Initial Condition:
You own 200 BTC.
Last exchange of USD for BTC was $4 per BTC.
You wish to borrow $400 from the network, so you post 200 BTC collateral.
New Condition:
You own 200 BTC (locked)
You owe $400 USD (but have $400 in paper USD)
You're right up to here, what happens from now is that you ignore your debt if it benefits you. If BTC goes to $4 + [price needed to compensate for interest you are paying] each, you do nothing, you pay the loan back automatically with interest but you make money in USD terms.
Now, if BTC goes to $1 each (illustrated by other players dumping BTCs OR from other mortgaged assets being force liquidated), you do nothing, you pay the loan automatically but only up to 200 BTC (which is worth $200 now) and you make $200 USD.
You have to somehow force someone to deposit more into the system if they have a negative balance.