type and the common desirable factors that should be considered.

Here are the different factors that determine a collateral asset’s quality.

Stability

Stability means that an asset's value does not undergo regular or sharp fluctuations. This provides the lender with confidence that the collateral asset can be sold for a given value at any point.

Unstable assets include speculative investments such as derivative instruments. On the other hand, gold is likely one of the most stable assets to hold.

Liquidity

Liquidity is determined by how convenient it is to realize the value of an asset in cash. Hence, a lender would analyze if the asset is desirable and part of a large market that is regularly undergoing transactions. 

This would make it easier to liquidate the asset if necessary. Note that cash is the most liquid asset as it is already in the form of currency and, hence, is the most desirable collateral for the lender. 

However, collateral assets usually take the form of machinery or property, as they can be quickly sold and converted to cash. Liquidity is determined by understanding the extent of activity in the secondary market.

Income Producing

An asset is considered to be income-producing when its use can regularly create cash flows. For instance, real estate can be leased out for housing needs or commercial needs to create a regular income source.

The cash flows generated from such an asset can be easily used to judge the value for an investor. Therefore, lenders prefer highly desirable and strong income-producing assets as they are much simpler to liquidate, given their attractiveness to investors.

A commercial property located in a prime location that is already leased out is an example of an income-producing asset that may be used as collateral. Lenders may ask for Net Operating Income (NOI) data on the asset to determine its quality.

Overall Long-term Desirability

Lenders often need to ask themselves questions to analyze and differentiate between high- and low-quality collateral. Given that lenders issue loans for long periods, such as 30 years, it is imperative to consider that asset qualities may fluctuate over that time.

Analyzing overall desirability means that the lender considers the big picture by examining the asset's long-term health.

For example, a lender may find, after analysis, that a large residential property of lower value is of much higher quality compared to a higher-valued industrial property that is depreciating because of rough use.

Hence, the lender can choose an asset that they believe will be more desirable over the long term instead of analyzing the asset only in the immediate or short term.

Therefore, the lender must engage in a due diligence period to judge the bigger picture and accurately predict asset quality in the long term.

The factors discussed so far highlight the importance of stability and desirability in judging a collateral asset's quality. As you can see, all the above factors are connected. 

Lenders commonly use the Marketable Ascertainable Stable Transferrable (MAST) framework to assess whether an asset meets several criteria. This framework encompasses the factors listed previously.

Asset Appraisals 

Many assets are not marked-to-market, which means that they are not actively traded from individual to individual. Thus, their present value is difficult to judge. 

When a third-party expert carries out an analysis to determine an asset's value, the outcome is referred to as an appraisal. 

For example, consider a commercial property that had been leased out for 10 years. The lease is close to ending with a low chance of renewal from the tenant because they wish to move elsewhere.

In such a case, the last sale data of this specific property is quite old and thus unreliable, given different market conditions. An appraiser uses comparable assets in the area and other methods to judge the condition of the property and its desirability to determine its fair value.

Therefore, appraisals also provide information on the condition of the property, such as whether some expensive repairs or renovations are required. Moreover, the report provides data on the appraiser's perspective on the price of the asset based on similar assets.

Appraisers charge a fee for their services. Lenders can use the expertise of appraisers to conduct an in-depth analysis of the quality of a prospective collateral asset, allowing them to safeguard themselves against default.

Examples of Lenders Seizing Collateral Assets

Several examples exist of lenders needing to resort to seizing a collateral asset to recover a small or significant amount of the loan. This section will aim to illustrate the extent to which lenders go to seize collateral assets.

Here are some examples of large institutions seizing collateral assets in situations of default:

• August 2022: Evergrande creditors find themselves in a tough situation as banks seize about $2 billion in bank deposits. These deposits were found through an investigation in July and classified as collateral to satisfy unpaid loans issued to third-party borrowers, as reported by Forbes.
• October 2021: Creditors, as reported by Reuters, are turning to seize collateral from Chinese property developer Oceanwide Holdings Co. (SHE: 000046) after a missed payment.
• February 2020: The UK high court orders Anil Ambani, the previous chairman of Reliance Group, to deposit $100 million of his personal wealth to partially pay back the debt to three Chinese banks, which was issued to then bankrupt Reliance Communications (NSE: RCOM), as reported by the mint.

The several examples indicate that lenders typically take default seriously and pursue the borrower in whatever capacity they can to seize the collateral and personal assets, if necessary.

Hence, even individual borrowers should evaluate their payment-paying ability to understand their probabilities of default. Further, regular evaluations are necessary to account for changing financial and market conditions.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Collateralized Loan Obligations (CLO)
• Creditworthiness
• Credit Analysis
• Mortgage Rate
• Sovereign Default