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A new twist for the surety bond.

According to legend, 50 miles off the coast of Brazil, a tall sailing ship was stranded on a windless sea under the hot tropical sun. Supplies and drinking water were rapidly running out. When the captain spotted a passing ship, he signaled for fresh water. The reply from the other ship was, "Cast down your bucket where you stand." Naturally, the captain thought the reply was a mistake. But when he repeated his message, he got the same response. Mystified, the captain ordered a bucket lowered away. To his astonishment, the bucket came back full of fresh water. The ship had all along been sitting on the outflow of the Amazon River.

Despite the heightened demand for capital and the limited capacity of banks, corporate America is sitting on a sea of usable, untapped assets. To remain competitive, the business community needs to find the means to put its assets to more creative uses. Raising capital through securitization, long a practice of Blue Chip companies, is now accessible to middle market companies using credit enhancement in the form of surety bonds. All that is needed on the part of management to accomplish this goal is a willingness to view unfamiliar and foreign waters with an open mind.

Especially in today's economy, risk managers should be on the lookout for ways to contribute to the firm's bottom-line performance. This objective includes adding value in areas previously reserved for other departments within the company. Applying a traditional insurance-related product-the surety bond-in the less traditional context of financing will accomplish just that. The surety bond will allow risk managers to introduce an insurance product as a solution to the company's most pressing concerns, namely lowering the cost of capital funds, expansion capability and improved net income.

The growing demand for financing with credit enhancement has created a niche for financial service and insurance organizations that specialize in providing credit enhancements. These enhancements can take different forms, including surety bonds, letters of credit, limited guarantees, overcollateralization or senior subordination. The goal of each of these techniques ensures timely payment of principal and interest under a debt obligation. Assets used for credit-enhanced financing include consumer receivables, trade receivables, certain unsecured obligations, and prime income producing properties.

A Surety Revolution

Historically speaking, the uses of insurance and the wide range of insurance products has come a long way since the days of ancient Babylon when merchants would join financial forces to guarantee safe delivery of goods to their customers. While the basic concept of surety has changed only slightly in more than 2,000 years, the methods of using surety have been revolutionized. The most recent innovation has been to use a surety bond to guarantee payment of principle and interest under certain types of corporate and commercial arrangements. This surety guaranty creates less expensive debt for the borrower at lower interest rates than could otherwise be obtained through normal channels.

How does this affect the role of the risk manager? Most importantly, it will create a profile for the risk management department in an area not considered under its purview, namely, assisting its firm in obtaining lower cost of capital and thereby improving net income and providing the means for necessary expansion.

For what type of company is the surety best suited? Generally speaking, it fits any firm with high-quality, marketable assets of $5 million or more. However, the best candidates are probably companies in the middle market sector which may benefit from asset- or mortgage-backed borrowing of $100 million or more.

The market is broad-based. Middle market companies now account for approximately half the country's production of goods and services and have provided most of the jobs created during the past decade, according to the U.S. Chamber of Commerce.

Middle Market Squeeze

Debt capital to finance growth for middle market companies is still available, but it is costly. Most bankers will say that pricing for middle market lending is relatively inefficient due to the lack of market information and the fact that they are forced to make their decisions on instinct. Even among companies in the same industry and with the same credit rating, the speed in lending tends to bear this out. Tighter regulatory scrutiny has also put a pinch on the availability of long-term funds, requiring some banks to pare their portfolio of financially sound customers. In addition, the experience of most companies during the 1970s and 1980s demonstrated that banks are not always the best source of capital. Junk bonds and other highly leveraged financing arrangements have revealed their disadvantages, including the devaluation of the underlying assets. Traditional instruments, such as securities and new equities issues, are no longer the answer for every company because of economic and market considerations.

Of approximately 23,000 companies in this country with sales of more than $35 million, only about 1,800 issue bonds and even fewer can issue investment-grade bonds. Therefore, it would seem that more than 95 percent of American companies are considered to be below investment grade. When available, junk bond financing may present spreads of 650 to 750 basis points over U.S. Treasuries, which is hardly an economical option for most middle market companies.

Yet another viable option for many mid-sized companies is asset- or mortgage-backed financing, also referred to as securitization. Following recent trends, it is likely that more and more middle market companies will turn to the asset side of their balance sheets for funds, using credit enhancement and securitization, especially once the opportunity to raise capital at reduced financing costs becomes apparent.

Blue Chip Monopoly

The idea of using surety bonds to secure debt is not new. Securitization caught on in the mid-1970s when U.S. government agencies issuing Fannie Maes and Freddie Macs were buying mortgages and issuing securities backed by them, giving birth to a vigorous secondary market. Then banks, finance companies, large retailers and firms in the real estate sector took the lead from the government and began packaging mortgage and auto loans and credit card receivables for sale to both institutional and individual investors. In 1990, Citibank issued almost $6 billion in asset-backed securities, and Ford issued approximately $4 billion in auto loan-backed securities. According to the New York-based IDD Information Services, the total mortgage-and asset-backed securities market in 1990 -broadly defined to include collateralized commercial paper and a variety of mortgage-related debt other than mortgage-backed bonds-totaled $329 billion, which represents a 28 percent increase over the previous year.

Commercial banks began to see asset- and mortgage-backed securities as a tool to regain the corporate customers lost to the commercial paper markets. They wanted to show customers how to raise capital by securing their own assets. Asset- and mortgage-backed financing could help these corporations improve their capital ratios, enhance their return on equity and, simultaneously, boost net income. This movement meant that high-grade AA or AAA financing was no longer the bastion of the Blue Chip giants which readily sold their receivables and other assets to special purpose companies to issue securities at favorable rates. Today most middle market companies with excellent credit or high-quality income producing assets are using high grade debt instruments via a third-party credit enhancement to obtain low cost money and improve their bottom lines.

A model scenario would follow these steps: A firm assigns designated assets, such as receivables or income producing properties, to a bankruptcy remote trust or special purpose company. Then, the trust or special purpose company issues medium-term notes, commercial paper or senior-mortgage bonds using the assigned assets as collateral. Finally, an AAA- rated organization issues a surety bond to guarantee payment of principal and interest to holders of the notes, paper or bonds.

The surety bond virtually eliminates event risk-the sudden downgrading of a security's credit resulting from a corporate takeover or restructuring. Through this type of credit enhancement, even middle market companies can offer investors AAA-rated, guaranteed debt instruments trading at premiums of 125 to 200 basis points over the London Interbank Offered Rate or the Federal Reserve commercial paper rates. It is an opportunity not far over the spread for debt issued by the few companies with AAA ratings of their own.

There are three or four specialized insurance companies, licensed by the state and regulated by the department of banking and finance as well as the Federal Deposit Insurance Corp. that provide surety bonds as credit enhancement. Rating agencies, such as Standard & Poor's and Duff & Phelps, periodically review these transactions before a new guarantee is issued, and they look closely at underwriting standards and procedures, exposure limits and capital adequacy. The insurance company's underwriting should consist of evaluating the assets and issuing financial guarantees that assure the highest ratings and investment quality for the asset- or mortgage-backed securities.

There are three basic components of the deal: the credit quality of the seller, the reliability of the cash flow or market value of the assets, and the safety of the legal structure of the deal. As a general rule, the issuer of the security bond only insures transactions that would be considered investment-grade quality by the rating agencies-in the triple-B to single-A range-even before their guarantee. Their objective is to underwrite risks to zero expected loss standards.

The use of credit enhancement is popping up in many types of financial arrangements: initial financing of a leveraged buyout, the public securitization of recreational vehicle receivables and boat loans, the use of a partial guarantee with a stated-maturity surety bond on an asset-backed issue, a program designed to deal with counter party risk in a trading system for OTC options on U.S. Treasury securities, securitization of a home equity loan portfolio, issuance of commercial paper secured by consumer receivables for a department store in Chapter 11, a commercial paper secured by insurance company investment funds, an issue of Eurodollar bonds backed by a pool of international commercial mortgages, and an issue of fixed-rate bonds secured by residential and commercial mortgages in Australia and Britain.

However, it should be noted that, because asset-based financing is viewed as less risky than mortgage-backed, credit is more readily available for transactions based on assets or receivables. At this time, there is a limited market for real estate financing transactions ranging from $5 million to $20 million. By contrast, the market for asset-based transactions begins as low as $30 million. Because the fixed costs involved, such as due diligence and legal expenses, credit enhancement becomes far more cost efficient with transactions of at least $50 million.

Nevertheless, by the look of these types of financing projects, future growth prospects for the surety bond market are great. Asset-backed financing has jump started a trend too strong and too essential to resist in the market-driven economy that is spreading throughout the world today. Michael L. Stoll is manager of Special Risk Services for Hobbs Group Inc., in Greenwich, CT.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Author:Stoll, Michael L.
Publication:Risk Management
Date:Nov 1, 1991
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