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. It is specifically implemented when an asset or multiple assets collateralize CollateralizeCollateralization 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 us dive in further to understand cross-collateralization in more detail.

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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 the securitization of loans in real estateReal EstateAt its most basic principle, Real Estate can be defined as properties that comprise land and its tangible attachments. The land includes the actual surface of the earth and any permanent natural objects such as water, dirt, or rock and any minerals or particulars under the surface. read more.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 multiple loans like a credit card, auto loan, or any personal loan using a piece of land he owns.

Example of Cross-Collateralization

Let us consider the scenario of a gentleman named Ross who wants to buy a property whose current value is $15 million. Consider the case when Ross has only $2 million as available cash. He wants to take the loan for the remaining amount. However, per the bank’s policy, a minimum 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 to sanction any loan. Hence, Ross cannot qualify for the loan in such a scenario. (This is summarized as scenario 1 in the following table.)

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. Using this information, the bank can unlock the potential value of this asset as the total ($2 million + $1 million) now passes the LTV test of the bank. Hence, Ross can be granted the loan. (This is summarized in scenario two below)

Effectively cross-collateralization helped increase the leverage and removed any liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more crunch for Ross.

Advantages of Cross-Collateralization

Given below are a few advantages of cross-collateralization.

  • In simple terms, cross-collateralization’s biggest and foremost advantage is its leverage. It helps firms raise capital on behalf of the assets sitting on their balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more and getting depreciated daily. Simply put, it helps unlock the value of the assets and, in turn, creates more cash-generating opportunities for the firm.Cross-collateralization is a boon for borrowers with a bad credit history who do not qualify for loan approvals. These borrowers can be entitled to loans if one can use the existing collateral to get an additional loan, thereby helping reduce the liquidity crunch. If not solved at the right time can lead to a credit crunch crisis.The borrower has other benefits, such as ease of transaction and low establishment fees. In addition, 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 get the loan on the same asset, it can be equally disastrous in bad times. The borrowers may lose the investment if there is a default or delay in payments, even on anyone’s loan payment schedule. Not to forget, the correlation between the assets increases in times of distress.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 pooled as part of cross-collateralization for a secured loan Secured LoanSecured loans refer to the type of loans approved and received against a guarantee or collateral. If they fail to do so, the lending institution acquires the collateral to compensate for the amount that the borrowers were allowed.read more.

Important Points to Note

  • Cross-collateralization helps borrowers qualify for a larger loan than they normally are entitled to. Many people 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, cross-collateralization offers a mechanism to finance multiple assets into a single unit for real estate investors and consumers.The assets are often under stress when collateralized because of cyclic economic downturns. However, the same investment can be valued better when the cycles turn. Using cross-collateralization, assets that have been devalued due to cyclic economic downturns can be collateralized to raise more money.Cross-collateralization helps firms claim better tax benefits as they are entitled to multiple tax deductions, lowering the effective taxEffective TaxEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more applied and increasing profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more.

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 collateral for the loan. However, it is much more than just an implementation mechanism in practice. It helps a borrower, whether a retail borrower or a corporate firm, 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 investors losing ownership of the collateral if the loan payments are delayed. Hence, one should understand 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, cross-collateralization attracts the scrutiny of the regulators.

This article is a guide to Cross Collateralization and its definition. Here, we discuss types and examples of the cross-collateralization loan with a scenario and advantages and disadvantages. You can learn more about financing from the following articles: –

  • Combined Ratio in InsuranceCollateralized Debt ObligationLoan SyndicationLoan Shark