Cross Collateralization

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 collateralizationCollateralizationCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay.read more one or more loans. Let’s dive in further to understand cross-collateralization in more detail.

Cross Colletralization

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Types of Cross-Collateralization Loans

Cross Colletralization Type

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Based on the mechanism in which it has been implemented, cross-collateralization can be further classified into two major categories

  1. 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.
  2. 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 valueLoan To ValueThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value.read more) 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.)

Scenario 1(in Millions)
Market Value of Property15
Available Cash2
Loan to Value Requirement80%
Required Cash for Loan Eligibility3
Differences1
Car Loan be GrantedNo

Consider the scenario when Ross has another property whose equity valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more 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)

Scenario 2(in Millions)
Market Value of Property15
Available Cash2
Loan to Value Requirement80%
Required Cash for Loan Eligibility3
Equity Value of Another Property1
Differences0
Car Loan be GrantedYes

Effectively cross-collateralization helped in increasing the leverage and removed any liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more crunch for Ross.

Advantages of Cross-Collateralization

Given below are a few advantages of Cross-Collateralization.

Disadvantages of Cross-Collateralization

The following are some disadvantages of Cross-Collateralization.

Important Points to Note

Conclusion

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 assetsValue Of Fixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more, 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 –

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