A financial guarantee is a contract by a third party (guarantor) to back the debt of a second party (the creditor) for its payments to the ultimate debtholder (investor). Some examples include a large corporation (the creditor) borrowing a significant amount of money from the market, backed by a guarantee from a large insurance company (guarantor). Another example might be a shipping company (the creditor) seeking a guarantee for the value of a particular shipment, backed by a guarantee from a maritime insurance company (guarantor). Finally, there are personal financial guaranties, where Uncle Jim (guarantor) agrees to back a loan to his nephew Bob (the debtor). Uncle Jim may have to make a pledge to the ultimate lender, the bank, e.g., maintaining a pledge on a certain amount of assets to cover the loan to nephew Jim.
Quick Takeaways on Financial Guarantees
- Financial guarantees are essentially insurance policies that guarantee that a particular debt issue will be paid if the debt issuer experiences financial difficulties.
- For large companies, financial guarantees are typically issued by insurance companies or other large, extremely stable financial companies, frequently a parent company for the benefit of a subsidiary.
- Financial guarantees can result in a higher credit rating, lowering the cost to the issuer.
- While ostensibly carved in stone, financial guarantors have been known to falter in extreme circumstances, such as the financial crisis of 2007-2009.
- Personal financial guarantees may require a pledge of assets to back the debt being extended.
Basics of Financial Guarantees
On the corporate level, a financial guaranty is a non-cancellable indemnity bond backed by an insurer or other large, secure financial institution, 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 can result in a better credit rating, due to the outside insurance, which lowers the cost of financing for issuers.
Most bonds are backed 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 financial guarantee firms to have their credit ratings slashed.
An Example of a Financial Guarantee
Consider XYZ Company, which has a subsidiary named ABC Company. ABC Company wants to build a new manufacturing facility and needs to borrow $20 million to proceed. If banks determine that company ABC has potential credit deficiencies, the bank will likely ask XYZ Company to provide a financial guarantee for 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.
A financial guarantee doesn't always cover the entire amount of 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.