Collateral

The collateral is an asset that serves as collateral against the granting of a loan, a bond issue or any other financial transaction. The quality of collateral support will depend on the credit rating of the collateral and its good behavior.

For this reason, the analysis of the collateral is vital to assess operation qualification ( securitization in English), which is nothing more than a group of loans by selling financial assets backed by them, which in the case of titration are asset-backed securities .

Historically, when the securities market began to develop, the collateral was mainly composed of mortgage loans, but as financial markets have evolved, the variety of assets has been greater and therefore, there are greater assets that can be used as backup or collateral.

Collateral is also very common in repo operations . In fact, it is by definition the operation that necessarily carries collateral in the financial markets. Recall that in a repo operation there is an exchange between two counterparts. On the one hand, a fixed income asset is delivered as a bond or a letter and on the other cash, so that in a certain period the opposite operation occurs, that is, the fixed income asset is returned on the one hand, and the other part the cash plus interest.

In the financial derivatives markets we find collateralization agreements , which, as the name implies, are agreements that provide protection against the potential breach of the counterpart of any of its obligations in a derivatives operation. These agreements, by means of a legal document, standardize the credit risk mitigation mechanism (counterpart), defining the deliverables to guarantee the obligation.

Types of collateral

There are different types of collateral:

  • Loans: We can differentiate personal loans and loans with real collateral.
  • Collection rights:As a result of transactions with individuals and companies with deferred payment.
  • Operating rights: These are income in the form of fees such as royalties , franchises, rentals, etc.
  • Service contracts : Supply contracts such as water, electricity, gas, etc., despite being non-precise amounts.

Collateral Analysis

To analyze whether the quality of coverage or support of a collateral is good, we must take into account the following factors:

  1. Predictability ofincoming cash flows .
  2. Delay in payments and risk of default and liquidity . 
  3. Diversification ofsectoral and geographical risk .
  4. Additional guarantees associated withthe collateral.
  5. Legality and regulatory frameworkof that asset.
  6. Cross collateralization, in case of collateral of a group of assets, if one fails, the rest can be used to cover that asset.

Collateral Example

The most common example of collateral is the negotiation of  repos , because it is one of the operations most used by banks and other large companies to obtain liquidity, and is essential for the proper functioning of the bond market.

In a repo a part has debt securities, which as a general rule, are usually risk free bonds, and also needs liquidity. The other party has excess liquidity, and will exchange it for the bonds (with a firm return agreement) in exchange for an interest rate or “repo price”.

The logic behind this transaction is the same as that of a mortgage, that is, that the one who makes the loan has the possibility of securing his position by executing an asset. The reason for limiting collateral to risk-free bonds is to maintain the stability of the value that serves as collateral.

As a general rule, the American Treasury Bills (T-bills) or the German 10-year bond called Bund are used . Therefore, in double purchase-sale operations such as repos, there is the guarantee of a collateral, normally a public debt title, which favors the execution of the investment-financing operation and, lowers, the interest rate with respect to to a risky operation. Such guarantee may be Treasury Bills, Bonds or Obligations of the State and even corporate promissory notes and private fixed income bonds or issuers other than the State. Being guaranteed operations, they generate, as we have said, interest rates lower than those of the interbank deposit market for the same term.

Another example of collateral is found in the US, through mortgage-backed title bonds, called Mortgage Backed Securities (MBS). In this case, a series of ABS bonds are issued that will pay their investors an interest rate, which will come from the hand of the mortgage payments, discounting a commission that will be on the one hand for the bank and for the special vehicle created to make the degree out of the bank’s balance sheet (taking risks from the balance sheet).

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