Lesson 19 of 25 · 7 min

The two-sided squeeze: cost rising while collateral falls

Raising the numerator and lowering the denominator costs more headroom together than the same two moves cost apart.

Every lesson so far has followed one leg at a time. This one runs both at once, on one facility, from one cause — and the result is not the sum of the parts.

The facility: a pledged portfolio worth $2,140,000, a drawn balance of $780,000, and a maintenance threshold of 65 percent of market value. The trigger value is 780,000 ÷ 0.65 = $1,200,000, so headroom is (2,140,000 − 1,200,000) ÷ 2,140,000 = 43.93 percent. That is a comfortable-looking facility by any ordinary reading.

One cause now moves: rates rise 3.10 points across twelve months, from 5.85 percent to 8.95. On the cost leg, interest capitalised monthly on an Act/360 basis across 365 days takes the balance to $840,634.90, having added $60,634.90. On the collateral leg, an effective duration of 6.2 applied to 3.10 points is a fall of 19.22 percent, taking the portfolio to $1,728,692.

Recompute. The trigger value is 840,634.90 ÷ 0.65 = $1,293,284.45, and headroom is (1,728,692 − 1,293,284.45) ÷ 1,728,692 = 25.19 percent. Headroom fell 18.74 points, from a facility that was never drawn again and never sold a share.

Now separate the two. Had only the balance risen, headroom would be (2,140,000 − 1,293,284.45) ÷ 2,140,000 = 39.57 percent, a loss of 4.36 points. Had only the collateral fallen, headroom would be (1,728,692 − 1,200,000) ÷ 1,728,692 = 30.58 percent, a loss of 13.34 points. Those two losses sum to 17.70 points. The actual loss was 18.74. The remaining 1.04 points is the interaction: a larger numerator being divided into a smaller denominator, which is a third effect belonging to neither leg.

The squeeze is worse than the sum of its halves by a point of headroom, and that point exists only because both legs moved. Model them separately and you will understate the position every time.

Key terms

Two-sided squeeze: Interest raising the balance while repricing lowers the collateral, from one cause. Both terms of the headroom ratio move the wrong way at once.
Interaction: The part of a combined effect belonging to neither cause alone. It appears whenever two changes are divided into each other rather than added.
Headroom decomposition: Splitting a fall in headroom into the part from the balance, the part from the collateral, and the part from the two together.

Worked example

Twelve months, one cause, two legs

Portfolio $2,140,000, balance $780,000, threshold 65 percent of market value, effective duration 6.2. Rates rise 3.10 points across twelve months. Act/360, interest capitalised.

Starting headroom: 43.93%
Balance after twelve months: $840,634.90
Collateral after repricing: $1,728,692
New trigger value: $1,293,284.45
Ending headroom: 25.19%
The two effects taken separately: 4.36 and 13.34 points

A borrower who priced the interest leg alone would have expected to lose 4.36 points of headroom. The facility lost 18.74, and 1.04 of those belonged to neither leg on its own.

Check yourself

A balance of $410,000 sits against $1,150,000 of collateral with a threshold of 60 percent of market value. The balance then rises 9.4 percent and the collateral falls 14.8 percent. What happens to headroom, and how does it split?

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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.