## Overview

The most common form of credit risk mitigation is collateral. Collateral helps to offset the inherent credit risk of a loan within a given risk grade. Collateral helps lower credit risk in two ways:

**Quantity**- The more collateral the better. The quantity of collateral is usually expressed in terms of “Loan-to-Value (LTV)”**Quality**- The higher the quality of the collateral the greater the impact it has on offsetting credit risk. For example, cash is much better quality collateral than say work-in-process inventory.

This article walks through using collateral when pricing an opportunity in PrecisionLender. If you don't see the option to add Collateral to your opportunity, your administrators might have enabled Facility Ratings instead. To learn more, visit **Using Facility Ratings.**

## In this Article

- Collateral Types within PrecisionLender
- Adding Collateral to a Loan within an Opportunity
- Prior Liens
- Cross-collateralization

## Collateral Types within PrecisionLender

Collateral types are fully customizable by your local administrator but typically include: Commercial Real Estate, Cash, Accounts Receivable, Inventory, Fixed Assets or Equipment, Land, Residential Real Estate, Marketable Securities, etc.

If the Collateral Type you need is not available in your drop down list, please contact your Administrator and ask them to add the additional collateral type. Your local administrator also controls the recovery factors for your various products. You can view this factors for the loan product you're pricing in the Assumptions Screen.

## Adding Collateral to a Loan within an Opportunity

To add collateral, click the "Collateral" field, then click "Add" and select the applicable Collateral Type from the list. Then enter either the "Value" or the "Combined LTV" and any applicable "Prior Liens".

**Combined LTV**: The ratio of the Loan Value AND prior liens to the value of the Collateral.- You can enter this, or it will be calculated if you enter the "Value."
**Value**: The dollar value of the collateral.- You can enter this, or it will be calculated if you enter the "Combined LTV."
**Prior Liens**: The total value of all Prior Liens against this Collateral- See section below on Prior Liens for more detail.
**Effective Value**: The collateral value necessary to realize the same return after taking into consideration the prior lien and the recovery factor.- Effective Value = Collateral Value - (Prior Lien / Recovery Factor)

- If there is a Prior Lien then:
- See section below on Effective Value.
**Effective LTV**: The ratio of the Loan value to the Effective Value of the Collateral.

## Prior Liens

When a piece of collateral has prior liens against it, PrecisionLender allows you to enter the sum of those prior liens along with the collateral's value. PrecisionLender then calculates the Combined LTV as well as the Effective LTV and Effective Value of the Collateral.

### For Example:

**Loan Value**= $800,000**Collateral Value**= $1,000,000**Prior Liens**= $200,000**Collateral LTV**= 80% = $800,000 / $1,000,000**Combined LTV**= 100% = ($800,000 + $200,000) / $1,000,000**Recovery Factor for Collateral**= 0.35- The recovery factor will reflect the net expected proceeds, after all carrying and selling costs, in the event that liquidation of the collateral is required. This is set by your administrators and can vary from product to product. You can view recovery factor assumptions while pricing your opportunity in the Assumptions Screen.
**Effective Value**= $428,571 = $1,000,000 - ($200,000 / 0.35)**Effective LTV**= 186.67% = $800,000 / $428,571- The
**Collateral Mitigation**of this collateral position will be $150,000. This is the post-liquidation amount that will be available after taking into account the recovery factor and the prior lien-holder's position. The Collateral Mitigation value is used behind the scenes to calculate the overall return of the opportunity. This value is calculated as ($1,000,000 x .35) - $200,000

### How the Effective Value works

The Effective Value is the collateral value necessary to realize the same return after taking into consideration the prior lien and the recovery factor. As you can see in the example below, once the prior lien of $200,000 is introduced, the Effective Value decreases from $1,000,000 to $428,571 and the return drops from 22% to 15.18%. Essentially, an $800,000 loan balance with a first lien position on a collateral value of $428,571 returns the same return as an $800,000 loan balance in a second lien position behind a $200,000 first lien on a collateral value of $1,000,000.

An $800,000 loan and a $1M collateral position with no prior liens:

**Resulting Return**= 22.0%

Adding $200,000 of prior liens decreases the effective value from $1,000,000 to $428,571:

**Resulting Return**= 15.18%.

A Collateral valued at $428,571 with no prior liens has an equivalent effective value:

**Resulting Return**= 15.18%

### Limitations on how PrecisionLender handles Prior Liens

The modeling of Prior Liens does not take into account real-life recovery factors that may occur when a first lien holder liquidates a piece of collateral in an attempt to cover the first lien. Such recovery factors could be lower than your expected recovery factors for the same class of collateral.

### Infinity LTV

If you have a piece of collateral with a prior lien, you may see an Effective Value of $0 and an LTV of Infinity. This occurs when the prior lien exceeds the amount of recoverable collateral determined by the recovery factor. Since the prior lien is eating up what money can be recovered from the collateral, there is nothing left for the loan currently being priced so PrecisionLender considers the collateral unsecured.

## Cross Collateralization

### Multiple Loans in an Opportunity

If the same piece of collateral is being used to secure multiple loans within a PrecisionLender Opportunity, each loan should list the collateralized amount from the other loan as a prior lien. While not a perfect solution, this method ensures that the collateral is not double-counted in the Return calculations for the Opportunity.

### New Loan for an Existing Relationship

When a piece of collateral secures an existing loan that your bank owns (the bank is in first position) is being secured against a new loan being originated by your bank (the bank will be in second position), you can enter the weighted collateral value in the Value field to avoid double counting the collateral.

To obtain the weighted collateral value

- (New Loan Value / New & Existing Loan Value) * Current Collateral Value = Weighted Collateral Value

### For Example:

**New Loan Value**= $2,000,000**Existing Loan Value**= $3,000,000**Current Collateral Value**= $8,000,000

**Weighted Collateral Value** = ($2,000,000 / $5,000,000) * $8,000,000 = $3,200,000