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Credit Enhancement Product Briefing Note

Portfolio Collateralization 
(Source : New York,September 8, 1999, Morgan Guaranty Trust Company of New York, )


The portfolio collateralization product is one of a class of mechanisms, which may be used to reduce or mitigate credit risk. The major advantage of the collateralization method is that it may be applied to a wide range of products in a portfolio where legal certainty of close out netting exists 1.  It requires one or both parties to pledge or deliver assets as collateral, and the perfection of a security interest in such collateral, pursuant to applicable laws.


Two parties enter into a variety of derivative transactions, which together constitute the portfolio.  All of the transactions must be documented under a 1992 ISDA Master Agreement between the parties 2.

The range of products covered by an ISDA Master Agreement is broad, and may include interest rate swaps, currency swaps, interest rate caps and floors, floating rate agreements, foreign exchange, foreign exchange options, commodity swaps, commodity options, equity swaps, equity options, bond index swaps, bullion forwards, bullion swaps, bullion options, hybrids, and options on any of the above asset classes.

The Credit Support Annex to the Master Agreement defines the requirement for one or both parties to deliver eligible collateral equal to the market value of the portfolio. Generally this involves the "out-of-the- money" party delivering collateral to the "in-the-money" party 3. Delivery of collateral may be contingent upon a certain threshold value which the portfolio breaches, a rating change, or a predetermined review date. Variations on these themes are possible, such as only providing collateral to the extent that the market value of the transactions exceed a certain threshold.

Collateral is held in a segregated custody account. Under a pledge agreement, ownership is maintained by the pledgor 4, and there is a requirement to register or perfect a security interest in the collateral, such that it may be seized and liquidated in the event of default.

To illustrate the mechanism, consider a diversified portfolio containing an interest rate swap, an FX option and a hybrid swap. Each individual deal can be valued to determine its current mark-to-market value.

The market values are expressed from the perspective of Party A and net, Party A is in-the-money by USD 4M.

Therefore, Party B will pledge or deliver to Party A eligible collateral, which has a current market value of at least USD 4M. There is no change in title of the collateral. Likewise, there is no adjustment to the terms or value of any of the three individual deals within the portfolio. 

Legal Issues

There are key legal issues that should be addressed before entering into a portfolio collateralization agreement. Bankruptcy law is complex and hence advice should be sought from a lawyer on the specifics of each case before entering into any agreement. Relevant questions to ask from the outset are:

Is the pledge or delivery of collateral by each party intra vires or does it breach existing negative pledge conditions or regulatory restrictions?

Is close out netting in bankruptcy recognized and enforceable in the jurisdiction concerned? Are there potential difficulties surrounding the registration or perfection of security interest in the collateral in the jurisdiction concerned?

Are there any statutory or other judicial limitations on the secured party's ability to enforce collateral agreements in bankruptcy (e.g. stay periods, preference periods)?

Morgan Support

Full calculation and administrative support for this structure is provided by Morgan, who acts as principal in the transactions within the portfolio. Support as a third party agency is not available at this time.


The portfolio collateralization method of credit enhancement is particularly suited to large and diversified portfolios where close out netting certainty reaches a reasonably high confidence level and the key legal questions have been answered satisfactorily.

In the absence of explicit framework legislation or established case law in the jurisdiction concerned, there must exist a high legal certainty that in the event of a default, obligations would be closed out on a net basis, without "cherry-picking."
2 A 1992 ISDA Master Agreement is the preferred Morgan agreement. Alternatives include the IFEMA and AFB.
3 At any point during the life of a transaction one can assess the aggregate present value of all future cashflows due to be paid by one party against the aggregate present value of all the future cashflows due to be received by that party. If, overall, that party will receive more that it pays the transaction is said to be "in-the-money," or to have a positive mark-to-market value; if more will be paid than received, the transaction is "out-of-the-money" and has a negative mark-to-market value.
4 There are alternative agreements, such as the ISDA Credit Support Annex under English law, which allow title transfer.

Recommended further reading:
Documentary and Standby letters of Credit
Typical suggestion for a Due Diligence Checklist