Pledged asset
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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]
Examples of Pledged asset
- Cash: Cash can be pledged as collateral to secure a loan. This is often done for small business loans or lines of credit. The borrower will place a certain amount of cash in an account that is blocked until the loan is repaid.
- Stocks: Stocks are another common form of pledged asset. A borrower can pledge stocks as collateral for a loan. The stock is held in an account and not sold until the loan is repaid.
- Real Estate: Real estate can be used as a pledged asset for a loan. The lender will take a lien on the property, which gives them the right to take possession of the property in the event of default.
- Precious Metals: Precious metals such as gold and silver can be used as a pledged asset. The borrower will deposit the metal with the lender and they will be held until the loan is repaid.
- Commodities: Commodities such as oil, gas, and other natural resources can be pledged as collateral for a loan. Again, the commodity is held by the lender until the loan is repaid.
Advantages of Pledged asset
Pledged asset offers several advantages to lenders and borrowers alike. These include:
- Reduced Risk: By pledging an asset as collateral, lenders are able to reduce the risk associated with loan defaults. This can help lenders feel more secure in lending money and ensure that borrowers are able to receive loans more easily.
- Lower Interest Rates: Loans secured with a pledged asset tend to have lower interest rates than unsecured loans. This is because the risk of default is lower with pledged assets, and the lender is more likely to receive the full loan amount back.
- Easier to Qualify: Borrowers who pledge assets as collateral may be able to qualify for a loan more easily than those without any asset to pledge. This is because the lender is able to use the asset to reduce their risk and make the loan more attractive.
- Improved Credit Score: Paying off a loan secured by a pledged asset can help improve a borrower’s credit score. This is because the lender is able to report the loan as being paid in full, which can help improve the borrower’s credit score.
Limitations of Pledged asset
Pledged asset as a collateral has certain limitations. These include:
- Lack of liquidity - Pledged assets are not readily available in the market, which can make it difficult to liquidate them when needed.
- Risk of default - When the borrower defaults on their loan, the pledged asset can be seized by the lender, thereby reducing the value of the asset and the lender's potential return.
- Transaction costs - There are costs associated with the transfer of pledged assets, such as registration fees, legal and accounting fees, and insurance costs.
- Volatility - Pledged assets can be subject to market volatility, which can affect the value of the asset as well as the lender’s return.
- Limited marketability - Pledged assets may have limited marketability, depending on the type of asset and the lender’s creditworthiness.
A pledged asset is an asset that is used to secure a loan and reduce loan losses. There are several other approaches related to pledged assets:
- Loan Guarantees: These are arrangements that allow the lender to receive a guarantee from a third party in the event of a default by the borrower.
- Mortgage Insurance: This is a form of insurance that is taken out to protect the lender in the event of a borrower defaulting on their mortgage payments.
- Collateralization: This is a process in which the borrower pledges an asset as collateral for the loan.
- Credit Insurance: This is a form of insurance that is taken out to protect the lender in the event of a borrower defaulting on their loan payments.
In summary, pledged assets are used to secure a loan and reduce loan losses, and there are several other approaches related to pledged assets, such as loan guarantees, mortgage insurance, collateralization, and credit insurance.
References
- Ayotte K., Gaon S. (2011) Asset-Backed Securities: Costs and Benefits of "Bankruptcy Remoteness" The Review of Financial Studies, Vol.24, No. 4
- Fabozzi Bond Markets and Strategies Sixth Ed. CHAPTER 14 Asste-backed securities
- Singh, M. M. (2011). Velocity of pledged collateral: analysis and implications (No. 11-256). International Monetary Fund.
- ↑ Coco G. (2000) On the use of collateral Journal of economic surveys
- ↑ Nagaraj G., Meyer R. L. (1995) Collateral for loans: when does it matter? Economics and Sociology Occasional Paper No. 2207
- ↑ Benmelech E. (2012) An empirical analysis of the fed's term auction facility NBER Working Paper
