A financial guarantee bond is a type of surety or indemnity bond underwritten by an insurer so that investors are guaranteed payment of principal and interest payments. For example, let's say Company X owns several subsidiaries. One of them is Company A that wants to build a new manufacturing facility. To do that, Company A takes out a loan from a bank. That lending institution may ask Company X to financially guarantee the loan in case Company A can't meet the obligation. These tools are common in the railroad industry when one company leases another's roads. The lessee guarantees the debt of the lessor.

Most of these arrangements are made by financial guarantee firms, also called monoline insurers. This industry was hit hard by the financial crisis of 2008 and 2009. Many guarantors found themselves with plunging credit ratings and billions of dollars in mortgage-related liabilities because of defaults.

How Does a Financial Guarantee Work?

The parent company, Company X in our example, usually guarantees the obligations of a subsidiary such as Company A. These parent company guarantees are the most common variety. However, other situations might involve a financial guarantee. A vendor might ask for such a guarantee when there is a question about the customer's ability to pay. The customer's bank might issue the guarantee and pay the vendor if the customer defaults.

Financial guarantees vary in structure.

  • The guarantee may not always cover the full amount of the liability. Some arrangements might cover only the interest or principal but not both.
  • Sometimes a guarantee involves multiple companies providing the security. In this structure, each guarantor may be responsible for a prorated share, or they may be responsible for each other's portions in the event of a default.

Why Are Financial Guarantees Used?

Financial guarantees are useful to lenders in attracting investors. Investors feel more comfortable knowing that the lender will be repaid if borrowers default. Because they are popular with banks and other lenders, many insurance companies specialize in these products. Financial guarantees also make it less expensive for lenders to do business because they earn a better credit rating and lower interest rates.

It's important to note that financial guarantees reduce risk, but they don't make securities risk-free. The guarantor might default itself if the liability is too great or if the guarantor's own business is struggling. The guarantee is just another layer of security that can improve a credit rating.

What Are the Disclosures Required of a Financial Guarantor?

Financial guarantors must disclose the details of their guarantees in their financial statements. However, arrangements between parent companies and their subsidiaries don't have to be reflected as liabilities on the balance sheet. In our example, the arrangement between Company X and Company A would not have to be listed on the balance sheet. However, the financial guarantees must still be disclosed, along with the terms, maximum liability, and any provisions for recovery. In the past, financial guarantors disclosed the details of their guarantees in the notes of financial statements.

What Is a Market Financial Guarantee?

Market financial guarantees are used when a supplier faces a risk that a debtor may go into default. Legally speaking, a contract of guarantee is a contract involving three parties, a guarantor, a debtor, and a creditor. The guarantor agrees to perform the responsibility of the debtor in the case of a default. If the debtor does not repay, an underwriter becomes the debtor. This type of guarantee is requested by the creditor and cannot be used as collateral.

Usually, the borrower has to find the guarantor. However, sometimes the creditor makes the loan first to be guaranteed by a special guarantee corporation after.

Guarantees can be verbal or in writing, but most creditors require written documentation. Market financial guarantees can be given by a single entity or jointly by multiple organizations.

How Is a Financial Guarantee Different From a Performance Guarantee?

A financial guarantee ensures repayment of money in the event that the borrower defaults. A performance guarantee assures that a party will be compensated, even if the conditions of a contract are not completed adequately or in a timely manner. Some examples of performance guarantees are matters being handled by the courts and tax-related issues.

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