The use of collateral for credit risk management

Using collateral in a credit agreement is the oldest and most widely used tool to minimise credit risk emanating from either the non-ability' or non-willingness of an obligor to repay debt. The popularity of this method as a tool for minimising credit risk is due to its simplicity and efficiency. Collateral is typically provided in the form of a valuable asset from the obligor to the creditor. The right of the creditor is exercised only in case the obligor defaults, in order to recover part or the whole value of the debt due. Thus, the use of collateral of high value increases the recovery rate of the creditor in case a default event happens. In addition, the use of collateral reduces or eliminates the creditor’s cost to pursue the necessary legal procedure of the liquidation of the obligor’s assets in case of a default event. In practice, the types of valuable assets used as collateral may vary widely depending on the notional value of the debt due and the type of credit agreement. For example, the collateral used in shipping bank loans is typically the financed vessel itself. In several cases, lenders may require additional collateral in the form of real estate, cash or financial assets (bonds or stocks) or even personal guarantees from the obligor and/or a third party'.

The value of collateral in a credit agreement is periodically marked-to-market to reflect changes in its value. This is a standard procedure followed by creditors in order to ensure that the current (market) value of the collateral is enough over time to cover the prespecified percentage of the original value of the loan granted to the obligor. This practice is typically followed also in shipping bank loan agreements as ship prices may fluctuate substantially within small periods of time. Therefore, the value of the vessel used as collateral is periodically' marked-to-market to reflect changes in the value of the vessel. In case the collateral’s (vessel’s) value is less than the agreed percentage of the notional value of debt, then the creditor reserves the right to ask for additional collateral to be committed in the agreement. In case the obligor fails to comply, a technical default may be triggered, i.e. a breach of the agreed terms of the credit facility may be declared.

To illustrate through an example, consider a shipowner who has financed the acquisition of a newbuilding vessel through a bank loan and faces a contractual restriction by the creditor to maintain the Asset Cover Ratio (ACR), i.e. the ratio of a vessel’s value over loan’s value, above a specific level, say 125%, throughout the repayment period of the loan. In case the ACR falls below 125% due to, for example, a drop of the second-hand vessel prices, the obligor faces a technical default and the creditor may require additional collateral - typically in the form of cash — on top of the ship’s current market price to raise the asset coverage ratio above the agreed level of 125%. The collateral used in bond issues depends on their seniority, see Kavussanos and Tsouknidis (2014). The seniority can vary from senior secured bonds, which are covered with collateral of high value, to junior subordinated bonds, which have limited or zero collateral. As expected, senior secured bonds (junior subordinated bonds) carry much lower (higher) yield premiums in order to reflect the significantly lower (higher) credit risk they expose the bondholders to.

Credit enhancements

Credit enhancements are instruments which can be applied on top of the traditional collateral assets used in a credit facility' to increase its credit quality'; that is, to lower the credit risk the lender is exposed to. The primary use of credit enhancements is to improve the chances of the loan applications to be accepted by credit providers, which would otherwise be unacceptable due to their high risk. Typical credit enhancements may take the form of intangibles such as credit derivatives¹¹ or tangible assets such as real estate property'. Other credit enhancements used in practice include the use of collateral of higher value, say in the form of additional cash, and/or personal guarantees which may use as collateral privately owned real estate assets of the shipowner; requests for insurance or third party assurances, say in the form of corporate guarantees by' a subsidiary company; granting specific rights, say freight earnings earned to repay directly the bank loan agreement; and letters of credit.¹² Another commonly used credit enhancement is the so- called Master Agreement. This is defined as the legal documentation signed by the parties involved in a credit transaction, which facilitates cross-default triggers and is used in a variety of transactions, including positions in derivatives and foreign exchange products.¹³ The most popular type is the 1992 ISDA Master Agreement.¹⁴ The Master Agreement is typically' used to minimise credit risk in OTC financial transactions by' specifying: default events, termination events, netting legislation or early' termination payments.