Overcollateralization is a type of credit enhancement, a practice where a company takes steps to get a better credit rating from a ratings agency by improving the finances backing a secured transaction. In the case of overcollateralization, a business backs a loan with assets in excess of the loan, thereby limiting credit risk for the creditor and enhancing the credit rating assigned to the loan. In a simple example, a company could back a $100,000 United States Dollars (USD) loan with $120,000 USD worth of assets.
There are a number of reasons for companies to use overcollateralization in a secured transaction. Getting a high credit rating for asset-backed securities is important, as it will make it possible to sell derivatives with high ratings, attracting investors interested in profits but concerned about risks. In pools of securities brought together and packaged to create derivatives, overcollateralization is also a tactic used to make those securities look more appealing. 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 lowered interest rate.
One major drawback to overcollateralization is who defines the value of the assets. In the credit crisis that began exploding in 2007, one of the most significant contributors was asset-backed securities, many of which were overcollateralized. In theory, these products were backed by assets in excess of their worth, lowing credit risks significantly, but when the true value of those assets was revealed, some of them experienced a rapid downgrade in credit ratings, and panic was triggered among investors.
Another issue is that as long as assets are used to back a loan, the borrower does not have free and clear access to them. They cannot be sold or transferred, used to back other debts, or utilized in other ways, because the creditor controls them. Thus, it is possible to tie up assets in an attempt to get a loan, reducing potential liquidity. This can cause problems when a company needs to raise capital quickly or wants to sell off assets with falling values before they trigger losses.
Credit enhancement in general began attracting controversy during the credit crisis of the early 2000s, as a number of firms began questioning the practice and asking if it had contributed to the creation of bubbles in some areas of the market. While tools like overcollateralization were initially seen as valuable things for investor confidence, critics suggested that they actually created a sense of false confidence that led to poor investment decisions.