Collateral

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

Collateral

For this reason, collateral analysis is vital to assessing a securitization transaction. This is a grouping of loans, selling financial assets guaranteed by them, which in the case of titling are securitization bonds.

Historically, when the securitization market began to develop, collateral was primarily comprised of mortgage loans. However, as financial markets have evolved, the variety of assets has been greater. Therefore, there are currently greater assets that can be used as backing or collateral.

Collateral is also very common in repo operations. In fact, it is, by definition, the transaction that carries collateral obligatorily in the financial markets. Let us remember that in a repo operation there is an exchange between two counterparties. On the one hand, a fixed income asset such as a bond or bill is delivered and, on the other, cash. All this, in order that, in a certain period, the opposite operation takes place. That is, the fixed income asset is returned on the one hand, and, on the other, the cash plus some interest.

In the financial derivatives markets we find collateralization agreements . These, as their name suggests, are agreements that provide protection against the potential breach of the counterparty of any of its obligations in a derivatives transaction. These agreements, through a legal document, standardize the credit risk mitigation mechanism (counterparty). To do this, defining the assets that can be delivered to guarantee the obligation.

Types of collateral

There are different types of collateral:

  • Loans: We can differentiate personal loans and loans with real guarantee.
  • Collection rights: As a result of transactions with individuals and companies with deferred payment.
  • Exploitation rights: They are income in the form of fees such as royalties , franchises, rentals, etc.
  • Service contracts: Supply contracts such as water, electricity, gas, etc., despite not being 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:

  • Predictability of incoming money flows.
  • Delay in payments and risk of default and liquidity.
  • Diversification of sectoral and geographic risk.
  • Additional guarantees associated with the collateral.
  • Legality and regulatory framework of this asset.
  • Cross collateralization, in case of collateral of a group of assets, if one fails, the rest can be used to hedge that asset.

Collateral example

The most common example of collateral is found in repo trading. This is because it is one of the operations most used by banks, and other large companies, to obtain liquidity. Therefore, it is essential for the proper functioning of the bond market.

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

The logic behind this transaction is the same as for a mortgage. In other words, the person making 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 security that serves as collateral.

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

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