Portfolio Collateralization 
(Source : New York,September 8, 1999, Morgan Guaranty Trust Company of New York,  clarke_michael@jpmorgan.com )

Summary
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.

Description
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........................

More information is provided in the Member Area

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