Collateral: How It Is Posted, Valued and Haircut

Collateral is an asset a borrower pledges so that a lender can seize and sell it if the loan is not repaid. The lender values it from its own seat, asking what it would fetch in a quick, forced sale, and applies a haircut, a discount below the owner's number, sized to how fast and how far the price could fall. If the value drops, the lender asks for more collateral or repayment.

A promise to repay is worth only what the person making it can be made to give up. Lending spends most of its energy avoiding that sentence, dressing the question up as interest rates, credit histories and cash flow tests. Collateral is the part that does not pretend. Collateral is the giving-up written down in advance, agreed while everybody is still on good terms, so nobody has to negotiate it on the worst day. Everything else comes out of that one idea: the three things that change hands when an asset is posted, the two steps that turn an owner's value into a lending value, the reason goods in a warehouse are discounted harder than money owed by buyers, and the sequence that runs automatically when collateral falls in value.

What is collateral, and why does a lender want it?

Consider something small enough to hold. A neighbour asks for Rs 20,000/- until his salary lands. The money can be handed over on his word alone, in which case what has been bought is a promise, and if the salary is delayed there is nothing to do except ask again. Or it can be handed over against his mother's gold chain, left behind until he pays. Now two things have been bought: the same promise, and a chain sitting in a cupboard. The promise is what repayment is expected on. The chain is what the lender falls back on when the promise fails.

Collateral does not make a borrower more likely to repay a lender; it makes the lender less dependent on whether the borrower repays. The distinction between reducing the lender's dependence and improving the borrower's behaviour explains almost everything a lender does afterwards. An unsecuredLent on the borrower's promise alone, with no particular asset attached to the loan. If the borrower fails to pay, the lender has a claim on the borrower generally, not on any named thing. lender is betting on the borrower's future. A securedLent with a named asset attached to the loan, so the lender has a right over that specific asset if the borrower fails to pay. lender is betting on the borrower's future and, if that bet loses, on a named asset it can reach. Two bets are safer than one, so the secured lender charges less for the money and lends more of it. The chain is why the neighbour gets the Rs 20,000/- rather than an apology.

Sohan Ply and Boards Private Limited, an invented maker of plywood and laminates running one plant, is the business worked through here. Sohan Ply sells Rs 1,80,00,00,000 of boards and laminates a year and carries two borrowings from an invented lender, Amaltas Commercial Bank: a term loan of Rs 40,00,00,000 for the plant itself, and a working capital line of Rs 15,00,00,000 for the gap between paying for timber and getting paid by dealers. Neither is a loan against Sohan Malhotra's character. Each is a loan against a specific pile of assets, named in the agreement, with a number attached that the bank calculated rather than accepted. The rest of this guide is how that number is reached.

How is collateral posted, and what actually changes hands?

Posting collateral sounds like handing something over, and sometimes it is exactly that. The neighbour's chain goes into a cupboard. But a business cannot hand over its plant, and it certainly cannot hand over the plywood it intends to sell next week. So the arrangement usually gives the lender a right rather than the thing, and the difference between those two is what matters here.

Business lending mostly hands over no asset at all, only a registered right over one, so the borrower keeps using the asset while the lender keeps the claim. Three arrangements do nearly all the work. Where the asset is small, valuable and idle, the lender takes possession: the chain in the cupboard, shares held to the lender's order. Where the asset has to keep working, the lender takes a chargeA right created over an asset in favour of a lender, recorded in an agreement and usually registered publicly, so that the lender can have the asset sold if the borrower defaults. over it and leaves it where it is: this is what happens to Sohan Ply's presses, its stacks of boards and the money its dealers owe. Where the asset is land or a building, the lender takes a mortgage. A mortgage is the same idea written into the property records. In the second case the right often runs over a pool that changes every day. A pool like that is pledged by hypothecationA charge over movable goods that stay in the borrower's possession and keep being used or sold, such as stock in a warehouse or money owed by buyers. The lender's right follows the pool rather than any one item.. The right attaches to whatever boards are in the yard at any moment, so the individual boards leaving on a truck are not the bank's concern.

Three consequences follow, and each one bites later. The right has to be registered somewhere public, so a second lender can see it exists and knows it is second in line. A burnt plant is a claim on ashes, so the borrower has to keep the asset insured and in condition. And a right over a changing pool is worth nothing unless somebody counts the pool, so the borrower has to report the pool regularly, usually monthly. Ritu Chandran, the finance head at Sohan Ply, sends Amaltas Commercial Bank a statement of stock and money owed by dealers every month, and it is that statement, not the balance sheet, that decides how much the working capital line will actually allow.

Why is the lender's number lower than the owner's number?

Ask Sohan Malhotra to value the plant and he gives what it cost, less the wear written off since: Rs 90,00,00,000 on the books. He is not being dishonest. The book figure values the plant for an owner who has time, who knows the machines, and who intends to keep running them. Asked the same question, Amaltas Commercial Bank gives Rs 70,00,00,000, and the gap is not a negotiating position. The two numbers answer two different questions.

The lender is not valuing the asset in use. The lender is valuing the asset in the one circumstance where it will ever have to sell it: a fast sale by an unwilling seller who has already had bad news. Three things pull that number down. Time is the first: a plant sold over eighteen months finds a buyer who wants a plant. A plant sold in ninety days finds whoever happens to be looking. The number of buyers is the second: a plywood press is useful to people who make plywood, and there are not many of them in reach of one town. Cost and condition are the third: enforcing a claim, storing the goods, paying valuers and lawyers, and repairing whatever was neglected while the business was failing all come out of the sale proceeds before the lender sees a rupee. Put those together and the bank writes down what it calls the forced-sale value.

Then it does something else, and this is the step that surprises owners. The bank does not lend the forced-sale value either. Against the plant, Amaltas Commercial Bank lends 60 per cent of Rs 70,00,00,000, or Rs 42,00,00,000, and it sanctioned a term loan of Rs 40,00,00,000 inside that. All those percentages are illustrative choices rather than any published standard. So the plant that is worth Rs 90,00,00,000 to Sohan Malhotra supports Rs 40,00,00,000 of borrowing, a loan-to-valueThe loan as a share of the asset's value. The same loan gives a different loan-to-value depending on which value it is divided by, so which value is being used always matters. of 44 per cent against the book number and 57 per cent against the forced-sale number. Notice that the same loan produces two very different-sounding ratios. A careful reader always asks which value the ratio was struck against.

What is a haircut, and what decides how big it is?

A haircut is the percentage a lender knocks off the value of collateral before deciding how much that collateral will support. The word is casual and the arithmetic is not. Cutting 50 per cent off Rs 27,00,00,000 of stock says, in one number, that the lender expects to recover half of it and is willing to be wrong by a wide margin before being hurt. The haircut is not a forecast of the sale price. The haircut is the cushion between the sale price the lender expects and the sale price that would leave it short.

The size of a haircut is set by how fast the collateral can be turned into cash, how far its price can move while it is being turned, and how many buyers exist for it at all. Each of the three shows plainly in familiar assets. A fixed deposit with the same lender needs no time and has no price movement, so almost nothing is cut. Money owed by 300 dealers spread across four states takes weeks to collect, and some of it will never arrive, so a quarter is cut. Standard plywood in common sizes has real buyers but they will bargain hard against a seller who must sell this month, so half is cut. A press built to one specification for one plant has almost no second-hand market at all, and a lender will often refuse to count it. The pattern holds: the haircut grows as the asset becomes slower, narrower and more specific.

The two pools Sohan Ply has posted against its working capital line run the same way. Money owed by dealers, Rs 30,00,00,000, takes a 25 per cent haircut, leaving Rs 22,50,00,000. Stock, Rs 27,00,00,000, takes a 50 per cent haircut, leaving Rs 13,50,00,000. Both figures are illustrative. Why is stock cut twice as hard? Money owed is already the outcome of a sale that has happened at an agreed price to a named buyer. Stock is a sale that has not happened yet, at a price nobody has agreed, to a buyer nobody has found. Stock must also be stored, guarded and moved before it becomes money, and against that the second haircut stops looking harsh.

What happens when the collateral's value falls?

Here is the part that catches people. A falling collateral value opens no conversation. The fall starts a calculation that runs on a schedule and produces a demand. Ritu Chandran sends the monthly statement of stock and dealer dues. Amaltas Commercial Bank applies the same haircuts it has always applied, arrives at a new number, and compares it with what Sohan Ply currently owes on the line. The new number has a name: drawing powerThe amount a lender will actually allow a borrower to owe on a working capital line this month, calculated from the current value of the pledged pools after haircuts. It moves every month even though the sanctioned limit does not., and the sanctioned limit of Rs 15,00,00,000 is only a ceiling above it. The business can actually owe only the lower of the two.

When collateral loses value the lender does not renegotiate the loan; it recomputes the drawing power and asks for the difference, and the sequence from a falling price to a demand for cash is automatic. Follow it left to right. Prices fall or stock runs down. The month's statement shows a smaller pool. The haircut is applied to the smaller pool, so the drawing power drops. If the drawing power is still above what is owed, nothing happens and nobody rings. If it has fallen below what is owed, the difference becomes payable, usually inside a short notice period stated in the agreement, and the borrower has exactly three ways to answer: post more collateral, repay the difference in cash, or defaultFailing to do what a loan agreement requires, whether that is missing a payment or not meeting a demand to top up collateral within the time allowed.. Where the collateral is priced daily rather than monthly, the same demand arrives with a different name, a margin callA demand to top up collateral immediately because its value has fallen below the level required against the amount owed. The word is most used where prices are marked every day., and it can arrive the same afternoon the price moved.

Two features of this sequence are worth holding on to. First, it is one-directional in practice: when the pool grows, the extra drawing power sits there unused until the business asks for it, but when the pool shrinks the demand comes to the borrower. Second, the trigger is the comparison, not the fall. A pool that halves while the borrowing is small produces no call at all. A pool that slips 10 per cent while the borrowing sits right against the drawing power produces one immediately. Distance from the line matters more than the size of the move.

What does Sohan Ply's borrowing look like, collateral by collateral?

With the two borrowings side by side, the whole of it is arithmetic. Sohan Ply owes Rs 55,00,00,000 in total across the term loan and the working capital line, and every rupee of it is attached to something. The two borrowings are not loans against the business as a whole, but two loans against two piles, each pile valued the lender's way and then cut.

The pile decides how a loan behaves when the business has a bad year, so read a borrowing by asking what pile each rupee sits on. The term loan behaves like the plant: slow to move, revalued rarely, and unlikely to produce a surprise demand next month. The working capital line behaves like the stock and the dealer dues: recalculated every month, and capable of shrinking in a season. Two loans of similar-sounding kinds, two completely different failure patterns, and the difference is entirely in what was posted.

Against that drawing power of Rs 36,00,00,000 the line is drawn at Rs 15,00,00,000, so Sohan Ply is sitting Rs 21,00,00,000 clear of any demand. The cushion looks comfortable, and on these numbers it is. But notice what the comfort actually rests on: Rs 57,00,00,000 of current assets, of which Rs 21,00,00,000 has not yet been paid for, an amount Sohan Ply owes its own timber suppliers. A lender doing a tighter review counts only the stock the borrower has paid for, and the cushion narrows sharply the moment it does. Counting only the stock already paid for is the first switch in the interactive above, and it takes the spare cover from Rs 21,00,00,000 to Rs 10,50,00,000 with nothing else changing at all.

How do a lender, a finance head and an investor actually use this?

A lender uses collateral to decide two things at once: whether to lend at all, and what to charge. Take the same borrower to two lenders, offer one a mortgage on the plant and the other nothing, and the price of the money will differ by more than most people expect. The second lender is pricing the whole loss, and the first is pricing only the part its claim will not reach. The lender's private question is never how much this asset is worth today. The question is what it will fetch in ninety days, in the year the lender is least happy about, after paying the people who have to be paid to sell it.

A finance head uses collateral as an inventory of what is still free. Ritu Chandran knows, on any morning, which assets already carry a charge and which do not. Only unencumberedCarrying no lender's charge or claim, so the asset is still free to be offered as collateral for a new borrowing. assets can fuel the next borrowing. Finance teams resist pledging more than a loan needs for exactly that reason: a charge that covers Rs 57,00,00,000 of current assets to support a Rs 15,00,00,000 line has spent collateral that a future lender would have wanted. Collateral, once posted, is used up as a source of new money even though it is still sitting in the business.

An investor or a lending analyst uses it as a map of where the losses land. Deodar Growth Partners, an invented investor looking at a minority stake in Sohan Ply, will read the charge register before it reads the profit statement. The register names which assets a bank reaches first if the business struggles, and therefore what an equity holder is actually left standing behind. And a household reader meets the same mechanism in the plainest possible form: a gold loan against a chain, where the lender weighs the gold, applies a rate and lends a fraction of the value, or a home loan where the bank lends a share of the agreed value rather than all of it. The fraction has a reason, and it is the one set out here.

Sohan Ply and Boards Private Limited, Sohan Malhotra, Ritu Chandran, Amaltas Commercial Bank and Deodar Growth Partners are invented.
Educational material. Not advice on any investment, tax, budget or market position.