Secured Loans - Banking Explained

The ability for a lender to advance funds and in doing so take a security charge over specified collateral is the cornerstone of the modern banking system. The humble loan secured by a mortgage has enabled hundreds of millions to acquire properties through proffering their home as security for the loan. The financial press were a great cheerleader of the globalization of capital markets that enabled rapid lending growth during the boom years.The recent credit crunch has highlighted the importance of secured lending in the financial system and shown the catastrophic effects that a drying up of liquidity can have upon both individuals and corporate entities.

The ability of businesses to access long-term, revolving bank committed capacity has proved the difference between success and failure. An instructive contrast can be seen in the fate of the Detroit auto giants during the credit crisis of 2007-9. Ford survived the recession since it had arranged secured finance with numerous banks prior to the credit crisis, pledging its plants and intellectual property amongst other items as collateral. General Motors, in contrast, relied largely on unsecured financing. It ended up as a recipient of federal aid and finally in Chapter 11 bankruptcy.

Throughout history secured loans have boosted the power of the so-called “credit multiplier”, a fundamental idea in economics. This concept means that a bank can take cash in the form of deposits then lend these sums several times over, provided that sufficient covering capital is retained. The ability to take physical assets as security is essential to give financial institutions the confidence to lend. In defiance of medieval restrictions on usury, secured loans were pioneered by Florentine and Venetian bankers in the Renaissance era.  The ability to enforce security was of course always less than certain in an age before modern legal systems and democratic institutions.

Perhaps the most spectacular historical example of enforcing a secured loan took place in the Victorian Age. In 1875, Great Britain purchased shares in the Suez Canal amounting to 44% of its total stock. The next year the government of Egypt defaulted on its bonds. Security was enforced quite literally by the British military invasion of the country in 1882. Historians continue to debate whether Prime Minister Gladstone’s extensive personal investments in Egyptian securities influenced his decision to invade.

A cursory search of the internet will reveal plenty of bank and non-bank institutions offering secured loan, often seeking a second charge on a residential property in order to advance funds. This can be a highly lucrative industry. Some lenders quote rates of 16-20% per annum; given that the bank’s own cost of funds will be priced at a reasonably small margin over LIBOR (around 1% at the time of writing), this doubtless represents a hefty mark-up. Even after allowing for the risk of extensive credit losses and the need to cover operating costs, secured lending is clearly not a low margin business.

Receivables secured on collateral can also be securitized. Indeed, the bundling and tranching of loans to higher risk individuals (so-called “sub-prime” loans) has been widely blamed by the media as a cause of the credit crunch. In a typical residential mortgage backed securitization structure, the receivables, including the security interest, are transferred to a legally isolated special purpose vehicle. This entity then issues bonds in to investors using the receivables as collateral. Typically the notes are tranched for different investor risk appetites, with the subordinated (junior) pieces taking the first principal loss once reserve accounts are exhausted. Public securitization issuance in the U.S. ground to a halt after the fall of Lehman Brothers in September 2008 but has recently started to revive.

Here are seven checks a bank might typically ask before granting a secured loan to an individual or a small business. Practices will of course vary between banks, jurisdictions and in accordance with locally applicable laws and regulations.

1. Proof of identity
2. Check against electoral register and for court judgments
3. Proof of address e.g. bank statement or utility bill
4. Refer to a credit bureau score to understand previous and current credit history. Notable credit bureaux include Dun & Bradstreet and Equifax.
5. Refer to a proprietary credit scorecard. These are highly sophisticated models incorporating historic loss and delinquency rates which may be constructed in house by the bank or bought off the shelf by a third party supplier.
6. Proof of collateral – for example title deed to a property
7. Proof of income – from wage slips and bank statements etc.

Clearly if an individual takes out a secured loan, and is unable to keep up repayments of interest or principal as per the loan contract, an event of default may occur. This typically follows a catastrophic life event such as unemployment, divorce or illness. In such cases the lender may be able to perfect the security,for example seeking a repossession order to reclaim a property. The property would then be disposed of at auction, perhaps at a fire-sale value. The wave of foreclosures that took place in the US from 2007 onwards has been cited as a major contributor to the subsequent credit crunch and house price crash. A high level of foreclosures can act as a brake on economic activity in entire states or regions.

Given the dramatic consequences of enforcing security, secured lending is heavily regulated in most jurisdictions. Primary legislation and case law will often give the consumer significant protection from onerous bargains or grossly excessive interest rates. The local regulator will usually apply additional rules and regulations. For example, in the U.K. the Financial Services Authority requires lenders to operate according the rules of "Treating Customers Fairly" (TCF).

There are six desired outcomes arising from the Treating Customers Fairly (TCF) principles -

1. Consumers can be confident they are dealing with firms where the fair treatment of customers is central to the corporate culture
2. Products and services are designed to meet the needs of identified consumer groups and are targeted accordingly
3. Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale
4. Where consumers receive advice, the advice is suitable and takes accounts of their circumstances
5. Consumers are provided with products that perform as firms have led them to expect, and the associated service is both of an acceptable standard and also as they have been led to expect
6. Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.

As the credit crunch eases and securitization markets recover, there is no doubt that secured lending will remain an area of great government and regulatory scrutiny.

Disclaimer: This hubpage is designed to give general information on an academic basis. It is not offering or intending to offer any financial or legal advice whatsoever. No reliance should be placed on any content within. All text is copyright (c) 2009