Lesson 1 of 25 · 7 min

Why the second loan feels safer than the first

Nothing went wrong the first time, which is a fact about the market during that period and not about the structure.

A second draw is usually larger than the first and is decided in less time. The reason is rarely that anything new has been learned about the facility. It is that the first draw produced an outcome, the outcome was uneventful, and an uneventful outcome gets read as evidence that the structure is safe.

That reading is outcome bias: judging a decision by how it turned out rather than by the distribution it was drawn from. One completed episode is a sample of one, and the sample was taken from whatever the market happened to do during those months. If the collateral rose across the life of the first draw, the episode contains no information about what the facility does when collateral falls, because that case never arose. The absence of a call is not evidence of distance from one. It is evidence that the distance went untested.

Work the arithmetic. You pledge a holding worth $1,340,000 against a line whose maintenance threshold is 65 percent of market value, and you draw $290,000. The trigger value is $290,000 ÷ 0.65 = $446,154, so headroom is ($1,340,000 − $446,154) ÷ $1,340,000 = 66.7 percent. Eighteen months later the holding is worth $1,612,000 — up 20.3 percent — and you draw another $290,000. The balance is $580,000, the trigger value is $580,000 ÷ 0.65 = $892,308, and headroom is ($1,612,000 − $892,308) ÷ $1,612,000 = 44.6 percent.

Both of the facts being attended to are true. The first loan caused no trouble, and the collateral is larger than it was. Neither of them is the cushion. The cushion fell 22.1 points, from two thirds of the position to under half, because the balance doubled while the collateral grew by a fifth. Twenty percent of collateral growth does not fund a hundred percent of balance growth, and the gap between those two rates is the whole of the change.

A first loan that ended quietly is a report on the market during that period. The second loan is often priced by the borrower as though it were a report on the loan.

Key terms

Outcome bias: Judging a decision by the result it happened to produce rather than by the range of results it could have produced.
Sample of one: A single completed episode used as evidence about a process. It carries no information about the cases that did not occur.
Headroom: The percentage fall in collateral value that can be absorbed before the maintenance threshold is reached.

Worked example

Two identical draws, two very different cushions

Maintenance threshold 65% of market value. Collateral $1,340,000 at the first draw, $1,612,000 eighteen months later.

Trigger value after the first $290,000 draw: $446,154
Headroom after the first draw: 66.7%
Collateral eighteen months later: $1,612,000
Trigger value after the second $290,000 draw: $892,308
Headroom after the second draw: 44.6%
Change in headroom: 22.1 points lower

The collateral grew by a fifth and the cushion shrank by a third. The second draw was the riskier of the two on the day it was taken.

Check yourself

A borrower draws $290,000 against $1,340,000 of collateral at a 65 percent threshold. Eighteen months later, with the collateral at $1,612,000, the same $290,000 is drawn again. Which draw left less room, and by how much?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.