Pledged asset

From CEOpedia | Management online
Pledged asset
See also


Pledged asset is a collateral used to secure loan and reduce loan losses. It is an asset that cannot be sold by borrower because it pledges loan. For example, lender may ask borrower to put some amount of money on special account that will be blocked until the loan is fully paid. Other pledged asset can be stocks.

However, pledged asset value can also decrease in time. Therefore, banks usually require higher value of pledged asset than the loan value. If the value of pledged asset drops significantly, bank can require additional pledged assets to secure the loan.

Purpose

Pledged asset is to reduce the level of risk for lender. Therefore, it is possible for borrower to obtain loan with lower interest rate. It can be beneficial for both sides of agreement. Furthermore, the borrower can still earn money on pledged asset if the asset is put on high-interest account or value of stocks increases.

“Collateral may be used to influence entrepreneurs’ choice. [...] Collateral may be the most efficient way to deal with conflicts between shareholders and bondholders. In particular they show that the possibility of issuing secured debt expands the investment capabilities of a firm and thereby increases the firm's value.” [1]

“The theoretical literature predicts that lenders can use collateral to screen and sort among observationally homogenous borrowers. In these models, lenders offer a menu of contracts with various combinations of collateral requirements and interest rates. Borrowers with a low probability of default are more inclined to accept an increase in collateral requirements for a certain reduction on loan interest rates than are those with a high probability of default.” [2]

Types of collateral

There are different types of assets that may be used as a collateral.

The most popular type of collateral used by the borrowers are mortgages. It means that the real estate asset (for instance house) is considered to be a pledged asset. It means that in case that the borrower defaults on a loan or fails to repay the debt the lender might use pledged property to pay back the loan.

The next category of collateral is asset-backed securities. Pledged assets may also be used to create asset‐backed securities (ABSs). They are not as widespread as mortgages but are also quite common. In that case loans (excluding mortgages) taken by consumers are accumulated together as the security which can be bought. The most common loans used as a collateral are commercial loans, commercial real estate and corporate securities.

Specific type of ABS are MBS (mortgage-backed securities) in which one or more mortgages are put together to create a bond.

The other type of ABSs are CDOs (collateralized debt obligations). It is a financial instrument based on debt.

ABSs are given a credit rating which determines it's risk. The safest are AAA-rated securities. AA- or A-rated securities are also secure but not as much as AAA. A little bit less secure are BBB, BB or B-rated. C and D-rated are rather junk bonds which means that they are highly speculative. [3]

References

  1. Coco G. (2000) On the use of collateral Journal of economic surveys
  2. Nagaraj G., Meyer R. L. (1995) Collateral for loans: when does it matter? Economics and Sociology Occasional Paper No. 2207
  3. Benmelech E. (2012) An empirical analysis of the fed's term auction facility NBER Working Paper