Over-Collateralization (OC)
What Is Over-Collateralization?
Over-collateralization (OC) is the provision of collateral that is worth all that anyone could need to cover likely losses in cases of default.
For instance, a business owner seeking a loan could offer property or equipment worth 10% or 20% more than the amount being borrowed. Over-collateralization might be utilized by companies giving bonds for a similar explanation.
In the financial services industry, over-collateralization is utilized to offset the risk in products, for example, mortgage-backed securities. In this case, extra assets are added to the security to cushion any capital losses due to defaults on the individual loans that are packaged in the security.
Regardless, the purpose of over-collateralization is to increase the credit rating or the credit profile of the borrower or the issuer of securities by diminishing the risk to the investor.
Figuring out Over-Collateralization (OC)
Securitization is the practice of changing an assortment of assets, like loans, into an investment, or security. Ordinary bank loans, for example, home mortgages are sold on by the banks that issue them to financial institutions that then package them for resale as securitized investments.
Anyway, these are not liquid assets but rather interest-delivering debts. In financial phrasing, they are asset-backed securities (ABS). Practically any sort of debt might be securitized incorporate residential or commercial mortgages, student loans, vehicle loans, and credit card debt.
Credit Enhancement
A key step in the securitization of products is deciding the suitable level of credit enhancement. This alludes to risk reduction to further develop the credit profile of the structured financial products. A higher credit profile prompts a higher credit rating, which is key to finding purchasers for securitized assets.
Investors in any securitized product face a risk of default on the underlying assets. Credit enhancement can be considered a financial cushion that permits the securities to absorb losses from defaults on the underlying loans.
10% to 20%
The rule of thumb for the amount of over-collateralization required to further develop a credit profile.
Over-collateralization is one technique that might be utilized for credit enhancement. In this case, the issuer backs a loan with assets or collateral which has a value that is in excess of the loan. That limits the credit risk for the creditor and improves the credit rating assigned to the loan.
The Rule of Thumb
Over-collateralization is accomplished when the value of assets in the pool is greater than the amount of the asset-backed security (ABS). Thus, even assuming that a portion of the payments from the underlying loans are late or go into default, the principal and interest payments on the asset-backed security can in any case be produced using the excess collateral.
As a rule of thumb, the value underlying a pool of assets is frequently 10% to 20% greater than the price of the issued security. For instance, the principal amount of a mortgage-backed security issue may be $100 million, while the principal value of the mortgages underlying the issue may be $120 million.
A Cautionary Note
It ought to be noticed that numerous asset-backed securities were evidently over-collateralized at the hour of the 2008 financial crisis. As a matter of fact, the value of the assets utilized as collateral was a lot of lower than introduced, or the risks that the borrowers would default was a lot higher than expected, or both. That drove straightforwardly to the sub-prime crisis that resulted in 2008.
Features
- An issuer of asset-backed securities might use over-collateralization to reduce the risk to likely investors.
- Regardless, over-collateralization might upgrade the credit rating of the borrower or the issuer of debt.
- A borrower might involve over-collateralization to get better terms for a loan,
