In a lending agreement, collateral is an asset that a borrower puts up against the loan. It is something the lender can seize if the loan ends up in default.
Collateral acts as a guarantee that the lender will receive back the amount lent even if the loan is not repaid as promised. It is used to offset the principal and interest that is tied to the loan.
This type of lending is called secured since the loan is backed.
An example of this is a mortgage. When a bank lends money to a borrower, the property is used as the collateral. If payment is not made, the house it taken over by the bank. This is usually then resold to recoup the losses.
Using collateral does a number of different things:
- it reduces the risk on the lender's part associated with the potential of default
- a lower interest rate can be charged due to this reduced risk
The collateral serves as a hedge on the financial transaction. While unsecured loans tend to have a higher APR, they come with greater exposure to loss.
Risk In Lending
Secured loans carry less risk as compared to unsecured ones. This does not mean they are risk-free.
The ratio of the asset backing the loan and the outstanding balance are vital. If the value of the former drops a great deal, then the loan is considered upside down. When borrowers find them in this position, they often find it better to default as opposed to keep making the payments on a declining asset.
This was one of the major issues during the Great Financial Crisis. The belief was that people simply did not stop paying their mortgage. When the bubble burst in real estate, prices collapse by degrees we never saw in that market. This caused borrowers to simply "walk away" from their homes, leaving them to the bank.
It is a risk that is associated with any asset. Whether the collateral is a stock, derivative, car, or house, it can always go down in value.
For this reason, lenders will ask for more collateral than is being lent out. Overcollateralization is often common. In finance, when an asset is volatile, a lender might require more collateral to reduce the risk.
Collateral As Money
The Eurodollar System is completely based upon secured lending. All transactions, either bilateral or trilateral, have to be secured with collateral. This means that collateral is the money for the system.
It is ledger based,. There is no currency involved. All assets are entries on the ledger, many off-balance sheet items for the banks.
Most of global trade is funded using this system. For this reason, collateral requirements take on a different meaning. Credit-worthiness is not really a major consideration. The credit of the collateral means nothing. Instead, liquidity is the primary factor.
When it comes to collateral in the Repo market, nothing tops U.S. Treasuries. This will garner the best interest rate along with the least amount of collateralization. The key is whether the bond or note is on the run. As long as it is, lenders are more than willing to take it.
Off-the-run Treasuries will be met with the same resistance as other collateral. If a security cannot be unloaded, it is less than desirable as collateral.
Collateral Transformation
One of the results of the Great Financial Crisis is a change in the laws pertaining to the lending system. While this was something the lawmakers and regulators thought would be a positive step, it only necessitated another step for the financial institutions. It also created another market.
One of the unintended consequences of shift all lending to secured was the need for high quality collateral. As sovereign debt of many countries became unappealing, collateral transformation became a necessity.
Under this scenario, one goes to a bank with collateral. For sake of discussion, we will use corporate bond. On the open market, when trying to structure a deal, this will garner a high interest rate along with a vast amount of overcollateralization, especially as compared to US Treasuries. So what does one do if there are none on the balance sheet?
The deal ends up having two parts to it:
A bank such as JP Morgan has access to the Treasuries. The party interested in doing the deal approaches JPM and offers the corporate bonds in exchange for the Treasuries. JPM agrees, charging a rate of interest to "borrow" the Treasuries.
The party now heads to the market to complete the deal, offering US sovereign debt as the collateral instead of corporate bonds.
The net here is the interest rate (the rate paid on the deal plus what is promised JPM) is still less than what would occur using the corporate bonds. As we can see, with quality collateral in need, banks that have access to the Treasuries can create a steady business.