Define: Collateral

In lending agreements, collateral is a borrower’s asset that is forfeited to the lender if the borrower is insolvent — that is, unable to pay back the principal and interest on the loan. When insolvent, the borrower is said to default on the loan, in which case the lender becomes the owner of the collateral. In a mortgage, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to pay mortgage interest, the ownership of the real estate is transferred to the bank in the process known as foreclosure.

Collateral is an asset provided to secure an obligation. Traditionally, banks might require corporate borrowers to commit company assets as security for loans. Today, this practice is called secured lending or asset-based lending. Collateral can take many forms: property, inventory, equipment, receivables, oil reserves, etc.

Concept Of Collateral

Collateral, especially within banking, may traditionally refer to secured lending (also known as asset-based lending) as well as more recently as collateralization arrangements 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. Another example might be to ask for collateral in exchange for holding something of value until it is returned (i.e., I’ll hold onto your wallet while you borrow my cell phone).

In many developing countries, the use of collateral is the main way to secure bank financing. The ease of acquiring a loan depends on the ability to use assets, whether real estate or any other, as collateral.

A more recent development is collateralization arrangements used to secure repo, securities lending and derivatives transactions. Under such arrangement, a party who owes an obligation to another party posts collateral—typically consisting of cash or securities—to secure the obligation. In the event that the party defaults on the obligation, the secured party may seize the collateral. In this context, collateral is sometimes called margin.

An arrangement can be unilateral, with just one party posting collateral. With two-sided obligations, such as a swap or foreign exchange forward, bilateral collateralization may be used. In that situation, both parties may post collateral for the value of their total obligation to each other. Alternatively, the net obligation may be collateralized—at any point in time, the party who is the net obligator posts collateral for the value of the net obligation.

In a typical collateral arrangement, the secured obligation is periodically marked-to-market, and the collateral is adjusted to reflect changes in value. The securing party posts additional collateral when the market value has risen or removes collateral when it has fallen. The collateral agreement should specify:

• Acceptable collateral: A secured party will usually prefer to receive highly-rated collateral, such as Treasury bonds or agencies. Collateral whose market value is volatile or negatively correlated with the value of the secured obligation is generally undesirable.
• Frequency of margin calls: Because the value of an obligation and the value of posted collateral can change, a secured party typically wants to mark-to-market frequently, issuing a margin call to the securing party for additional collateral when needed.
• Haircuts: In determining the amount of collateral that must be posted, haircuts are applied to the market value of various types of collateral. For example, if a 1% haircut is applied to Treasury bonds, then Treasury bonds are valued at 99% of their market value. A 5% haircut might be applied to certain corporate bonds, etc.
• Threshold level: Only the value of an obligation above a certain threshold level may be collateralized. For example, if a USD 1MM threshold applies to a USD 5MM obligation, only USD 4MM of the obligation will actually be collateralized.
• Close-out and termination clauses: The parties must agree under what circumstances the obligation will be terminated. The form of a final settlement in the event of such termination—and the role of the collateral in such settlement—is specified.
• Valuation: A methodology for marking both the obligation and the collateral to market must be agreed upon.
• Rehypothecation rights: The secured party may wish to have use of posted collateral—possibly lending it to another party or posting it as collateral for its own obligations to another party. Rehypothecation is not permitted in many jurisdictions.

Legal treatment of collateral varies from one jurisdiction to another. In some jurisdictions, the secured party takes legal possession of collateral but is legally bound by how the collateral may be used and the conditions upon which it must be returned. Such transfer of title provides the secured party with a high degree of assurance that it may seize the collateral in the event of a default. Transfer of title, however, may be treated as a taxable event in some jurisdictions. In other jurisdictions, the securing party retains ownership of collateral, but the secured party acquires a perfected interest in it.

Revolving Collateral

It refers to collateral that undergoes constant change, like inventory or accounts receivable. Accounts receivable of a company is a monetary amount that is owed by a customer to that company for a good or service that has already been provided. Accounts receivable are recorded as a current asset on a company’s balance sheet. Inventory refers to a company’s raw materials, unfinished products, merchandise, and finished products that are yet to be sold. Inventories are considered to be liquid assets. Securities purchased by dealers or brokers ( meant for reselling) are also termed inventory.

Collateral Loan

A collateral loan is secured loan. A secured loan can offer a wide variety of securities, like bonds or stocks, and property ownership. Banks, as well as different types of financial institutions, offer collateral loans. Collateral loans attract a lower rate of interest as compared to unsecured loans (due to a repayment guarantee in case of default). Collateral loans are also granted against ‘expected collaterals’. Expected collateral includes items like expected returns from an investment or from a harvest.

If the value of collateral declines and the borrower defaults on loan repayment, then that borrower is required to repay the amount at which this collateral was originally assessed. Hence, collateral loans usually cover a portion of the total value of a pledged asset.

Collateralized Securities

Collateralized Securities have high credit ratings. Credit ratings measure the default likelihood of a security. They are also more marketable. Lesser-known companies find ready appeal in the secondary market if its securities are collateralized. Collateralized securities also affect interest rates. The addition of collateral to a security essentially lowers its risk profile. It thus affects its returns. Collateralized corporate bonds normally display low coupon rates as compared to their noncollateralized counterparts. The situation is slightly different with government bonds. Government-collateralized securities like municipal bonds are deemed riskier than other government bonds, which are backed by the government’s power of taxation.

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 11th April, 2024.