Collateral and the Art of Lending
Vol #74 - March 25th, 2022
Finance is the art of inventing new things to do with money.
Money can be used to pay for things, and good money acts as a store of value. With money you can buy items to consume like food and wine. You can also buy assets like apartment buildings in the hopes they will produce income, or assets that appreciate in value - also wine.
Equities are a combination of both. You hope they go up in value because the well run business continues to improve its expectations of future cash flow. Stocks also pay dividends and distribute a share of their profits to their owners.
While you can sell stocks with a click of a button on your phone, assets like real estate tend to be fairly illiquid, which means the value is harder to access quickly. Selling a house is a many months process that involves not only time but has very high transaction costs.
Most assets are fairly easy to price within a relative degree of certainty. The more liquid, the better. 252 trading days a year, the value of a claim on Microsoft’s future earnings is priced to the penny. In most housing markets there are enough comparables to have a good idea of where something will change hands.
Once you have a good idea of what an asset is worth, the art and science of finance begin. Borrowing against an asset unlocks the value without having to sell that asset. Stocks, houses, watches, and cryptocurrencies become collateral for loans.
Different forms of collateral can be measured by how pristine they are. While a Rolex is beautiful, a pawn shop is likely to prefer cash. The volatility of the price of that asset, as well as its usefulness and fungibility are going to dictate the required collateral ratio, or amount you can borrow.
Basel III has thousands of pages dedicated to valuation techniques for risk assets, but it’s a fairly intuitive concept. If someone gives you a treasury bond, you’re probably willing to lend up to 90 or 95% of it’s value, knowing it’s easily exchangeable and highly likely to hold its value.
If someone gives you a Monet, you might only be willing to lend 50% of its value. If impressionists ever fall out of fashion, it's going to be hard to find a buyer and the value could plummet quickly - on top of the sellers premium charged by Sotheby’s.
The standard loan to value in the housing market requires a 20% down payment, though 5% and 10% loans are increasingly available. This means you’re borrowing between 80%-95% of the home's value in cash, to pay the seller at closing. The lower that percentage gets, the bigger bet the lender is making on both you and the housing market.
If the home (collateral) value drops, the bank is less sure of getting their money back and homeowners have an incentive to walk away from their liability. No one wants to hold collateral that’s “under water”. Ask any bank who was issuing no down payment loans in Florida and Las Vegas circa 2008.
Securities make for interesting forms of collateral. A stock is constantly priced in the open market, and brokers generally have very good ways of quickly liquidating a position. If you borrow $150 against your $170 Apple shares, when the stock price drops close to $150, the broker will automatically sell your shares and close out the loan.
High net worth individuals have been borrowing against their securities positions for decades. It’s a nice double dip that means they don’t have to pay taxes on selling the asset, and they can also hold on in expectation of future gains. Brokerage accounts with margin make this option increasingly accessible to individual investors.
As you increase the amount you borrow, the position is at greater risk of liquidation. Borrowing 5% of a diversified portfolio is a fairly safe bet, but pulling out 80% cash against Tesla holdings is adding gasoline to an already hot fire. Borrowing is essentially adding leverage to your position. If you borrow 50%, every tick becomes twice as valuable.
There are some interesting strategies using options to help neutralize these risks. If you want to borrow more against your equities, buying puts will protect that value for a premium. Selling upside calls against that can help finance the cost of puts, effectively creating a “collar” around the amount you’ve borrowed, preserving the value of that collateral.
Digital assets must solve this collateral problem within the constraints of decentralization. While a bank can call up a sheriff to evict a defaulting homeowner, there’s only code and smart contracts in DeFi. When borrowing against volatile assets like ETH or BTC, there must be an efficient liquidation mechanism should the value of the collateral drop. This protects all stakeholders, and defends the value and usefulness of issuance.
Unlocking the value of collateral in DeFi has other knock-on benefits beyond the consumption or investment potential of traditional securities based lending. Protocols like Maker that issue stablecoins (DAI) based on collateral help create monetary devices that grease the wheels of DeFi transactions.
Increasingly there are even stablecoins that are only partially backed by collateral, or entirely based on algorithmic mechanisms. The fractional reserve banking system built on the trust of institutions and power of government is slowly creeping into DeFi. If there’s enough trust in the system, even decentralized money can be built on faith.