Over-collateralization involves providing collateral that exceeds enough to cover potential losses in cases of default. This strategy is often leveraged to enhance the creditworthiness of borrowers or issuers of securities.
Benefits of Over-Collateralization
Over-collateralization can lead to significantly better loan terms and bolster the credit profile of asset-backed securities, thereby minimizing risk for investors.
Example of Over-Collateralization
A business owner seeking a loan offers property or equipment valued at 10% to 20% more than the borrowed amount. Companies issuing bonds may also employ this strategy for similar reasons.
Key Takeaways
- Over-collateralization can secure favorable loan terms for borrowers.
- Issuers can use it to shield potential investors from risk.
- It generally improves the credit ratings of borrowers or issuers.
In the financial services industry, over-collateralization is often used to negate risks associated with products like mortgage-backed securities, where additional assets cushion against capital losses due to defaults.
How Over-Collateralization (OC) Works
Securitization Process
Securitization transforms a collection of assets, such as loans, into an investment security. Banks sell standard loans, such as home mortgages, to financial institutions that package these loans for resale as securitized investments.
These securitized loans, known as asset-backed securities (ABS), generate interest despite not being liquid assets. These can include residential or commercial mortgages, student loans, auto loans, and even credit card debt.
Credit Enhancement
A crucial phase in securitizing products is determining suitable levels of credit enhancement. This involves reducing risk to boost the credit profile of structured financial products, leading to a higher credit rating essential for attracting buyers.
Investors in securitized products risk default on underlying assets. Credit enhancement acts as a financial cushion that absorbs such losses, protecting the ultimate value of the securities.
10% to 20%: The Rule of Thumb
Over-collateralization backnotes loans with surplus collateral to limit the credit risk for creditors, thereby enhancing the loan’s credit rating. As a general rule, the asset pool’s value should be 10%-20% higher than the issued security’s price. For example, a $100 million mortgage-backed security may be supported by mortgages worth $120 million.
Understanding the Collateralization Ratio
The collateralization ratio is defined as the collateral value divided by the loan value. Loans are over-collateralized if their value exceeds 1 and under-collateralized if the ratio is below 1.
Insight into Under-Collateralized Loans
If the collateral’s value is less than the loan being offered, it constitutes an under-collateralized loan. This scenario poses a risk to the lender. Should the borrower default, the lender might struggle to recover the loan’s total value from the collateral.
The Value of Over-Collateralization
By backing loans with more collateral than the loan amount, lender risk is significantly cut. In the event of borrower default, the surplus collateral can more than cover losses.
The Bottom Line
Over-collateralization involves offering collateral exceeding the loan’s worth, primarily to secure better loan terms and ensure an elevated credit standing. While providing lower collateral to minimize risk is often preferred, over-collateralization can sometimes be essential to secure favorable financial deals.
Related Terms: Credit Enhancement, Collateralization Ratio, Asset-Backed Securities, Under-Collateralization.
References
- Office of the Comptroller of the Currency. “Credit Risk: Risk Management”.
- Consumer Financial Protection Bureau. “Mortgage-Backed Securities”.
