What is Over-Collateralization?
Over-collateralization is a when the asset pledged for a debt far exceeds the debt principal. Here, the asset placed as collateral on a loan has a value that exceeds the value of the loan. Over-collateralization reduces the lender’s risk and raise the borrower’s creditworthiness. It is most commonly used when a bond issuer wishes to improve its credit rating.
In the money services, Over-collateralization is used in offsetting the risk in products like mortgage-backed securities. In this case, assets are added to the security in order to ease any capital losses that may arise as a result of set backs on a persons loans which are kept in the security.
However, the purpose of over-collateralization is to raise the credit rating or the credit profile of the borrower by reducing the risk to the investor.
OC In Deatils
Change of assets, like loans into an investment, or security is known as securitization. Home mortgages which are bank loans are sold on by the banks that issue them to financial house who then have them kept them for resale.
However, these are not liquid assets rather high yield debts. In money terms, they are asset-backed securities (ABS). Note that almost any kind of debt may be securitized this includes: student loans, car loans, and credit card debt.
One major step is to note the level of credit to improve. This means the risk is to change the credit profile of the money products. A higher credit profile will lead to a high credit rating which is good to finding buyers for such assets.
In any securitized products, people face a risk of default on the assets. You can think of credit to be improved as a financial cushion that enables the securities to absorb losses from defaults on the loans.
Over-collateralization can be used for credit raise. In this case, the issuer backs a loan with assets which has a value that is in excess of the loan. This limits the credit risk for the creditor while enhancing the credit rating given to the loan
The Rule of Thumb
As a rule of thumb, OC is achieved when the value of assets in the pool is greater than the amount of asset-backed security (ABS). Thus, even if some of the payments from the loans are late or go into default. The payments on the asset-backed security can still be done using the excess collateral. As a rule of thumb, the value of assets must always be 10% – 20% greater than the price of the issued security.