On the management of financial guarantees - Market Microstructure and Corporate Finance Special Issue

Financial Management (Financial Management Association), Winter, 1992 by Robert C. Merton, Zvi Bodie

(iii) To facilitate recognition by the authorities regulating SubCo of PareCo's total equity investment. Suppose that SubCo is subject to price regulation, and is allowed only a "fair" rate of return on its invested capital. A "fair" rate of return of 15% on $2 million TABULAR DATA OMITTED of conventional balance-sheet equity is $300,000, which is only a 3 1/3% rate of return on the $9 million of actual economic equity capital. It thus makes an enormous difference how SubCo's equity capital is computed.(49)

V. Government Guarrantee

Robert C. Merton is George Fisher Baker Professor of Business Administration at Harvard University, Boston, Massachusetts. Zvi Bodie is a Professor of Finance at the School of Management, Boston University, Boston, Massachusetts.

Guarantees of financial performance on loans and other debt-related contracts are widely used throughout the U.S. and international financial systems. Parent corporations routinely guarantee the debt obligations of their subsidiaries. Commercial banks, insurance companies, and, on occasion, sovereigns offer guarantees in return for fees on a broad spectrum of financial instruments ranging from traditional letters of credit to interest rate and currency swaps and even put warrants on stock indices. More specialized firms sell guarantees of interest and principal payments on mortgages and tax-exempt municipal bonds. Every state in the United States has an insurance guaranty fund that guarantees policyholders against losses from insurance company insolvencies. The federal and provincial governments of Canada have, in the past, made extensive use of loan guarantees to subsidize local corporations.(1)

The largest provider of financial guarantees is almost surely the U.S. government, either directly or through its agencies. The most important of its liability guarantees, both economically and politically, is deposit insurance. However, guarantees are also used extensively elsewhere. In the corporate sector, the government has guaranteed the debt of small businesses and, on occasion, as with Lockheed Aircraft and the Chrysler Corporation, it has done so for very large businesses. Established in 1980, the United States Synthetic Fuels Corporation was empowered to grant loan guarantees to assist the financing of commercial projects that involve the development of alternative fuel technologies. The Pension Benefit Guaranty Corporation (PBGC) provides limited insurance of corporate pension-plan benefits. Residential mortgages and farm and student loans are examples of noncorporate obligations that the government has guaranteed. The U.S. government has also given guarantees of other sovereigns' debt as a form of foreign aid.

But guarantees are even more pervasive than this list of explicit guarantees would suggest. Any time a loan is made, an implicit guarantee of that loan is involved. To see this, consider the fundamental identity, which holds in both a functional and a valuation sense:(2)

Risky Loan Loan Guarantee |equivalent to~ Default-Free Loan.

Risky Loan |equivalent to~ Default-Free Loan - Loan Guarantee.

Thus, whenever lenders make dollar-denominated loans to anyone other than the United States government, they are implicitly also selling loan guarantees. The lending activity therefore consists of two functionally distinct activities: pure default-free lending and the bearing of default risk by the lender.

To see this point more clearly, it will perhaps be helpful to think of the lending activity taking place in two steps: (i) the purchase of a guarantee and (ii) the taking of a loan. Suppose that the guarantor and the lender are two distinct entities. In the first step, the borrower buys a guarantee from the guarantor for $10. In the second step, the borrower takes this guarantee to the lender and borrows $100 at a default-free interest rate of ten percent per year. The borrower winds up receiving a net amount of ($100 - $10 =) $90 in return for a promise to pay back $110 in a year. Of course, often the lender and the guarantor are the same entity -- for example, a commercial bank -- and the borrower simply receives the net $90 from the bank in return for a promise to repay $110 in a year. The interest rate on the loan is then stated as 22.22%, i.e., ($110 - $90)/$90. This promised rate reflects both the risk-free interest rate and the charge for the guarantee. To see that the two are separable activities, note that the holder of the risky debt could buy a third-party guarantee for $10. The holder would then be making a total investment of $90 $10 = $100 and would receive a sure payment of $110.

The purchase of any real-world loan is thus functionally equivalent to the purchase of a pure default-free loan and the simultaneous issue of a guarantee of that loan. In effect, the creditor simultaneously pays for the default-free loan and receives a "rebate" for the guarantee of that loan. The magnitude of the value of the guarantee relative to the value of the default-free loan component varies considerably. A high-grade bond (rated AAA) is almost all default-free loan with a very small guarantee component. A below-investment-grade or "junk" bond, on the other hand, typically has a large guarantee component.(3)