Lesson 5 of 25 · 7 min

The month you open a line, from inside

Origination is the most favourable the facility will ever be, and its impressions are the ones that last longest.

Every input to the decision is at its best on the day a line is opened, and the arrangement is structured so that this is necessarily true rather than a coincidence of timing.

What is true at origination and at no later date:

The balance is at its lowest, because nothing has accrued yet.
Headroom is at its maximum for the life of the draw, for the same reason.
The collateral is often near a high, because a rise in the collateral is frequently what prompted the enquiry.
The rate is the only term that has been quoted precisely, so it is the term that gets examined.
No adverse event has occurred, so the process for handling one has never been read.

The impressions formed in that month are durable because they were formed when the evidence was uniformly good, and they are not revised later, because revision requires an occasion and no occasion arrives. A line has no maturity date and no anniversary that demands a decision.

The drift is measurable with no market movement whatsoever. Collateral of $1,180,000, a balance of $416,000 and a threshold of 68 percent give a trigger value of $416,000 ÷ 0.68 = $611,765 and headroom of ($1,180,000 − $611,765) ÷ $1,180,000 = 48.2 percent. Leave the balance to capitalise at an illustrative 7.4 percent for fourteen months and it becomes $416,000 × (1 + 0.074 ÷ 12)^14 = $453,390. The trigger value is now $453,390 ÷ 0.68 = $666,750 and headroom is ($1,180,000 − $666,750) ÷ $1,180,000 = 43.5 percent.

Four point seven points of cushion disappeared into an interest charge, in a market that did precisely nothing. The impression retained from the opening month is of a position with 48 percent of room. The position has 43.5 percent, and the figure continues to fall on its own.

Key terms

Origination: The moment a facility is opened and the terms are set. The one point in the life of a loan at which every measure is at its most favourable.
Capitalised interest: Interest added to the balance rather than paid in cash. It raises the trigger value every month without any draw being taken.
Silent drift: Movement in headroom caused by the balance rather than by prices. It produces no statement entry that reads as a change.

Worked example

Fourteen months of nothing happening

Collateral $1,180,000, flat throughout. Balance $416,000, capitalising at an illustrative 7.4% a year, monthly. Threshold 68% of market value.

Trigger value at origination: $611,765
Headroom at origination: 48.2%
Balance after fourteen months: $453,390
Interest added: $37,390
Trigger value after fourteen months: $666,750
Headroom after fourteen months: 43.5%

The market contributed nothing to this and the borrower did nothing at all. The cushion still fell 4.7 points.

Check yourself

A balance of $416,000 capitalises at 7.4 percent for fourteen months against flat collateral of $1,180,000 and a 68 percent threshold. How much headroom is lost, and to what?

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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.