What is Cross-Collateralization?
Cross collateralization is a phrase used when collateral from one loan is reused further as collateral for another loan, thereby increasing the leverage for the borrower and increasing the lending capacity of the bank or the lender. More specifically, it is implemented when an asset or multiple assets are used to collateralization one or more loans. Let’s dive in further to understand cross-collateralization in more detail.
Types of Cross-Collateralization Loans
Based on the mechanism in which it has been implemented, cross-collateralization can be further classified into two major categories
- Multiple Assets collateralizing one or more Loans: In this scenario, one or more assets are pooled together for one or more loans. The simplest example would be a securitization of loans in real estate.
- A Single Asset to collateralize two or more Loans: Unlike the above case, in this scenario, a single asset’s value is unlocked to collateralize multiple loans. The simplest example would be a retail user who can collateralize its multiple loans like a credit card, auto loan, or any personal loan using a piece of land that he owns.
Example of Cross-Collateralization
Let’s consider the scenario of a gentleman Ross who wants to buy a property whose current value is 15 million dollars. Consider the case when Ross has only 2 million dollars as available cash and he wants to take the loan for the remaining amount. However, as per Bank’s policy, a minimum of LTV (loan to value) ratio of 80% is required for any loan to be sanctioned. Hence in such a scenario, Ross cannot qualify for the loan. (This is summarized as scenario 1 in the following table.)
Consider the scenario when Ross has another property whose equity value is 1 million dollars. Using this information Bank can unlock the potential value of this asset as the total (2 + 1 million $) now passes the LTV test of the bank. Hence Ross can be granted the loan. (This is summarized in scenario 2 below)
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Effectively cross-collateralization helped in increasing the leverage and removed any liquidity crunch for Ross.
Advantages of Cross-Collateralization
Given below are a few advantages of Cross-Collateralization.
- In simple terms, the biggest and foremost advantage of cross-collateralization is the leverage that it provides. It helps firms in raising capital on behalf of the assets which are sitting on their balance sheets and getting depreciated day by day. Simply put, it helps in unlocking the value of the assets and in turn create more cash-generating opportunities for the firm.
- Cross collateralization is boon for the borrowers who have a bad credit history and hence do not qualify for the loan approvals. These borrowers can be entitled to loans if the existing collateral can be used to get an additional loan, thereby helping in reducing the liquidity crunch which if not solved at the right time can lead to a credit crunch crisis.
- There are certain additional benefits for the borrower like the ease of transaction and low establishment fees as there can be a single cross-collateralized loan instead of multiple single loans.
Disadvantages of Cross-Collateralization
The following are some disadvantages of Cross-Collateralization.
- Though cross-collateralization helps in getting the loan on the same asset, it can be equally disastrous in bad times as the borrowers may lose the asset if there is a default or delay in payments even on anyone loan payment schedule. Not to forget that in times of distress correlation between the assets increases.
- In situations, when two assets are combined to secure a single loan, investors can lose ownership of both the assets if there is a delay or default in scheduled payments similar to the above scenario.
- It becomes difficult to sell assets individually when they have been pooled as part of cross-collateralization for a secured loan.
Important Points to Note
- Cross collateralization helps borrowers qualify for a larger loan amount than what they are normally entitled to. There is a significant section of people who have never taken a loan and hence have no credit history. Banks in such scenarios find it difficult to provide approvals for sanctioning the loan for these first-time users. This issue can be avoided using cross-collateralization.
- Specifically, for real estate investors and consumers, cross-collateralization provides a mechanism to finance multiple assets together into a single unit.
- Most often the assets are under stress when they are collateralized because of the cyclic economic downturns. However, when the cycles turn the same asset can be valued better. Using cross-collateralization, assets that have been devalued due to cyclic economic downturns can be collateralized to raise more money.
- Cross collateralization helps firm in claiming better tax benefits as they are entitled to multiple tax deductions, thereby lowering the effective tax applied and eventually increasing the profitability.
Cross collateralization in simple terms converts multiple single loans into a single loan wherein a single asset or group of assets are bundled together to act as a collateral for the loan. However, in practice, it is much more than just an implementation mechanism. It helps a borrower, whether a retail borrower or a corporate firm, to unlock the value of fixed assets, increase the leverage, get a lower interest rate and better tax benefits.
With so many advantages, there is also a catch. Over collateralization can lead to stressed assets and eventually leading to investors losing ownership of the collateral if either of the loan payments is delayed. Hence one should understand both the pros and cons of such a sophisticated mechanism before opting for it. In fact because of such dependence on assets and how they have been valued in the loan documents, more often than not,cross-collateralization attracts the scrutiny of the regulators.
This has been a guide to what is Cross Collateralization and its definition. Here we discuss types and examples of cross-collateralization loans with a scenario along with advantages and disadvantages. You can learn more about financing from the following articles –