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Using Collateral

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Collateral

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.

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.

 

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 ROE after taking into consideration the prior lien and the recovery factor.
    • If there is a  Prior Lien then:
      • Effective Value = (Value x Recovery Factor) - Prior Lien
    • 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
  • 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 ROE 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 ROE 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 ROE 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 ROE 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 ROE = 22.0% 

 

Demonstrating the way the collateral is entered into an opportunity - the scenario written out above has an LTV of 80%

 

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

  •  Resulting ROE = 15.18%.

Demonstrating the way the collateral is entered into an opportunity - the scenario written out above has an LTV of 187%

 

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

  •  Resulting ROE = 15.18%

Demonstrating the way the collateral is entered into an opportunity - the scenario written out above has an LTV of 187%

 

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.
infinity.PNG
 
 

 

Cross Collateralization

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 ROE calculations for the Opportunity.
 
 
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