Lesson 1 of 25 · 6 min

The lender's question is recovery, not repayment

A secured lender underwrites the sale it hopes never to make, which is why your income barely appears in the file.

An unsecured lender asks whether you will pay. A collateral lender asks what it collects if you do not. Those are different questions and they produce entirely different paperwork.

The institution decomposes the problem into two factors. The first is how likely the borrower is to stop paying. The second is how much is lost in the cases where that happens — after the collateral is sold and the proceeds applied. Multiply the two by the exposure and you have expected loss, which is the number the pricing runs on.

Liquid pledged securities do almost nothing to the first factor and almost everything to the second. A borrower's chance of default is a fact about the borrower; collateral does not change it. What collateral changes is the loss given default, and against continuously priced shares it can be driven close to zero. That asymmetry is why a securities-backed file contains a portfolio breakdown and very little about you.

Every mechanism in this track descends from that one substitution. The advance rate, the maintenance threshold, the concentration cap, the eligibility test and the discretion clause are all answers to the same question, asked at different points in the life of the loan: if this has to be sold, what comes back, and how fast.

The lender is not deciding whether to trust you. It is sizing a sale it may never make, and pricing the difference.

Key terms

Expected loss: Exposure multiplied by the chance of default multiplied by the share of the exposure lost when default happens. The figure a credit price is built on.
Loss given default: The portion of a loan not recovered after the collateral is sold. Good collateral compresses it; it does not make default less likely.
Exposure: The amount actually at risk, which on a line of credit is the drawn balance plus accrued interest rather than the limit.

Worked example

The same borrower, secured and unsecured

A $250,000 loan to one borrower, priced two ways. Illustrative figures throughout.

Chance of default assumed in both cases: 2.4%
Exposure at risk of default: $6,000
Unsecured: 68% of exposure lost: $4,080
Secured on liquid shares: 4% lost: $240
Ratio of expected losses: 17 times

Nothing about the borrower moved. The whole seventeenfold difference came from the second factor, which is the only one collateral touches.

Check yourself

A lender books two $400,000 loans to the same person in the same week. It assumes a 1.8 percent chance of default on both. On the unsecured one it expects to lose 55 percent of the exposure; on the securities-backed one, 6 percent. What is the expected loss on each?

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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.