What is Overcollateralization?
Overcollateralization (OC) is the process of posting more collateral than is needed to obtain or secure financing. Overcollateralization is often used as a method of credit enhancement by lowering the creditor's exposure to default risk.
Understanding Overcollateralization (OC)
Securitization is a complex financial process of issuing securities that are backed by a pool of assets, such as debt. The underlying assets are converted to securities, hence, the term “securitization.” The financial terminology ascribed to these converted assets is asset-backed securities (ABS). Securitization typically involves assets that are illiquid, since each individual debt is unique and requires separate administrative processing. The process of securitization involves combining multiple illiquid assets into one pool and creating a market for the pool. Examples of assets that can be securitized include residential mortgages, student loans, car loans, credit card debt, etc. A key step in securitization of products is determining the appropriate level of credit enhancement.
Credit enhancement refers to a risk-reduction technique that improves the credit profile of structured financial products or transactions. It is usually implemented to improve the credit rating of a securitized product. Investors of a securitized product face a risk of default on the pool of underlying assets. You can think of credit enhancement as a financial cushion that allows securities backed by a pool of collateral to absorb losses from defaults on the underlying loans, thereby, offsetting potential losses. To reduce default risk, a credit enhancement technique known as overcollateralization may be employed.
With overcollateralization, excess collateral is used to enhance credit in order to get a better debt rating from a credit rating agency. An issuer backs a loan with assets or collateral which has value in excess of the loan, thereby, limiting credit risk for the creditor and enhancing the credit rating assigned to the loan. Overcollateralization is achieved when the value of assets in the pool is greater than the amount of the asset-backed security (ABS). So, even if some of the payments from the underlying loans default or are late, principal and interest payments on the ABS can still be made from the excess collateral. The principal underlying a pool of assets is often greater than the principal amount of the issued security by approximately 10 to 20%. For example, in the case of a mortgage-backed security (MBS), the principal amount of an issue may be $100 million while the principal value of the mortgages underlying the issue may be equal to $120 million.
Overcollateralization makes it possible for issuers to sell securities with a high rating attached. Investors that are interested in profiting from securitized product, but wary of the risks involved in these products, will favor an ABS that is credit enhanced, such as through overcollateralizing debt, over an ABS with no credit enhancement. An offer of a high collateral will also make it easier to get a loan, and will secure better terms on the loan, such as a lower interest rate.
Prior to the 2008 credit crisis, many asset-backed securities in the market were overcollateralized, with the securities backed by assets in excess of their values. While this lowered credit risks and made the financial instruments appealing to investors, it was soon uncovered that the value of the assets used as collateral was actually much lower than presented. This led to a credit rating downgrade of numerous issuers, leading to the sub-prime crisis that ensued in 2008.