What is Financial Guarantee
A financial guarantee is a non-cancellable indemnity bond backed by an insurer to guarantee investors that principal and interest payments will be made. Many insurance companies specialize in financial guarantees and similar products that are used by debt issuers as a way of attracting investors. The guarantee provides investors with an additional level of comfort that the investment will be repaid in the event that the securities issuer would not be able to fulfill the contractual obligation to make timely payments. It also lowers the cost of financing for issuers because the guarantee typically earns the security a higher credit rating and therefore lower interest rates.
BREAKING DOWN Financial Guarantee
Most bonds are insured by a financial guarantee firm (also referred to as a monoline insurer) against default. The global financial crisis of 2008-2009 hit financial guarantee firms particularly hard. It left numerous financial guarantors with billions of dollars of obligations to repay on mortgage-related securities that defaulted, and it caused firms to have their credit ratings slashed.
Financial Guarantee Reporting Responsibilities
Typically, financial guarantors disclose the scope and intent of their guarantees in financial statement notes. Guarantees issued between parent companies and their subsidiaries do not have to be recorded as liabilities on a balance sheet. For example, in the case of a parent company's guarantee of a subsidiary's debt to a third party or a subsidiary's guarantee of the parent company's debt to a third party or another subsidiary, neither would have to list these obligations on a balance sheet. However, all financial guarantees must be disclosed, including with the nature of the guarantee (terms, history and events that would activate the guarantee), the maximum possible liability and any provisions that might enable the guarantor to recover funds paid out in a guarantee.
How Financial Guarantees Work
Consider XYZ Company, which has a subsidiary named ABC Company. ABC Company wants build a new manufacturing facility and needs $20 million from a bank. The bank will likely ask XYZ Company to provide a financial guarantee of the loan. By doing so, XYZ Company agrees to repay the loan using funds from other lines of business – if ABC Company can't come up with the cash to repay the debt on its own.
Usually, a parent company will offer a financial guarantee of bonds issued by one of the parent's subsidiaries, but there are also other situations that might call for a guarantee. For example, vendors sometimes require financial guarantees from customers if there's any uncertainty about the customer's ability to pay. In these situations, a customer's bank might financially guarantee the customer's payment and will pay the vendor if the customer cannot.
A financial guarantee doesn't always cover the entire amount of a liability. For instance, a financial guarantor might only guarantee the repayment of interest or principal, but not both. Sometimes, multiple companies sign on as a party to a financial guarantee. In these cases, each guarantor is usually responsible for only a pro-rata portion of the issue. In other cases, however, guarantors may be responsible for the other guarantors' portions if they default on their responsibilities.