Collateral Valuation: Credit Risk: Collateral Management of Security Interest
Earlier we discussed the creation and perfection of security interest in collateral. It is also important that collateral be properly managed. The post below discusses two elements of collateral management.
Collateral Management broadly encompasses two risk management concepts:
- Credit Risk Management (CRM)
- Safeguarding the enforceability of security interest
a. Credit Risk Management
In terms of CRM, collateral management is part of maintaining the Credit File of the borrower, ensuring that proper records are kept of the collateral and the collateral valuation process and that the collateral is regularly revalued/ reappraised and monitored against the credit exposure.
Records of the following will be kept:
- The written appraisal, the appraisers name, address and signature, the effective date of the appraisal
- A description of the collateral (current and projected, including its use)
- The valuation method used
- The assumptions used in the valuation and for any adjustments made to the value
- A description of the source information
- A description of the analysis and supporting information
- An estimate of the value of the collateral as well as the loan officer’s opinion of the appraisal
Collateral needs to be revalued on a regularly basis and needs to be monitored against the amount of outstanding debt. The frequency depends on:
- The type of collateral being value
- The market condition
- Passage of time
- Volatility of the local market
- Availability of financing
- Environmental contamination
- Improvements/ lack of maintenance
- Changes in zoning
- Inventory of competing properties, etc
For example real estate revaluation usually occurs once over 6 months or annually where as an on-site survey of the same would happen once every 1-3 months. Farm products may be valued on a weekly basis, investment property may be subject to daily marking to market, etc.
When the collateral is revalued the lender’s credit/ collateral balance table will be updated. This table shows:
- By facility; the original amount of credit extended and the loan proceeds outstanding.
- By collateral; the original collateral value, the latest collateral value, a haircut applied to the value of the collateral (depending of the type of collateral and the perceived risk associated with holding that asset) and the collateral value after the haircut
- The total unsecured balance which is the total of the loans outstanding less the total collateral value after haircuts.
b. Safeguarding Enforceability
This includes the dual task of safe custody and maintaining the collateral book.
To safe guard the enforceability of the security agreement the following items must be kept in safe custody:
- Collateral / security agreement (usually ordered by borrower name)
- Pledged goods and documents (usually ordered and kept by type)
Collaterals and associated documents (e.g. fire insurance on property pledged) which are subject to a limitation period or a maturity date need to be kept in order of date to ensure that timely and appropriate action is taken with regard to them.
There must be limited access to the items put in safe custody and they should be protected against natural disaster.
A collateral book for each type of collateral will be created and will be managed by a senior manager. This is done to allow the lender to manage the:
- Collateral inventory
- Expiration of the limitation period/ maturity dates on certain collateral so that appropriate action may be taken (e.g. the filing of continuation papers on the expiration of limitation periods for the perfection of security interests, the settlement of negotiable instruments, like promissory notes or certificates of deposits, which need to be settled without delay on maturity, etc.)
The collateral book should assign a number to each collateral asset / document which in turn should be tagged with the number, the borrower’s name/ number, pledger’s name, date, etc.
The senior manager responsible for the collateral book will need to periodically check the collateral book against the physical inventory of the collateral. Any collateral that is added or removed from the inventory should be registered in the appropriate collateral book. When accepting or returning collateral/ documents a receipt would need to be issued or received from the borrower stating the collateral type, quantity, date and signature.
In this post we have considered collateral management with respect to credit risk management and safeguarding the enforceability of security interest in collateral. In the next post we will see how security interests are enforced when a credit risk event, such as default occurs.