Collateral Evaluation and
Credit Risk Management
Contents
1. Why is Collateral Evaluation Important?
2. Types of Collateral and Regulatory Pitfalls
3. Evaluation of Collateral (RealEstate)
4. Evaluation of Collateral (Other Assets)
5. Protection of Collateral
Creation of Security Interest
Perfection of Security Interest
6. Collateral Management
Collateral Management for Credit Risk Management
Safeguarding the Enforcement
7. Enforcement of Collateral
8. Extinguishing Security Interest in Collateral
1. Why is Collateral
Evaluation Important?
Why is Collateral Evaluation Important?


The more accurate the evaluation, the more enhanced credit risk
management in place.
Large actual loan loss exceeding the estimated LGD could lead to a
serious depletion of bank’s equity capital.
Value Added
PRICE
Unexpected Loss (Required Return ×
Allocated Economic Capital)
Operating Cost
Funding Cost
MARGIN
Expected Loss (PD × LGD)
By reducing loss
given default, the
bank can reduce
the margin without
reducing value
added.
EL: Expected Loss
PD: Probability of Default
LGD: Loss Given Default
UL: Unexpected Loss
Why is Collateral Evaluation Important?


LGD is estimated from default-weighted average loss rate during a
certain time period.
Loss rate is given by:
1-
PV at the default date of recoveries + PV of costs associated with collecting
EAD (Exposure at default)
PV: Present value


To reduce average loss rate, banks need to collect on the default
exposure as much as and as fast as possible.
If a bank does not properly estimate collateral values, the collection
upon default would become smaller and take a longer period of time,
leading to a depletion of capital and lower profits.
Wrong
Collateral
Evaluation
Higher
Wright-offs
Higher LGD
Estimation
Higher
Provision
Capital
Waste
Lower
Profits
Role of Collateral in Financial Intermediation I

Collateral stabilizes financial intermediation

Collateral better aligns interests of the lender and borrower
because:



The lender can maximize the safety of repayment
The borrower will minimize the risk taking
Without collateral:



The lender will solely rely on borrower’s cash-flow generated by the
project (business) for the repayment.
The borrower tends to take more risks in the project (business), which
may cause instability in generating cash-flow.
There will be more vulnerable banks and more risky businesses in the
economy, otherwise, resulting in shallow financial intermediation.
Role of Collateral in Financial Intermediation II

Lender (specifically)




Encourage willingness of payment to reduce PL.
Substitute the repayments to reduce LGD.
Protects against borrower’s over-borrowing.
Borrower (specifically)



Access to credit: let borrowers monetize their illiquid assets to raise funds
Cost of Credit: potentially reduce funding costs for the lower EL
calculated by the lender
Overcoming asymmetric information problems: access to funds even in a
financially difficult time, or even without audited financial reports
EL: Expected Loss
PD: Probability of Default
LGD: Loss Given Default
UL: Unexpected Loss
2. Types of Collateral and
Regulatory Pitfalls
What is Collateral?

Under modern collateral law systems, collateral can be any asset
which produces future cash flow directly or indirectly, and can be
created by any lender and borrower, in any present or future assets
and in all transactions, to substitute payments for a part or the entire
outstanding debt upon default.

Under unreformed collateral law systems, there would be various
constraints on asset types eligible for collateral, on persons or legal
persons qualified to collateral agreements, or on the enforceability
of some collateral, due to the lack of efficacy and integrity of the
system.
Collateral Laws and Collateral Types

Collateral Law


Independent and comprehensive
“collateral law” is rare: generally
collateral law is a system which is
constituted by several relevant
laws and regulations.
Goods







Extent of collateral



After-acquired property
Proceeds
Supporting obligation

Intangibles





Unmovable Collateral




Real Property: Land and Building
Plant and Equipment
Natural Reserves
Timber to be cut


Consumer goods
Farm products
Inventory
Equipment
Fixtures
Accessions
Negotiable instrument
Document of title
Investment property
Account (book debt
General Intangibles
Other kinds of collateral


Deposit accounts
Life insurance policy/health-care
insurance receivable
Source: Collateral, Collateral Law and Collateral Substitutes, B. Balkenhol and H. Schutte,
Social Finance Programme, Working Paper No. 26, p17
3. Evaluation of Collateral
(Real Estate)
Principles of Collateral Evaluation
1.
2.
3.
4.
5.
Collateral evaluation is not to find an accurate, unique price, but to
find a price and logic which are realistic, practical, and acceptable
by ordinary market participants.
Evaluate collateral on the basis of the market value rather than
book value.
Apply the most conservative evaluation method.
If possible, collateral property should be located within a distance
bank officers can take frequent visits.
Watch the market price if it’s rising fast: a price bubble may be
developing.
Basics of Land Collateral Evaluation

Step 1: Estimate a price par square meter/feet either by:
(1) The sales comparison approach
(2) The income capitalization approach (mainly for lease properties)
(3) The cost approach (in case of houses and buildings)

Step 2: Adjust the price by factors unique to the real estate
(1) Usage of the property
(2) Trends of real estate price
(3) Conditions of the property/nature of the surrounding area
(4) Legal issues
Sales Comparison Approach

If recent transactions or sells prices for the similar real estate are
available in the city, town or village, the sales comparison approach
provides good estimates.
Price B (2,450$/m²)

30m
Weighted-average 
of A and B (Price D)

50m
Unadjusted estimated Price E ($/m²)?
150m
Price C (1,900$/m²)

70m
Price A (2,000$/m²)

Note: Each price points should not be
separated by a major street or river,
which affect the price differences
Sales Comparison Approach: Example


Evaluate the land price E.
Three recent real estate transactions around E.



On the map, locate price D between A and B
Distances between these points are:


A: $2,000, B: $2,450, and C: $1,900
A-D: 70m, D-B: 30m, D-E: 50m, and C-E 150m.
Then dollar price par square meter of E will be:
Price D = (Price A × 30) + (Price B × 70) = 2,315 ($/m²)
70 + 30
Price E = (Price D × 150) + (Price C × 50) = 2,211 ($/m²)
50 + 150
Income Capitalization I

Find a geographically weighted-average rent price per unit of land in
the same way before.
Rent price B (320$/month)

15m
Weighted-average 
of A and B (price D)

Estimated rent price E ($/month?)
10m
30m

Rent price A (350$/month)
40m
Rent price C (360$/month)

Note: Each price points should not be
separated by a major street or river,
which affect the price differences
Income Capitalization II

Calculate the present value of the rent income for the certain future
period.
Annual rent – (maintenance cost + property taxes)
PV= Σ
( 1 + r )n
PV: Present value

Income capitalization approach using rents may be used in a situation
where a loan officer knows the property concerned has a certain value
for the market, but there is no way to reasonably estimate and explain
the value due to the lack of transaction.


The estimated value may be much lower than a potential market value
(additional margin for valuation uncertainty).
It depends on bank’s loan policy, but time horizon should be limited to 10
to 12 years.
Income Capitalization Approach: Example




Evaluate the land price E.
Monthly rents of the three leasing properties are: A: $350, B: $320,
and C: $360
Distances between these properties are: A-D: 30m, D-B: 15m, D-E:
10m, and C-E 40m.
Using the above information, estimated rent price E will be:
Rent D = (Price A × 15) + (Price B × 30) = 330 ($/month)
30 + 15
Rent E = (Price D × 40) + (Price C × 10) = 336 ($/month)
10 + 40

Assume the annual maintenance cost including property taxes is
$300, interest rate is 8%, and you calculate up to 10 years, then
estimated collateral value is:
10
cost 300)
PV = Σ Annual rent (336×12)–(maintenance
t
( 1+0.08 )
t=1
= 25,042 ($)
PV: Present value
Income Capitalization Approach III

Basic concept of the capitalization rate


Factors affecting investors’ desired return on real estates


“The capitalization rate itself is a function of the investor’s desired return
and a combination of the costs of debt and equity employed in making
the investment.” (Bower 2001)
Culture, economic trends, other investment property type, other
investment opportunities, etc.
In practice


The most simplified way is to use available loan interest rates for such
an investment as a capitalization rate.
When interest rates are used as a capitalization rate, loan officers must
be aware that the interest rate does not include necessary returns for
taking risks inherent to the investment, hence, the outcome overvalues
the real estate.
Source: Understanding real estate values in a rising market—Brief Article, Gerald A. Bower, 2001
http://findarticles.com/p/articles/mi_m3601/is_29_47/ai_71565185
Price Adjustment I

Usage of the property

Own-use residential property


Own-use farm and forest land/factory and warehouse


The income capitalization approach
Residential/business property for lease





Most useful
Income capitalization approach
Rent prices in the neighborhood
Future occupancy rate estimation
Residential leasing property and business leasing property
For sale

Speculative in nature
Price Adjustment II

Trends of real estate price



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Sales and transaction prices
Information from neighbors
Information from experts, brokers, sales registries, and mortgage
registries
Income level of the area
Demand and supply conditions of the market
Published land prices and tax rates
Regional development plan
Availability of mortgage loan/foreign land ownership
Price Adjustment III

Conditions of the property/nature of the surrounding area








Geographic conditions, such as, close to the coast, river, cliffs, or located
on tilted land, in a dip, on the weak stratum
Size of the real estate
Shape of the real estate
Location of the real estate in the block
Accessibility to the public roads
Accessibility to public and commercial facilities
Existence of unfavorable facilities
Municipal services available
Price Adjustment IV

Legal issues



Easements: restrictions, encumbrances, leases, reservations,
covenants, contracts, declarations, special assessments, ordinances, or
other items of a similar nature.
“Eminent domain”: in common law countries, the government may have
the rights to buy real property without the owner’s consent for the
purposes of public usage, such as public utilities, highway, airport, and
railroads.
Legitimacy of buildings (illegal construction/usage)
Note: When the above legal issues are involved, the price of the property could
drop substantially.

What are the most major methods to evaluate real estate
collateral in your country?
4. Evaluation of Collateral
(Other Assets)
Collateral Evaluation I

Farm Product/Inventory








Market price basis
Interview with major buyers
Market liquidity
Market size
Market volatility
Perishable products
Dealer listings, market sales reports
Location of the storage
Collateral Evaluation II

Mobile Vehicle





Secondhand car market price basis
Interview with experts and dealers
Maker, type, popularity, market, in case of inventory
Age, depreciation schedule, unpaid taxes, prior lien, in case of
equipment
Government’s import tax policy or other policies affecting market
Collateral Evaluation III

Intangibles





Negotiable instrument: validity of the instrument, obligor, credit rating,
maturity, type of transaction: collateral/repurchase agreement/discount
Document of title: bill of lading: validity of the document, location of the
property, quantity, species/variety, measure/weight, value per unit,
quality, condition, schedule, as well as marketability and market price.
Investment Property: issuer, credit rating, market price, market
volatility, (maturity), OTC/exchange
Account (book debt): obligors, the extent of diversification, the length of
terms, aging schedule, the past default rate
General intangible: variability of the right (document), terms and
conditions, restrictions contained in the document, marketability, etc.
5. Protection of Collateral
Creation of Security Interest

Elements to create valid security interest:





“A value” in security agreement


A value is set in accordance with an amount intended to cover existing
or future credit outstanding in part or in total.
Other Issues



The debtor has rights in the collateral*
A security agreement must be authenticated by the debtor
A security agreement must contain a description of the collateral
A security interest cannot attach unless “value” is given*
Inter-creditor agreement
Pari-passu charge
Creation of security interest alone cannot preserve creditor’s priority
over lien creditors and other secured parties with an interest in the
same collateral.
*Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p57, 92, 95
Perfection of Security Interest


After perfection the secured party is protected against other
creditors and transferees of the debtor and in particular, against any
representative of creditors in insolvency proceedings instituted by or
against the debtor.*
Depending on the jurisdiction, different collateral may have different
rules for perfection






Perfection upon attachment alone
Temporary perfection in certain collateral
Perfection by pledge or possessory security interest
Perfection by filing (registration)
Perfection where filing is required under a special law
Perfection by public notice (example: news paper advertisement)
*Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p123
6. Collateral Management
Collateral Management

Collateral Management

Collateral management includes two risk management concepts:
 (1) Collateral management for credit risk management
 (2) Safeguarding the enforceability
Collateral
Management
for CRM
Credit File
Collateral
Management
Safeguarding
the
Enforceability
Safe Custody/
Collateral Book
• Record Keeping
• Revaluation/Reappraisal
against credit exposure
• Numbering/Tagging
• Maturity Management
• Renewal of security interest
• Periodical check of inventory
Credit File I

Record Keeping


Appraiser’s name, the effective date of the evaluation, and
signature and address (when the evaluation is outsourced)
Description of the collateral






Real estate: ownership, location, shape, condition, developments,
pictures, maps, neighborhood, usage, a copy of construction
approval, attached easement, etc.
Goods: location of the goods, quantity, species/variety,
measure/weight, value per unit, quality, condition, schedule
Intangibles: pledgor, amount, quantity, third party obligor, attached
security interest, etc.
Description of the evaluation method employed
Description of the source information used in the evaluation
An estimated value of the collateral and the opinion of the loan
officer on the evaluation
Source: Interagency Appraisal and Evaluation Guidelines, FDIC, 1994
Credit File II

Reappraisal



Collateral should be regularly revalued depending on the
collateral type.
Collateral value should be constantly monitored against credit
outstanding.
Frequency of reappraisal depends on the market condition






Real estate (revaluation): every 6 months or 12 months
Real estate (on-site survey): every month or 3 months
Farm product: every week or month depending on the market
Inventory: depending on the market
Mobile vehicle: every 3 month or 6 month
Intangibles: daily basis if mark-to-market is required (depending on
the type of transaction)
Credit File: Example

After evaluation of land and building the following credit/collateral
balance table is updated. How do you interpret the table and what
should be done?
Borrower: ABC Trading Co. Internal Credit Score: 4B External: n/a As of: Mar 08
Type of loan
Term loan A
Term loan B
Revolving line
Original
amount
or credit
line
50
120
30
Loan
proceeds
outstanding
10
95
0
Loan credit
outstanding
Type of collateral
10 Land
95 Building
30 Receivable
Public Guarantee
Original
Collateral
Evaluation
Latest
Collateral
Evaluation
110
50
40
10
90
40
40
10
40
100
25
0
54
0
30
10
12
0
12
Time deposits
Total
Thousand $
105
(A)135 Total
Unsecured Balance (A)-(B)
Haircut
Collateral
Value
(B)106
29
Safe Custody/Collateral Book I

Safe Custody

In order to safeguard and protect the enforceability of security
interest, (1) collateral agreement and (2) pledged goods and
documents should be put in a safe custody.





Collateral agreement (together with other relevant legal documents,
record of registry, fire insurance policy for collateralized buildings*,
etc.) may be kept in order by borrower name
Pledged goods and documents may be kept by type
Collaterals for which limitation period or maturity date is critical
should be kept in order by such date.
Limited access to the safe custody
Protection from natural disaster
Note: Fire insurance policy for collateralized building may be kept separately in order
by expiration date because of the importance of the expiration date management.
Safe Custody/Collateral Book II

Collateral Book



Role of collateral book includes (1) administrating the collateral
inventory, and (2) managing the expiration of limitation period and the
maturity date for certain types of collateral.
 Collateral book should be created separately for each type of
collateral.
Collateral book should assign a number for each pledged goods and
documents for the administrating purpose.
 Pledged goods should be sturdily tagged with a note indicating
name of pledgor, borrower number, date, collateral number, etc.
Collateral book should be managed by senior manager.
 Inventory of collateral should be checked against the collateral book
periodically (once in a month)
 Adding and removing of pledged goods from the custody should be
registered in the appropriate collateral book*.
Note: When accepting and returning collateral, receipt should be issued to and received from
the borrower by the bank, which should indicate concerned goods and documents in detail:
type, number/quantity, date, with signature.
Safe Custody/Collateral Book III

Maturity for certain types of collateral



Expiration for certain types of security interest



Negotiable instruments such as draft, certificate of deposit, and
promissory note have maturity date.
In accordance with the collateral agreement, such negotiable
instruments need to be settled without delay.
Depending on jurisdiction and on type of collateral, a perfection of
security interest may expire after a certain period (limitation period
effects).
Such limitation periods should be carefully managed in the collateral
book. A continuation statement should be filed within a certain period
before the expiration to renew the perfection of security interest.
How often do you reappraise real estate collateral?
7. Enforcement of Collateral
Enforcement of Security Interest I

Event of default



A breach by debtor of any of the terms of the security agreement
A grace period
Rights of secured party


Money suit
Repossession



Self-help
A pre-repossession notice
Foreclosure


Strict foreclosure
Deed in lieu of foreclosure
*Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p320-323
Enforcement of Security Interest II
Public or private sale



If it is applicable, private sale will be encouraged where private sales
through commercial channels will result in higher realization on
collateral for the benefit of all parties.*
Application of Proceeds
a)
b)
c)
d)
The expenses of retaking and disposing of the collateral, and
attorney’s fee and legal expenses (if a country’s law allows)
The debt owed the secured party, including principal, interest or
finance charges, and other lawful unpaid charges provided for the
security agreement
The debt owed by junior secured parties
Residual rights
*Based on: Law in a Nutshell: Secured transactions, Richard B. Hagedorn, Thomson West, 2007, p346
8. Extinguishing Security
Interest in Collateral
Extinguishing Security Interest

When all debt is repaid security interest should be terminated:




by filing a termination statement
by returning pledged goods and documents*
by returning the original security agreement
Preserving security interest long after the full repayment may:


let the borrower consider the lender being ready to provide another
loan.
let the security party face unexpected liability caused by any damage
incurred to the borrower by not possessing the pledged goods or
documents.
Note: When returning pledged goods and documents, receipt with the borrowers signature
should be provided.
Useful Documents

Land Daministration Guidelines, United Nations, 1996



Valuation Standards: Are we doing it right?, Chris Thorne, IVSC, 2007



This document has a slightly different view point but very useful to understand the value of
land in a society. The document lists conditions of a good land administration system in a
country, which are: guarantee ownership and security of tenure, support land and property
taxation, provide security for credit, develop and monitor land markets, protect State land,
reduce land disputes, facilitate land reform, improve urban planning and infrastructure
development, support environmental management, and produce statistical data (111 pages)
Available at: http://www.ica.coop/house/part-2-chapt4-ece-landadmin.pdf
This document tries to explain a new valuation concept for the globalized era. There are four
dimentions to valuation standards: conduct standards, process standards, definition
standards, and technical standards. It is useful to see how a leading institution in valuation
standards consider the challenge of valuation standardization. (11 pages)
Available at: http://www.ivsc.org/pubs/index.html
Real Estate Principles: A Value Approach, David C. Ling and Wayne Archer


A similar type of presentation file which tries to explain how to evaluate real estate. It is
useful to take a look at other presentations on the similar topic. The authors published a book
“Real Estate Principles.” (52 slides)
Available at:
www.bsad.uvm.edu/files/kcchiang/BSAD%20295/REP%20chapter%208%20&%209%20App
raisal.ppt