Collateral and Guarantee Guidance

This article will cover Collateral and Guarantee guidance.

 

In this Article

• Collateral and Net Recovery Rate Study Results
• Why should you care?
• Organizing the Results
• Key Findings
• Approach to Net Recovery Values for Collateral
• Best Practices
• Guarantee Type Table

 

Collateral and Net Recovery Rate Study Results

PrecisionLender studied net recovery rates by collateral type across its client base in 2Q 2023.  We found nearly 1 million possible combinations of collateral types and net recovery rates.  From this foundation, we distilled the source data into 21 common collateral types in use across the PrecisionLender platform.  In addition, we recorded the range of net recovery rates themselves and the frequency of collateral types in use across Financial Institutions (FI).  

We present the results here for the purpose of quantifying the range of net recovery rates in use for a given collateral type.  This information may assist administrators in evaluating their FI’s net recovery rate assumptions.  

Key Takeaways:

• Since our last update, net recovery rates have moved lower on most real estate types, with few exceptions.  Hospitality and Retail dropped 10%; Office fell 13%.  Exceptions include Multi Family and Industrial which maintained expected recovery value.   
• Within the non-real estate types, net recovery rates on segments of equipment dropped about 10% and agriculture equipment about 16% while inventory improved by 16%.
• In sum, there has been movement up and down the net recovery rate scale across these common collateral types.
• Results now share two additional break outs: Residential Construction and Agricultural Land.     
• PrecisionLender published two intermediate white papers on Hotel recovery rates and Office recovery rates since our last collateral update.  The conclusion of these white papers suggests ranges on net recovery on hotels and office space.  Please find the full studies here: 
  • Suggested Recovery Values for Hotel Loans
  • Recovery Rates for Office Property Collateral 

 

 

Why should you care?

• Net recovery rate affects ROE—Collateral and Guarantees can be used to reduce the credit risk associated with an opportunity, thereby increasing its profitability and return (ROE).
• Collateral and guarantees, their types, values and net recovery rates directly affect the annual loss and credit capital assignments for all commercial loans priced where these credit risk mitigants are part of the credit capital strategy employed by the FI.
• Collateral and guarantees are credit risk mitigants and offer protection to the lending institution in two ways: 1) quantity and 2) quality. Quantity in that greater amounts of collateral and guarantee reduce potential loss given default (LGD). Quality in that higher net recovery rate/liquidation value reduce potential LGD.
• The extent of the protection varies and is based upon assumptions with respect to net recovery rates. These are typically based on an FI’s actual experience, management’s estimates or industry information.
• This study is about the net recovery rates. To illustrate the sensitivity of net recovery rate on the credit capital assignment we examined rates ranging from 40% to 65% which cover most of the real estate, equipment and blanket lien types of collateral in use.
  
  The chart below demonstrates the sensitivity of the credit capital assignment to small changes in the net recovery rate of the underlying collateral. Between 45% and 60% net recovery rate, the resultant credit capital doubles in this illustration from 4% of loan balance to 8% of loan balance. The increased capital requirement brings pressure to increase revenue elements on lending opportunities to maintain return expectations. These revenue elements include note rate, fee income, spread to index, index selection and loan structure.

 

Organizing the Results

We organized the results into two levels of detail.  

 

 

 

 

Key Findings

• On the PrecisionLender platform, 100% of FI’s are represented by both Real Estate and Non-Real Estate collateral types. 59% are represented with Municipal types typically associated with Tax Exempt lending. 67% of FI’s allow for the consideration of unsecured lending opportunities.

• Within the construction lending space, when FI’s separate Residential construction projects from Commercial, there is a noteworthy distinction in average and median net recovery rates. Residential projects post a median 55% net recovery rate vs 45% for the commercial projects.

• Similarly, when Agricultural land is separated from general land as a collateral type, we find FI’s place a higher net recovery rate, at 60% median, on this type of mitigation compared to Land/Raw land at 40% median.

• Industrial, Retail and Office real estate types show the greatest consensus of net recovery rate ranges among the real estate categories. These three show a low end of 30% and a high end of 75% across the FI’s measured.

• PrecisionLender’s Office study suggests an overall net recovery rate of 38% with a range of 45% for Class A type properties and about 35% for B and C and Medical facilities. This level is below the 45% median above.

• The hotel study shows guidance at about 40% overall net recovery rate equivalent to the median above.

 

Approach to Net Recovery Values for Collateral

PrecisionLender employs a conservative approach to net recovery values. We consider how long it is expected to take to liquidate the collateral, measured from the time interest stops being paid per loan terms until the liquidation. We begin with a nominal recovery rate based on the expected liquidation value of the collateral and the full cost of its maintenance. We employ a 15% discount rate to bring the nominal recovery rate down to the economic net recovery rate. In this approach, the point of view is that liquidation options are limited, and the overall tone is one of difficult economic conditions with respect to liquidation speed and value. 

 

Best Practices

• Consider granular Collateral Types—avoid bundling collateral such as “accounts receivable, inventory and blanket lien” into a single category; the key is to think about how quickly and how
  much deviation from the original value the collateral will bring when setting up categories. For example, cash and non-marketable securities will not have the same characteristics when they are liquidated.
• Consider customizing collateral selection by product when distinct business lines are present.
• Always select a default Collateral Type for each product. This selection can act as a prompt to relationship managers when they are pricing an opportunity—they will update the default information with the specific details for the opportunity being priced.
• For clients using the Relationship Awareness module, make certain that all your actual valid Collateral Types are either referenced or mapped to a referenced Collateral Type. The LTV% and net recovery rates will fill in any data gaps from your core system(s) and will support an accurate credit capital assignment and profit calculation.
• Consider refining net recovery rates by both guarantee type and relative strength of guarantor.

 

Guarantee Type Table

PrecisionLender maintained our recommendations for guarantee types and their net recovery rates. For Personal and Related Entity guarantees, this line up attempts to define the degree to which a guarantor may be able to “make good” on an opportunity or obligation for which they are legally obligated to repay if the obligor defaults. The net recovery rate derivation follows the approach cited above using a nominal recovery rate discounted by 15% and a time to recovery estimate. Related Entity refers to an ongoing business enterprise that is affiliated with the borrowing entity generally through common ownership—for example: a parent or sister company.

 

For more insight into the impact recovery rates can have on the economics of a loan, check out this article. And if you need any assistance updating your Collateral or Guarantee Types, check out these Collateral and Guarantee articles.