Understanding the "Loan Loss Reserve"; Your Initial 20%
(originally published 03/27/19)
Any time a lender issues a loan to a borrower, the lender assumes an element of risk. Usually that risk is offset by the collateral offered for the loan; the borrower secures the loan with an asset of at least equal value in case of default. The more value the collateral has, the lower the level of risk to the lender. When you buy a house, the collateral pledged is the house itself. But the home buyer also has to contribute 20% of the total value of the house as a down payment; this initial equity in the house provides the mortgage lender the confidence that they can realize the full value of their loan in case of default, even accounting for market fluctuations. But even in cases where a loan is fully collateralized, banking regulations require central-bank approved lenders to maintain a “Reserve for Loan Losses”. This is simply an accounting adjustment showing that some portion of the loan amount has been “set aside” to offset a potential default. There are several ways to determine what that "set aside" value should be, but generally it is based on the risk level of the loan. With a FilmCabbage loan, the only collateral we request is the production that our money is being used to create. At the onset of the loan that project has very little actual value; it is nothing more than Intellectual Property and a plan. Confidence in the value of that collateral is low. As a result, in order for us to create an 80% credit facility for you we are required to show that 20% of the total cost of the project is already set aside – effectively positioning it as the “Loan Loss Reserve”. Positioning those funds in this manner does not make any claim against them, it simply must be in place in order meet regulations and fund the loan. Once our funds have been spent into your project it's perceived value is much higher, and our risk becomes continuously lower. By the time our 80% is spent and the project is 80% complete, there is no longer a need for your 20% to sit as a Loan Loss Reserve. As funds have been spent into the production, confidence has built that its value (our collateral) now exceeds the amount of the loan, and that initial 20% is then the last money spent to complete it. Again comparing a FilmCabbage loan to a house mortgage, in both cases the borrower must already have 20%. To buy a $500,000 house with $100,000 down, the bank's loan (their exposure to risk) is $400,000. If the loan goes into default and the house is foreclosed on, since the property already has 20% equity the sale of it should raise enough to cover the amount still owing on the mortgage. It is that initial 20% down that provides enough confidence in the value of the collateral to issue the mortgage. Similarly with a FilmCabbage loan, your initial 20% sitting on the sidelines as the Loan Loss Reserve provide the confidence in the collateral for our credit multiples to be rolled out. Much later in the house mortgage when the principal has been 50% paid off, the value of the house easily exceeds the remaining $200,000 owing on the mortgage. The lender's confidence that the collateral now exceeds the remaining value of the loan is very high. In a FilmCabbage loan, once our 80% is spent into your movie there is similar confidence that it is now worth much more than the outstanding value of the loan. At that time your funds are spent into the project to complete it, since the reserve is no longer necessary. The primary difference between a FilmCabbage loan and a house mortgage is that in the case of a house, your 20% is spent in first. In our program your 20% is spent in last. But in both cases the initial 20% simply sits there, doing nothing, other than being the “equity portion” of the asset. With a house the 20% sits in the house's value; with FilmCabbage it instead sits in a bank account somewhere. But in both cases it is the existence of that initial 20% that makes entire the loan possible.