Collateral (finance)

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In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. [1] [2] The collateral serves as a lender's protection against a borrower's default and so can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.

Contents

The protection that collateral provides generally allows lenders to offer a lower interest rate on loans that have collateral. The reduction in interest rate can be up to several percentage points, depending on the type and value of the collateral. For example, the Annual Percentage Rate (APR) on an unsecured loan is often much higher than on a secured loan or logbook loan.

If a borrower defaults on a loan (due to insolvency or another event), that borrower loses the property pledged as collateral, with the lender then becoming the owner of the property. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. If the buyer fails to repay the loan according to the mortgage agreement, the lender can use the legal process of foreclosure to obtain ownership of the real estate. If a second mortgage is involved the primary mortgage loan is repaid first with the remaining funds used to satisfy the second mortgage. [3] [4] A pawnbroker is a common example of a business that may accept a wide range of items as collateral.

The type of the collateral may be restricted based on the type of the loan (as is the case with auto loans and mortgages); it also can be flexible, such as in the case of collateral-based personal loans.

Concept

Collateral, especially within banking, traditionally refers to secured lending (also known as asset-based lending). More-complex collateralization arrangements may be used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations secured in the form of property, surety, guarantee or other collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more-liquid assets such as cash or securities, often known as margin. Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It also help some borrowers to obtain loan if they have poor credit histories. Collateralized loans generally have substantially lower interest rate than unsecured loans.

Marketable collateral

Marketable collateral is the exchange of financial assets, such as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable, assets must be capable of being sold under normal market conditions with reasonable promptness at current fair market value. For national banks to accept a borrower's loan proposal, collateral must be equal to or greater than 100% of the loan or credit extension amount. In the United States of America, the bank's total outstanding loans and credit extensions to one borrower may not exceed 15 percent of the bank's capital and surplus, plus an additional 10 percent of the bank's capital and surplus. [5]

Reduction of collateral value is the primary risk when securing loans with marketable collateral. Financial institutions closely monitor the market value of any financial assets held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin agreement.

Tokenization of securities like company shares, pharmaceutical & defence project patents and mining licenses is an emerging novel concept of dynamic investment despite still being considered and classified as relatively experimental. Spektral Investment Bank is currently the only example of above mentioned novel complete tokenization concept via establishment of 800.000.000.00 EU worth in-kind collateral based capital composed of exclusive pharmaceutical & bioceucal patent rights and reserve volume approved mining licenses.

Examples of Collateral

Intellectual property such as copyrights, patents, and trademarks, as well as royalty streams from licensing revenue, are increasingly being used as collateral. [6] The use of IP as collateral in IP-backed finance transactions is the subject of a report series at the World Intellectual Property Organization. [7]

See also

Related Research Articles

<span class="mw-page-title-main">Loan</span> Lending of money

In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations etc. The recipient incurs a debt and is usually liable to pay interest on that debt until it is repaid as well as to repay the principal amount borrowed.

A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial. In an efficient market, higher levels of credit risk will be associated with higher borrowing costs. Because of this, measures of borrowing costs such as yield spreads can be used to infer credit risk levels based on assessments by market participants.

<span class="mw-page-title-main">Repurchase agreement</span> Form of short-term borrowing

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities. The dealer sells the underlying security to investors and, by agreement between the two parties, buys them back shortly afterwards, usually the following day, at a slightly higher price.

Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm uses its internal reserves to satisfy its necessity for cash, while the term financing is used when the firm acquires capital from external sources.

Asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repaid, the asset is taken. In this sense, a mortgage is an example of an asset-based loan. More commonly however, the phrase is used to describe lending to business and large corporations using assets not normally used in other loans. Typically, the different types of asset-based loans include accounts receivable financing, inventory financing, equipment financing, or real estate financing Asset-based lending in this more specific sense is possible only in certain countries whose legal systems allow borrowers to pledge such assets to lenders as collateral for loans.

<span class="mw-page-title-main">Mortgage-backed security</span> Type of asset-backed security

A mortgage-backed security (MBS) is a type of asset-backed security which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals that securitizes, or packages, the loans together into a security that investors can buy. Bonds securitizing mortgages are usually treated as a separate class, termed residential; another class is commercial, depending on whether the underlying asset is mortgages owned by borrowers or assets for commercial purposes ranging from office space to multi-dwelling buildings.

Unsecured debt Obligation of repayment without a collateral

In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment. Unsecured debts are sometimes called signature debt or personal loans. These differ from secured debt such as a mortgage, which is backed by a piece of real estate.

Second mortgage

Second mortgages, commonly referred to as junior liens, are loans secured by a property in addition to the primary mortgage. Depending on the time at which the second mortgage is originated, the loan can be structured as either a standalone second mortgage or piggyback second mortgage. Whilst a standalone second mortgage is opened subsequent to the primary loan, those with a piggyback loan structure are originated simultaneously with the primary mortgage. With regard to the method in which funds are withdrawn, second mortgages can be arranged as home equity loans or home equity lines of credit. Home equity loans are granted for the full amount at the time of loan origination in contrast to home equity lines of credit which permit the homeowner access to a predetermined amount which is repaid during the repayment period.

Negative equity is a deficit of owner's equity, occurring when the value of an asset used to secure a loan is less than the outstanding balance on the loan. In the United States, assets with negative equity are often referred to as being "underwater", and loans and borrowers with negative equity are said to be "upside down".

<span class="mw-page-title-main">Credit</span> Financial term for the trust between parties in transactions with a deferred payment

Credit is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately, but promises either to repay or return those resources at a later date. In other words, credit is a method of making reciprocity formal, legally enforceable, and extensible to a large group of unrelated people.

Security interest Legal right between a debtor and creditor over the debtors property (collateral)

In finance, a security interest is a legal right granted by a debtor to a creditor over the debtor's property which enables the creditor to have recourse to the property if the debtor defaults in making payment or otherwise performing the secured obligations. One of the most common examples of a security interest is a mortgage: a person borrows money from the bank to buy a house, and they grant a mortgage over the house so that if they default in repaying the loan, the bank can sell the house and apply the proceeds to the outstanding loan.

Commercial mortgage Mortgage loan secured by commercial property

A commercial mortgage is a mortgage loan secured by commercial property, such as an office building, shopping center, industrial warehouse, or apartment complex. The proceeds from a commercial mortgage are typically used to acquire, refinance, or redevelop commercial property.

A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan. The debt is thus secured against the collateral, and if the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally loaned to the borrower. An example is the foreclosure of a home. From the creditor's perspective, that is a category of debt in which a lender has been granted a portion of the bundle of rights to specified property. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

<span class="mw-page-title-main">Line of credit</span> Arranged ability to borrow money

A line of credit is a credit facility extended by a bank or other financial institution to a government, business or individual customer that enables the customer to draw on the facility when the customer needs funds. A line of credit takes several forms, such as an overdraft limit, demand loan, special purpose, export packing credit, term loan, discounting, purchase of commercial bills, traditional revolving credit card account, etc. It is effectively a source of funds that can readily be tapped at the borrower's discretion. Interest is paid only on money actually withdrawn. Lines of credit can be secured by collateral, or may be unsecured.

The vast majority of all second lien loans are senior secured obligations of the borrower. Second lien loans differ from both unsecured debt and subordinated debt.

In finance, a secured transaction is a loan or a credit transaction in which the lender acquires a security interest in collateral owned by the borrower and is entitled to foreclose on or repossess the collateral in the event of the borrower's default. The terms of the relationship are governed by a contract, or security agreement. A common example would be a consumer who purchases a car on credit. If the consumer fails to make the payments on time, the lender will take the car and resell it, applying the proceeds of the sale toward the loan. Mortgages and deeds of trust are another example. In the United States, secured transactions in personal property are governed by Article 9 of the Uniform Commercial Code (U.C.C.).

<span class="mw-page-title-main">Mortgage loan</span> Loan secured using real estate

A mortgage loan or simply mortgage, in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any purpose while putting a lien on the property being mortgaged. The loan is "secured" on the borrower's property through a process known as mortgage origination. This means that a legal mechanism is put into place which allows the lender to take possession and sell the secured property to pay off the loan in the event the borrower defaults on the loan or otherwise fails to abide by its terms. The word mortgage is derived from a Law French term used in Britain in the Middle Ages meaning "death pledge" and refers to the pledge ending (dying) when either the obligation is fulfilled or the property is taken through foreclosure. A mortgage can also be described as "a borrower giving consideration in the form of a collateral for a benefit (loan)".

Intangible Asset Finance also known as IP Finance is the branch of finance that uses intangible assets such as intellectual property and reputation to gain access to credit. Like other areas of finance, intangible asset finance is concerned with the interdependence of value, risk, and time.

This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.

The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, took several steps to address the subprime mortgage crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." A 2011 study by the Government Accountability Office found that "on numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority under the Federal Reserve Act of 1913 to authorize new broad-based programs and financial assistance to individual institutions to stabilize financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008."

References

  1. Garrett, Joan F. (1995). Banks and Their Customers . Dobbs Ferry, NY: Oceana Publications. p.  99. ISBN   0-379-11194-2.
  2. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 513. ISBN   0-13-063085-3.{{cite book}}: CS1 maint: location (link)
  3. Postel‐Vinay, Natacha (2017). "Debt dilution in 1920s America: lighting the fuse of a mortgage crisis" (PDF). Economic History Review. 70 (2): 559–585. doi:10.1111/ehr.12342. S2CID   154648457.
  4. Subprime mortgage credit derivatives. Goodman, Laurie S. Hoboken, N.J.: John Wiley & Sons. 2008. ISBN   978-0-470-39274-4. OCLC   237093908.{{cite book}}: CS1 maint: others (link)
  5. "12 CFR 32.3 - Lending limits". LII / Legal Information Institute. Retrieved 2017-05-10.
  6. Security interests in intellectual property. Toshiyuki Kono. Singapore. 2017. ISBN   978-981-10-5415-0. OCLC   1001337977.{{cite book}}: CS1 maint: others (link)
  7. "Launch of new WIPO report series on unlocking IP-Backed Finance at Singapore's IP Week, 26 August 2021 – Sharing the Singapore Country Report". www.wipo.int. Retrieved 2021-12-24.