Recourse Debt Defined
Recourse debt is a type of debt in which there is no collateral pledged by the borrower to back the debt. Instead, the borrower is personally liable for the debt in the event of a default on payments. This means the bank has the right to pursue the assets of the individual taking out the recourse loan.
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Credit Risk
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Every time a bank lends money it is exposing itself to some level of risk that the loan will not be repaid or that the payments will be late. This is known as credit risk. Some borrowers, such as the federal government, are considered to have virtually zero credit risk, because they always repay their loans in full and are always on time with their payments. However, other lenders are considered more risky. For example, a borrower with a poor credit history and a low level of income probably provides a fairly high credit risk.
Collateral
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One tool used to manage credit risk is collateral. Collateral is something of value used to back up a promise to repay a debt. In the event the debt is not repaid, the lender has a legal right to take ownership of that collateral asset. Loans backed up by collateral are known as nonrecourse debt. Perhaps the most common type of nonrecourse debt is a home mortgage. In the event the borrower does not make payments on the home loan, the bank can foreclose on the home and sell it to recover the money owed by the borrower.
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Recourse Loans in Bankruptcy
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Unlike nonrecouse loans, recourse loans are not backed by collateral. This means that if a borrower fails to make his debt payments, the lending institution can hold the borrower personally liable for the money owed by asking a court to seize the borrower's personal assets. Many assets sought by lenders of recourse loans in a bankruptcy are the same types of assets that would be used as collateral in a nonrecourse loan, such as a home or vehicles.
From Nonrecourse to Recourse Debt
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In certain situations, nonrecourse debt can be converted to recourse debt by a court. Consider, for example, a small business owner who takes out a $250,000 loan, using her $150,000 home as collateral. In making this nonrecourse loan, the bank is risking the possibility that the borrower will default by more than $150,000, in which case repossession of the collateral will not fully repay the $250,000 loan. If the borrower does, in fact, default by more than $150,000, a bankruptcy court may convert the debt to recourse debt and allow the lender to pursue the personal assets of the borrower.
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