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SECURED LOANS

Many short-term loans are unsecured, but sometimes the company may offer assets as security. Since the bank is lending on a short-term basis, the security generally consists of liquid assets such as receivables, inventories, or securities. For example, a firm may decide to borrow short- term money secured by its accounts receivable. When its customers pay their bills, it can use the cash collected to repay the loan. Banks will not usually lend the full value of the assets that are used as security. For example, a firm that puts up $100,000 of receivables as security may find that the bank is prepared to lend only $75,000. The safety margin (or haircut, as it is called) is likely to be even larger in the case of loans that are secured by inventory.

Accounts Receivable Financing. When a loan is secured by receivables, the firm assigns the receivables to the bank. If the firm fails to repay the loan, the bank can collect the receivables from the firm`s customers and use the cash to pay off the debt. However, the firm is still responsible for the loan even if the receivables ultimately cannot be collected. The risk of default on the receivables is therefore borne by the firm. An alternative procedure is to sell the receivables at a discount to a financial institution known as a factor and let it collect the money. In other words, some companies solve their financing problem by borrowing on the strength of their current assets; others solve it by selling their current assets. Once the firm has sold its receivables, the factor bears all the responsibility for collecting on the accounts. Therefore, the factor plays three roles: it administers collection of receivables, takes responsibility for bad debts, and provides finance.

Factoring

To illustrate factoring, suppose that the firm sells its accounts receivables to a factor at a 2 percent discount. This means that the factor pays 98 cents for each dollar of accounts receivable. If the average collection period is 1 month, then in a month the factor should be able to collect $1 for every 98 cents it paid today. Therefore, the implicit interest rate is 2/98 = 2.04 percent per month, which corresponds to an effective annual interest rate of (1.0204)12 1 = .274, or 27.4 percent.

While factoring would appear from this example to be an expensive source of financing for the firm, part of the apparently steep interest rate represents payment for the assumption of default risk as well as for the cost of running the credit operation. Inventory Financing. Banks also lend on the security of inventory, but they are choosy about the inventory they will accept. They want to make sure that they can identify and sell it if you default. Automobiles and other standardized nonperishable commodities are good security for a loan; work in progress and ripe strawberries are poor collateral.

Banks need to monitor companies to be sure they don`t sell their assets and run off with the money. Consider, for example, the story of the great salad oil swindle. Fiftyone banks and companies made loans for nearly $200 million to the Allied Crude Vegetable Oil Refining Corporation in the belief that these loans were secured on valuable salad oil. Unfortunately, they did not notice that Allied`s tanks contained false compartments which were mainly filled with seawater. When the fraud was discovered, the president of Allied went to jail and the 51 lenders stayed out in the cold looking for their $200 million. The nearby box presents a similar story that illustrates the potential pitfalls of secured lending. Here, too, the loans were not as “secured” as they appeared: the supposed collateral did not exist.

To protect themselves against this sort of risk, lenders often insist on field warehousing. An independent warehouse company hired by the bank supervises the inventory pledged as collateral for the loan. As the firm sells its product and uses the revenue to pay back the loan, the bank directs the warehouse company to release the inventory back to the firm. If the firm defaults on the loan, the bank keeps the inventory and sells it to recover the debt.