You’d be surprised what can be used for collateral

On the Money
From the June 3, 2005 print edition

In May 2005, The Federal Reserve Board found that in the past three months, large banks have continued to ease their lending standards for commercial and industrial (C&I) loans.

Current C&I lending standards are now comparable to those of the 1996-1997 period. On average, the 54 domestic banks and 19 foreign banking institutions surveyed said that credit lines, costs, spreads of loan rates over bank costs, and premiums on risky loans were all slightly more generous than they were in ’96-’97.

Max Chafkin of Inc. Magazine reports, “The pattern is similar to the easy credit of 1996-197. However, that alone will likely not be enough to spur celebration among small-business owners, who continue to face a difficult period.”

Still, the four “C’s” remain very much the standard for borrowers. Lenders will always review the borrower’s C’s: capacity, credit, capital and collateral.

Here’s a creative examination of the last C, collateral.

Collateral is an asset pledged to a lender until a loan is repaid. If the loan is not repaid, the lender may seize the collateral and sell it to pay off the loan. Obvious forms of collateral include houses, cars, stocks, bonds, and cash; all things that are readily convertible into cash to repay the loan. Some of those assets are “hard,” such as houses and automobiles; others are “paper,” such as the stocks and bonds. That difference is important because of the amount of effort necessary for the lender to liquidate the asset.

Lenders like assets that are easy and inexpensive to liquidate. Keep in mind that the collateral’s worth isn’t based on the market value. It is discounted, taking into account the value that would be lost if the assets had to be liquidated quickly. However, there are other forms of collateral assets that are sometimes overlooked that can assist the new business in obtaining operating funds.

An asset is defined to be anything that has commercial or exchange value that’s owned by a business, institution or individual. While exploring some of these less traditional forms of collateral, remember that you need a lender familiar with non-traditional lending. Federally and state chartered banks are constrained by regulations that strictly define collateral acceptance. Also, the riskier the collateral, and the more difficult it is to liquidate, the more expensive the loan.

In additional to intrinsic or “hard” value, anything that has revenue or a potential future earnings stream can be used as collateral. This includes contracts for purchase or purchase orders. As the borrower, a purchase order issued to you from one of your customers represents future sales on your part. The purchase order can then be used to secure a loan for cash today, “collateralized” by the promise of future payment by your customer.

Another form of collateral is loans you have made to other people, either simple accounts receivable, or formalized promissory notes. Those payments to you represent a revenue stream. It is possible to pledge the loans you hold as collateral for another loan to yourself. This goes on frequently on a larger scale of in the form of “collateral backed bonds” traded on Wall Street.

Often overlooked as a source of collateral is “future earning power.” Basic to a lender’s willingness to make a loan is an assessment of the future earning power of the organization or individual. To the extent that earning power is enhanced, the lender will look more favorably at the borrower.

This is the principle behind all manner of educational loans; that is, with more education and training, the earning power of the borrower will be enhanced. However, universities and colleges are not the only organizations that increase earning power. There are lenders who specialize in more specific forms of training, such as: truck driving or bartending schools, medical procedures, commercial “learning centers,” seminars, and even dating services.

Other items that have been used as collateral include: watches, jewelry, interests in box seats at a sports arena, golf club memberships, lawn mowers, suits of armor, opera tickets, antique furniture, art collections, vinyl record collections, insurance policies, medical instruments, lottery tickets, wine collections, tires, and even specialized pumpkin seeds.

Though lending standards appear to be easing, both lenders and borrowers continue to search for more creative and non-traditional ways of facilitating cash flow. This means an increased willingness on the part of lenders to look at non-traditional collateral. It also means that borrowers should be open-minded and probing about what they may be willing to pledge.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.