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On the management of financial guarantees.

(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)

Guarantees are also involved in other financial contracts besides loans. In swap contracts, for example, guarantees of performance by both parties to the swap agreement are often provided by a third-party financial intermediary. If such a guarantee is not purchased, then each of the parties is providing de facto a guarantee of its counter-party's performance. As nonfinancial firms make increasing use of such contracts, their managers need to better understand how to efficiently manage the explicit and implicit guarantees associated with them.

The analysis of guarantees in the sections that follow has relevance to the evaluation of virtually all financial contracts, whether or not the guarantees are explicit. Lenders and counterparties to swap agreements face the same set of risk and control issues as any explicit guarantor. Therefore, the analysis of the methods used by guarantors to control the cost of providing contract guarantees is relevant more generally to corporate managers.

I. The Role of Guarantees

To properly understand the role played by guarantees of financial contracts, it is helpful to focus first on financial intermediaries, whose primary business is to deal in such contracts. We draw a distinction between the "customers" and the "investors" of a financial intermediary. Calling attention to the distinction between customers and investors of nonfinancial firms is rarely necessary, because it is generally obvious. Few would confuse the customer who buys a car from an automobile firm with the shareholder, lender, or other investor who buys its securities. Similarly, no one would confuse a customer who changes money at a bank or takes out a loan from it with an investor who owns shares in the bank.

But the customers of many types of financial intermediaries receive a promise of services in the future in return for payments to the firm now. Those financial services usually involve future payments to the customer of specified amounts of money, contingent on events and the passage of time. Those promised payments are liabilities of the firm, both economically and in the accounting sense. Since investors in the firm also hold its liabilities, the distinction between customers and investors is not always so clear for such intermediaries.

The distinction between the two can, however, be made. Customers who hold the intermediary's liabilities are identified by their strict preference to have the payoffs on their contracts as insensitive as possible to the fortunes of the firm itself.(4) For example, the function served by a life insurance policy is to provide its beneficiaries with a specified cash payment in the event of the insured party's death. That function is less efficiently performed if the contract instead calls for the death benefit to be paid in the joint event that the insured party dies and the insurance company is solvent. Even if the insurance company offers an actuarially fair reduction in the price of the insurance to reflect the risk of insolvency, a risk-averse customer would prefer the policy with the least default risk. Indeed, we doubt that many real-world customers would consciously agree to accept nontrivial default risk on a $200,000 life insurance policy, even in return for a large reduction in the annual premium from $400 to $300. Similar results obtain in theoretical models in which the customer has all of the relevant information necessary to assess the default risk of the insurer.(5) In most real-world cases, the customers do not have the relevant information, and this fact makes the potential welfare loss from default even larger.

By contrast, investors in the liabilities issued by the insurance company (e.g., stocks or bonds) expect their returns to be affected by the profits and losses of the firm. Indeed, their function is to allow the company to better serve its customers by shifting the burden of the risk and resource commitment from customers to investors. The investors are, of course, compensated for this service by an appropriate expected return. The resulting increase in efficiency of customer contracts from this shift in risk-bearing makes customers better off. Note that while the roles of "customers" and "investors" are distinct, the same individual can be both a customer of and an investor in a particular firm. Thus, I can both buy an insurance policy from a particular insurance company and also hold shares of its common stock as part of my investment portfolio.(6)

The distinction between an investor-held and a customer-held liability claim is not unique to financial intermediaries. For example, a customer who buys a warranty on a new car from an automobile manufacturer wants the repairs paid for in the event that the car is defective. In fact, the customer's contract pays for repairs in the joint event that the car is defective and the automobile manufacturer is financially solvent. If given a choice, customers would prefer not to accept additional default risk in return for an actuarially fair reduction in the cost of the warranty. Much the same point can be made about the implicit contract with customers to ensure that spare parts are available in the future for repairs. Although it can become quite significant for a financially distressed firm, default risk is probably a secondary consideration for most customers of an automobile manufacturer. In contrast, because of the substantial size and long duration of many financial contracts such as annuities and life insurance, default risk is a first-order issue for customers of financial intermediaries. Thus, the success of a financial intermediary depends not only on charging adequate prices to cover its production costs, but also on providing adequate assurances to its customers that promised payments will be made.

By definition, a financial intermediary is a firm whose primary business is to buy financial assets and issue financial liabilities. Its economic raison d'etre is to provide financial instruments and products to customers who cannot obtain them more efficiently by directly trading in security markets.(7) Some intermediaries serve their principal function by buying assets of a certain type from customers. They issue liabilities to investors to facilitate the performance of that principal function. For example, consumer-finance companies in the United States serve the primary purpose of making loans to their customers, and they raise all of the money they lend by issuing securities that are held by investors. Other intermediaries serve their principal function by issuing liabilities of a certain type, and they manage their assets to facilitate this principal function. One such type is a property and casualty insurance company that issues more or less customized insurance contracts to its policyholders, and invests almost exclusively in securities traded in the capital markets. Other intermediaries service customers from both sides of their balance sheets. Commercial banks and thrift institutions in the United States are examples. In order to service their customers, those institutions must have either "buffer" assets (including third-party guarantees of their own liabilities), or "buffer" liabilities (such as investor capital), or both.

There are essentially three ways for an intermediary (whether one- or two-sided) to provide assurances against default risk to the customers who hold its liabilities:

(i) By having investors put in additional capital beyond that required for funding of the physical investments and working capital needed to run the business. This "assurance" capital can be in the form of equity or subordinated debt.(8)

(ii) By purchasing guarantees of its customer liabilities from a private third party. This might be accomplished by a confederation of private parties as in the reinsurance market. This approach works best for covering customer liabilities where the risk is diversifiable, as in the case of mortality risk. It can also work where the risk, although not diversifiable, can be hedged in the capital markets, as in the case of stock market or interest rate risk.(9)

(iii) By government guarantees of its customer liabilities. This approach may be best where the risk cannot be diversified or hedged through the capital markets. An example would be if the risk is due to a possible failure of part of the financial system, as in the case of a major breakdown in the payments system.

A more detailed discussion of the issues underlying whether private or government provision of guarantees may be more efficient is presented in Section V. But first, we discuss issues relating to the management of guarantees that apply regardless of whether the guarantor is a private or governmental body.

II. Managing the Guarantee Business

The offering of guarantees is a business activity. Functionally, guarantees are insurance policies that oblige the guarantor to make the promised payment on a financial contract if the issuer fails to do so.(10) The economic loss to the guarantor is equal to the difference between the promised payment on the guaranteed contract and the price received from the sale of the assets that are available from the issuer as collateral for this obligation. This difference is called the "shortfall." It is generally assumed that the issuer will only default if the shortfall is nonnegative. All assets of the liability issuer that the guarantor has recourse to seize will be called "collateral" assets, even if they are not formally pledged and segregated. For the business to be viable, premiums charged for the guarantees must be large enough to cover both actuarial loss experience and operating costs.

Profitability is achieved by a mixture of adequate premiums, control of operating costs, and control of the frequency and the severity of shortfall losses. For example, consider the profit from the sale of a single guarantee. For simplicity, assume that there are no operating costs. If the value of collateral assets, V, exceeds the promised payments, E, the guarantor keeps the premium and pays nothing. But if the value of assets is less than the promised payments, the guarantor must pay the difference, E - V. The guarantor's maximum profit is equal to the premium plus interest earned from investing the premium prior to payment of losses or expiration of the guarantee. This maximum profit is diminished by the shortfall or loss experience from issuer defaults. The minimum profit (or, more accurately, the maximum loss exposure) is the promised payment. The guarantor's profit function is thus given by P(1 + r) - max |0, E - V~, where P is the premium and r is the interest rate.

The guarantor firm bears the full downside risk as if it were the owner of the collateral assets.(11) It does not, however, participate in the upside gains that an owner of those assets would receive. Because of this asymmetry, the guarantor's expected profit is a decreasing function of the variability of the shortfall. If the promised payment E is fixed, then the variability of the shortfall is the same as the volatility of the asset value.

To illustrate, suppose that the guarantor charges a certain premium at the beginning of the term of the guarantee and invests it at the risk-free interest rate. The premium charged by the guarantor plus interest earned on it is $10. The guaranteed payment is $100, and the underlying asset can take a value of either $120 or $80, each with a probability of 0.5. The asset's expected value is therefore equal to the promised payment of $100, but there is a possible shortfall of $20. The guarantor's expected profit is equal to the premium plus interest less the expected shortfall:

Guarantor's expected profit = $10 - 0.5 x $20 = 0.

Now suppose that there is no change in the asset's expected value, but its variability increases. Suppose that its value can be either $150 or $50, each with a probability of 0.5. The asset's expected value remains equal to the $100 promised payment, but there is now a 0.5 probability of a $50 shortfall. Since the premium charged by the guarantor plus interest earned is still $10, the expected profit has declined:(12)

Guarantor's expected profit = $10 - 0.5 x $50 = -$15.

There are three interrelated methods available to a guarantor to manage its business: (i) monitoring the value of the collateral assets; (ii) restricting the kinds of assets acceptable as collateral; and (iii) setting a premium schedule for the guarantee that is related to its loss exposure. In general, all three of these methods for managing the guarantee business are used in combination, but the relative importance of each varies.(13) We now examine each method in greater detail.

A. Monitoring

If the guarantor has a covenant right to surveil continuously and seize assets, shortfall losses can be minimized either by auditing the value of the assets and seizing them before their value dips below the promised payment, or by making sure that the assets accepted as collateral always have a value at least equal to the promised payment. This policy permits the guarantor to function with minimal restrictions on the type of collateral assets and with minimal premium charges. In some guarantees, the covenants provide that the assets cannot be seized prior to a specified future date. When there is such a provision (called a "term" guarantee), monitoring alone cannot limit the shortfall losses. That is, monitoring only works as a means of controlling shortfall losses if the guarantor has the right to seize assets when some predetermined minimum or maintenance value for the collateral assets is violated.

Perhaps the best example to illustrate how monitoring with continuous surveillance can work effectively to protect the provider of a guarantee is the case of broker margin loans. It is instructive, because the system functions with only a minimal fee for the guarantee provided and relatively weak asset restrictions. When an investor opens a margin account with a broker and borrows money to buy stocks or bonds, the broker effectively is in the position of loan guarantor. For example, consider an investor who invests $100,000 in stocks, borrowing half of the funds from the broker. In practice, brokers typically borrow the funds that they lend to investors from a bank and guarantee the bank payment in full even if the investor defaults.(14) The loan from the bank to the broker is collateralized by all of the broker's assets. These loans -- both the loan from the broker to the investor and from the bank to the broker -- are due on demand. The broker's fee for providing its guarantee (that is, for absorbing the default risk of the investor's collateralized loan) and for servicing the account is embodied in the spread between the interest rate it charges the margin investor and the interest rate it pays to the bank.

As guarantors, brokers set two types of capital requirements: initial margin and maintenance margin. The initial margin requirement is the required net worth of the investor's account at the time the margin loan is made and the securities purchased.(15) All the securities purchased by the margin investor remain in the possession of the broker as collateral for the loan, and the broker calculates the market value of these securities daily (and sometimes more often on days when there is unusual volatility in price movements). The net worth of the investor's account is calculated as the market value of the collateral less the debt to the broker. If the net worth of the account falls below a prespecified fraction of the value of the collateral, called the "maintenance margin ratio," the broker notifies the investor that he must add additional equity capital to his account immediately. If the investor does not respond to this margin call, the broker exercises its right to sell the securities serving as collateral and pays off the loan out of the proceeds. The investor receives the remainder, if any.

Brokers find that this system offers them substantial protection despite the fact that the prices of the securities held by investors are often quite volatile.(16) Indeed, the restrictions placed by brokers on securities that may be held in margin accounts are minimal, and brokers typically undertake only a minimal check of the borrower's total net worth. Nominally, the broker has recourse for any shortfall beyond the securities in the investor's account. However, brokers do not appear to rely on recourse to the investor's net worth to any significant extent.(17) Despite the price volatility of the securities held in margin accounts, the implicit fees charged by brokers for their guarantees are quite low. Indeed, we found a local discount broker who charged 50 basis points below the call-money-rate-to-brokers rate quoted daily in the Wall Street Journal.

To summarize, the key elements of this system of monitoring margin loans are: (i) the guarantor has possession of the collateral; (ii) the value of the collateral is recomputed frequently at readily ascertainable market prices; and (iii) the guarantor has the right to automatically liquidate the collateral to pay off the guaranteed liability if the ongoing capital requirement is violated. Each of these elements is essential for the system to function properly. In particular, frequent monitoring of the market value of the collateral would be pointless if the broker does not have the right to seize and liquidate the collateral as soon as the required maintenance margin ratio is violated.

Generalizing from this example of broker loans, we can make some observations about the requirements for an effective system of monitoring. First, the relevant market price to be used in valuing the assets is the price at which they can be sold -- the bid price. Any asset is therefore eligible to be held in a margin account as long as it has a bona fide bid price for the quantity to be sold. As long as assets are marked to market at the bid price, the illiquidity of an asset serving as collateral is not a problem for the guarantor. However, illiquid assets (which by definition have a large bid-ask spread) are not suitable for guarantee systems relying on monitoring because the borrower is vulnerable to having the asset seized and liquidated when the bid price falls, even if the average of the bid and ask prices falls by a relatively small amount.(18) The spread cost from this "bid-ask bounce" is a deadweight loss to the collectivity of the debtor and the creditor. Thus, if it is large and the chances of a violation are not negligible, this form of handling guarantee risk is inefficient for illiquid assets. Therefore, when the underlying assets are illiquid, a guarantee system that relies heavily on monitoring is not efficient.

The issue of the liquidity of the assets held as collateral is frequently associated with the question of the size of the required capital cushion. These are, however, logically distinct issues. The problem of liquidity is addressed by marking assets to the bid price. If the bid price fluctuates smoothly over time without any big, discontinuous "jumps," then the guarantor does not require a large capital cushion. The purpose of the cushion (i.e., the capital requirement) is to protect the guarantor against the possibility that the asset price will fall below the trigger point before the guarantor can seize and liquidate it.(19) The issue of liquidity of the collateral is sometimes treated inter-changeably with the possibility of large jumps in price because the two are likely to be positively correlated. But, as in the case of common stocks, it is possible for the assets to be very liquid and yet be subject to large discrete jumps in price.

The measure of "account net worth" or capital to be used as a trigger for seizure of assets should include only the value of assets that can be realized in a liquidation, net of any liquidation costs. To the extent that "going-concern" value or other intangibles can be preserved in a liquidation, then they should be included in capital. Otherwise, they should be excluded.

Note that the monitoring-audit activity described here is distinct from standard auditing activities such as verifying that the insured entity holds the assets it claims to possess. Auditing of this sort is designed to prevent fraud and to ensure compliance with asset restrictions and other nonvaluation covenants. Market valuation of assets and liabilities is not typically a part of it.

In many real-world situations, there is a nontrivial cost to valuing the assets held as collateral that rules out continuous surveillance of asset values as a feasible policy. This cost, together with the costs of seizure and liquidation, creates a tradeoff between the guarantor's operating costs on the one hand and limiting loss experience on the other. One would thus not expect surveillance to be effective if these operating costs are high. In order to lower the costs of surveillance, valuations to determine the solvency of insured intermediaries are often performed at discrete time intervals -- either randomly determined or scheduled in advance.(20) The guarantor may use readily available market information to help determine when to perform an audit of the solvency of an insured intermediary. If, for example, the insured intermediary's investor-held liabilities are traded in the capital markets, then their market value can provide useful information to the guarantor. Thus, an unusual decline in the market value of a particular bank's stocks or bonds, should increase the likelihood that the guarantor of the deposit liabilities of that bank undertakes an audit.

Surveillance is often performed by third parties who are not at risk of their own capital. The real-world reference here is to rating agencies (such as Standard & Poor's, Moody's, and A. M. Best) who provide outside surveillance services for a fee, but do not themselves guarantee loans. There are, however, limits on how much guarantors can prudently rely on those rating agencies as a substitute for their own surveillance. Even with the so-called "reputation" effect, the incentives of the rating agencies can be such that it may be more important to them to produce essentially the same forecasts (ratings) as their competitors than to be accurate in their forecasts. Under conditions where customers can only observe "noisy" signals of raters' forecasting skills, a rating agency that produces a correct prediction when its competitors are wrong may stand to gain less than it stands to lose by producing an incorrect prediction when its competitors are right.(21)

The surveillance and seizure system employed by brokers in protecting themselves against default risk on the part of their customers is not the only such system. The futures and options exchanges in the United States and throughout the world employ similar methods. Miller |53, section 2.1.2~, for example, describes how futures exchanges insure the parties to a futures contract against contract default risk by employing perfected collateral that is marked to market on a daily basis. There is an additional layer of protection against contract default risk built into the system in the form of a clearinghouse with both assurance capital and guarantees of its own performance from third parties. All contracts are formally between the buyer or seller and the exchange clearinghouse and thus carry that institution's guarantee. The same is true for exchange-traded options.

The swap market offers another example. The vast majority of swap contracts are between two parties through the intermediation of a bank or other financial-services firm. The role of the intermediary has been both to bring parties together and to provide performance guarantees (for a fee). Recently, however, swap contracts are being written to include perfected collateral that is marked to market frequently, thus making the provision of third-party guarantees less important and less expensive.

B. Marking to Market

A system of monitoring to control the risks faced by guarantors can only work if there are mutually acceptable rules and valuation procedures to determine when the intermediary's assets can be seized and liquidated by the guarantor. As already discussed, the valuation of assets for the purpose of implementing this system should be at the bid side of their current prices (including any impact on these prices caused by the sizes of the proposed transactions). Such periodic revising of values is called marking to market.(22)

Although the concept of marking to market is straight-forward, its implementation can be complex. If the collateral assets are traded in well-functioning, organized markets such as national stock exchanges and government-securities markets, then reliable market values are readily observable, and marking to market is a relatively easy process. However, for assets that trade either infrequently or in significantly smaller lot sizes than the holdings of the intermediary, estimates of market prices are subject to significant errors, and reaching agreement on the proper mark-to-market procedure is more difficult.

In the context of a surveillance and seizure system, these estimation errors impose risks on both the guarantor and the insured intermediary. If the errors overstate values, the guarantor will not seize as quickly as it should, and the proceeds realized from seizure will be less than expected. If the errors understate the values, the intermediary will be seized and liquidated when it is actually solvent. Thus, a "conservative" valuation method from the perspective of one party to the system will be an "aggressive" valuation method from the perspective of the other party. Hence, the valuation method should be unbiased. Protections for the parties from measurement errors in the prices can be provided by other rules of the monitoring system -- such as the minimum size of the intermediary's net worth before seizure is permitted.

Because of the natural tension between the guarantor and the insured intermediary over asset valuation, a key element of a mark-to-market system is that it seeks to minimize the opportunities for manipulation. Especially if its assets are traded infrequently, the intermediary has information about their true values that is not costlessly available to other parties including the guarantor. As indicated, the intermediary's incentives favor biased-high estimates of prices of its assets and biased-low estimates of the prices of its liabilities. Thus, while the intermediary may have information that could improve the accuracy of the valuation, it may be optimal to neglect its inclusion in the mark-to-market estimates, if inclusion of this information requires too much discretion on the part of the intermediary. That is, the accuracy of the valuation procedure is important, but just as important is that the procedure be known, agreed upon by both parties in advance, and difficult to manipulate.(23) In sum, a proper mark-to-market model is one that, specified ex ante, gives the best estimate of market price, using verifiable data.

A word on book values in a monitoring system. It is sometimes suggested that circumstances in which estimates of market prices are "noisy" are ones that favor using book values -- that is, amortized acquisition cost. This seems to us to be a non sequitur. We are not aware of scientific evidence that book values are the best estimates of market prices, especially for financial assets of the kind held by intermediaries. Indeed, since financial assets whose prices are observable fluctuate substantially over time, it is highly unlikely that the best-fitting unbiased, nonmanipulatable model would produce values that remain virtually constant (around predictable amortized acquisition cost) over time. Standard accounting rules for marking down book values of assets, such as creating a reserve for bad loans, are usually subject to considerable management discretion. One would therefore expect that for monitoring purposes, the guarantor would be reluctant to let an insured intermediary use book values for illiquid assets. There is a certain irony that the assets with the most uncertainty about their values would be valued by a book system which produces almost no variation in price.

Just as it is important to mark the assets to market, so guaranteed liabilities must also be marked to market. Otherwise, the exposure or shortfall estimates of the difference between asset value and promised liability payment value are distorted, and the monitoring process can become dysfunctional. In the case of broker margin loans or demand deposits, the guaranteed liability is equal to the original principal plus accrued interest. More generally, as in the case of annuities and other insurance policies, the stream of promised payments can stretch far into the future. The question of how to compute the present value of the payments that are guaranteed is, therefore, an important issue.

For example, consider an intermediary selling life annuities to its customers, and investing in bonds that are marked to market. Suppose, however, that its annuity liabilities are evaluated using an interest rate assumption that does not reflect the current market rate. If market interest rates rise, the firm may appear to be inadequately capitalized, because the market value of the bonds in its portfolio falls while the present value of the annuities computed at the nonmarket rate remains unchanged.(24) Symmetrically, a decline in interest rates will create the appearance that the firm is overcapitalized. Such a "mismatch" between asset and liability evaluation methods can be so dysfunctional that it causes the intermediary to avoid hedging or matching assets with liabilities, where such hedging would actually reduce the economic exposure of the intermediary and hence, of the guarantor.(25)

C. Capital Requirements

Since the collateral held in broker margin accounts consists entirely of securities traded by the broker, the cost of surveillance is relatively low. Margin requirements are determined by the need for a capital cushion to protect the broker against the possibility that the security prices will change discontinuously and "jump" below the trigger point before the broker can sell the securities. By comparison, it may be much more costly for the guarantor of an insured intermediary to audit the value of the intermediary's assets frequently. In such cases, the capital cushion can serve an additional function as an alternative to frequent surveillance.

If capital is large relative to the value of insured customer claims, then premiums charged by the guarantor can be low, and surveillance can be done less frequently. Since this saves surveillance costs, perhaps a lower-cost solution for the guarantor would be to simply require insured intermediaries to have large amounts of capital in the form of either equity or subordinated debt. Unfortunately, as with the frequent-surveillance solution, this too has its costs.

First, consider the equity-capital choice. As an empirical matter, financial intermediaries, both insured and uninsured, do not typically have large amounts of equity capital relative to the size of customer liabilities. As discussed in footnote 8, one theoretical explanation for this behavior is the agency and tax costs associated with equity financing of any corporate enterprise. The very characteristic of the equity cushion that makes it attractive to the guarantor of the intermediary -- that shareholders of the intermediary have no contractually specified claims to the firm's future cash flows -- is the characteristic that creates a moral hazard for the shareholders who provide that equity cushion.(26) The resulting agency and tax costs are thus the costs of using a large equity cushion as an alternative to more frequent surveillance.

The agency and tax costs associated with using equity for assurance capital can be significantly reduced by the use of debt, because debt instruments require the firm to make contractually specified payments in the future, and those payments are tax deductible for corporations. The use of subordinated debt to provide the assurance capital for insured intermediaries thus seems to offer a simultaneous, lower-cost solution to the requirements of both the providers of capital and the guarantor.

But there are problems with subordinated debt too. Debt instruments, such as corporate bonds, often offer investor-creditors ways of getting their cash payments out of a troubled institution before the guarantor can -- high-coupon payments, call provisions, sinking funds, and put-option provisions are examples.(27) Furthermore, these investor-creditors may become aware of the financial difficulties of an insured intermediary before the guarantor, especially if the guarantor has reduced its surveillance activities to save costs. Perhaps even more serious, at least in the United States, is the uncertainty surrounding actual priority of creditor claims in the event of financial distress.

As we know from the work of Tufano |69~, these problems are not new.(28) In recent times, the courts have interpreted the bankruptcy laws in such a way that there is considerable ambiguity about the priority of the guarantor's claims in the event of bankruptcy. In two recent cases, the courts have decided that the claims of the federal agencies that have assumed the guaranteed deposit liabilities of failed thrifts and the guaranteed annuities of bankrupt pension plan sponsors are to be treated pari passu with those of other creditors under Chapter 11 of the Federal Bankruptcy Code.(29)

Thus, unless the bankruptcy laws are changed to remedy the problem of settling the priority of claims for firms in financial distress,(30) high capital requirements in the form of subordinated debt may not be a good substitute for aggressive monitoring by the guarantor. It is essential for the guarantor to monitor the value of assets serving as collateral, and, in the event of a violation of the required capital ratio, to seize them before the other liability-holders of the firm cause the firm to seek Chapter 11 or other bankruptcy-law protections.(31)

D. Asset Restrictions(32)

As an alternative to monitoring, the second method a guarantor can use to control its potential losses is to require the insured firm to reduce the variability of the difference between the value of its assets and the value of its promised payments. An insured intermediary with long-term, money-fixed liabilities could, for example, be restricted to hold long-term, fixed-income securities; an insured intermediary with short-term deposit liabilities could be restricted to short-term assets. This type of restriction is known as "matching" (assets to liabilities) or "running a matched book" (of business). Asset restrictions are important to guarantor management even when full matching is not required, because the restrictions limit the amount of risk that the insured firm can take.

For example, consider a state guarantee fund that insures the payments on life annuities sold by life insurance companies doing business in the state. The guarantor could require each insurance company to hedge its fixed-income liabilities by investing in default-free, fixed-income securities with the same maturity as the benefits promised to policyholders.(33) This eliminates the risk to the guarantor stemming from uncertainty about future interest rates and from uncertainty about the solvency of the issuers of the fixed-income securities. The only remaining risk to the insurance company and therefore to the guarantor is mortality risk. By imposing the matching of assets and liabilities on its insurance companies, the guarantee fund can charge very low premiums and still be viable.

While simple in concept, the matching of assets and liabilities is not always as simple to implement in practice. Thus, one might believe that life insurance companies can hedge the interest rate risk of their annuity liabilities by simply investing in long-term, fixed-rate mortgages or bonds. However, at least in the United States, virtually all mortgages and bonds have prepayment or call provisions that allow the issuer to retire them early. Life insurance companies that attempt to match maturities must therefore deal with this prepayment risk.(34) Thus, we see that, even in this seemingly straightforward case, the matching of assets and liabilities can be complex to implement.

As a second example of the use of asset restrictions, consider the situation of a guarantee fund designed to insure savings accounts at savings institutions. The guarantor could require the savings institutions to hedge their deposit liabilities by investing in default-free, fixed-income securities with the same maturity as the deposits. Note that the asset restrictions cover both the default-risk characteristics of the fixed-income securities held by the insured institution and their maturities. If a savings institution has deposit liabilities with a short maturity and is allowed to invest in long-term bonds, the guarantor of the deposits can be subject to considerable interest rate risk, even if the bonds are free of default risk.

Starting in the 1980s, the development of trading in derivative securities -- financial futures, forward contracts, options, and swaps -- greatly enhanced the ability of intermediaries to reduce (or increase) their exposure to risk without necessarily changing their sources or uses of funds. Thus, by entering into an interest rate swap contract, an intermediary can effectively convert a long-term, fixed-rate asset or liability into a floating-rate one, or vice versa. For example, consider a thrift with an established set of customers on both sides of its balance sheet: depositors on the liability side and mortgage borrowers on the asset side. The deposit liabilities are floating-rate, while the loans are mostly long-term, fixed-rate mortgages. By entering a floating-rate for fixed-rate swap, in which it pays a fixed rate and receives a floating rate, the thrift can effectively match its floating-rate deposit liabilities to its long-term, fixed-rate assets.(35) Thus, by using interest rate swaps, the thrift can effectively match its assets and liabilities without either changing to new types of customers or asking any of its current customers (depositors or borrowers) to change their behavior.

The use of swaps by intermediaries to match their assets and liabilities is not limited to interest rate swaps. Swaps are remarkably flexible instruments with great potential as a risk management tool. For example, an intermediary that offers deposits linked to a stock market index to its customers and invests its funds in fixed-rate mortgages could enter an offsetting "equity-for-fixed-rate-debt-return" swap to create very low variability in its net worth. As in the previous example of the thrift, the swap allows the intermediary to offer its customers the products or services they demand while simultaneously controlling its risk exposure.(36)

Just as an intermediary with unmatched assets and liabilities can quickly reduce the variability of its net worth (and thus the exposure of the guarantor of its liabilities) by entering into swaps or taking offsetting positions in futures contracts, so it can quickly reverse the process and become unhedged. Indeed, an intermediary can even increase rather than decrease its unhedged risk exposure by taking positions in those derivative securities that accentuate the imbalance between its asset and liability positions. Thus, the very efficiency of the derivative-securities markets in permitting rapid and low-cost hedging of positions, can also make it difficult for the guarantor to keep track of the intermediary's exposure to shortfall risk. In order for the guarantor to monitor asset restrictions effectively, it must be aware of and understand the implications of all positions the intermediary holds in derivative securities at each point in time.

Another trend, developed during the 1980s, that has allowed intermediaries to reduce their risk exposure is securitization of mortgages and other assets such as credit-card receivables, car loans, and even some commercial loans. The growth of markets for securitized loans of various sorts has made it possible for intermediaries such as thrifts to continue to perform their traditional function of mortgage loan origination and servicing without bearing the full risk of the loans. From the perspective of the buyer of the securitized loans, the result of this process of securitization is a loan with perfected collateral.(37) At the extreme, if an intermediary sells all of its customer-based assets, it becomes a service agency. To overcome the resultant agency problem, the intermediary that sells its loans often offers a partial guarantee of the loans' performance.

E. Risk-Based Premiums

When monitoring is costly or inappropriate, perhaps because of asset liquidity problems, and when complete asset-liability matching is undesirable, then an alternative way for the guarantor to operate is to charge risk-related premiums. The system of property and casualty insurance works in this way. A precondition for the success of a system of risk-based premiums for financial intermediaries is that the guarantor has some control over the volatility of the value of the collateral asset portfolio. For risk-based premiums to work, asset variability need not be reduced to zero, but it does have to be known (or at least bounded) and not subject to significant unilateral change by the insured intermediary after the premium has been set. If the insured intermediary can unilaterally change the variability of the asset portfolio ex post, then the guarantor faces a problem of moral hazard.(38)

Estimation of the proper risk-based premiums for the kinds of guarantees discussed here is feasible. There is a substantial and sophisticated academic literature on estimating the value of loan guarantees and deposit insurance.(39) However, we choose here a simpler route to provide a sense of the private-sector market prices for loan guarantees. As discussed at the outset, the price of nonguaranteed debt plus the price of a loan guarantee for the debt is equal to the price of default-free debt with the same terms. It follows as a matter of subtraction that the value of the loan guarantee is equal to the difference in the prices of the two bonds. Corporate bonds traded in actual markets are not guaranteed. Hence, by estimating the prices for those bonds if they were default-free and subtracting the actual market prices of the bonds, we derive implied market prices for the guarantees.

Merton |46, Table 8~ presents such a tabulation for a sample of ten below-investment-grade bonds. We reproduce it here as Exhibit 1. The selection criteria were nothing more than picking lower-grade bonds issued by companies with names that are probably recognizable by most. None of the bonds were in default or trading "flat" at the time the selections were made. The estimates of their corresponding default-free prices are derived by discounting promised coupon and principal payments at nine percent, which was, at the time, approximately the current U.S. Treasury bond and note rate.

Since the purpose of Exhibit 1 is simply to provide an indicated range of implied market prices for guarantees, no adjustments were made for either cumulative interest or call provisions. Such detailed adjustments would not change the central point that the prices of loan guarantees can be quite large. Pan Am (even well before its recent bankruptcy filing) stands out as an extreme with an $89 price for the guarantee which is 150% of the bond's nonguaranteed price of $59. However, as indicated by the other entries in Exhibit 1, loan guarantee prices in excess of 50% of the bond price without the guarantee are not uncommon.


In summary, the three basic methods that a guarantor of liabilities has to manage its function on a sound business basis are:

(i) Monitoring. This method requires the guarantor to frequently mark-to-market the assets and liabilities of the insured institution and be ready and able to seize the collateral as soon as the institution's net worth falls below a predetermined maintenance target. It works best when the guarantor has perfected possession of the collateral and when the assets and liabilities have easily ascertainable market values.

(ii) Asset Restrictions. This method of controlling costs requires the insured institution to (at least partially) hedge its guaranteed liabilities, and limits the volatility of its net worth.

(iii) Risk-Based Premiums. Under this method, the guarantor charges a fee that is commensurate with the riskiness of the guarantee. It works best when the guarantor has access to the informational inputs needed to establish a fair price and when the risk characteristics of its assets and/or liabilities cannot be unilaterally changed by the insured intermediary after the premium has been paid.

In practice, guarantors (whether private or government) use mixes of all three methods. As we have seen, depending on the context, some mixes will be more efficient than others.

Note that no mention has been made of the investment and financing policies of the guarantor. There are three reasons. First, we have assumed for the analysis that the guarantor has sufficient capital so that the investment policy is not being relied upon to ensure that the guarantor can make good on the guarantee. If the quality of the guarantee is in question, then we are led to a potential problem of infinite regress -- who guarantees the guarantor, who guarantees the guarantor of the guarantor, and so on?

Second, to the extent that the guarantor earns a higher expected return by investing in assets with higher risk, there is no "excess" value to support lower premium charges by the guarantor. Higher expected returns are simply compensation for greater risk-bearing. Furthermore, even if the guarantor has special investment expertise which makes possible the achievement of higher risk-adjusted expected returns, there is no reason to assume that these higher risk-adjusted returns will or should be used to subsidize the guarantee business in the form of lower premiums.

For example, suppose there are two identical guarantee firms that have priced their guarantees to compete with each other. Since, by assumption, the guarantees issued by both firms are free of default risk, the premiums charged customers will be the same. Suppose that the first guarantee firm invests the premiums collected so as to minimize the risk exposure of its shareholders -- say, by investing in Treasury bills, while the second invests the premiums in a stock market index fund. The shareholders of the second guarantee firm are thus exposed to stock market risk in addition to the risk of the firm's guarantee liabilities. They are compensated for bearing the stock market risk by the expectation of earning a higher return on their investment in the equity of the guarantee firm. But this can only be achieved by "passing through" to the shareholders the higher expected returns on the firm's stock market assets. Competition from other guarantors prohibits the firm from charging higher premiums to customers to "cover" its losses from stock investments. Hence, there is no reason to believe that the second firm will or should change the premiums it charges for its guarantees based on the outcome of its stock market investments. Similarly, if the second firm has skill in either stock market timing or in security selection, so that it can actively manage its investment portfolio to earn a noncompetitive higher risk-adjusted expected return, there is no reason to believe that this excess return will or should be used to subsidize its guarantee business, since realizing superior investment performance does not require that one be in the guarantee business.

III. Corporate Guarantees

Guarantees are ubiquitous in the world of corporate finance, although often they are implicit rather than explicit. Some common situations in which the analysis of guarantees is central to decision-making and control by corporate financial officers are:

* Parent company guarantees of the debt or other contractual obligations of a subsidiary. (The chief financial officer is likely to be the decision-maker.)

* Swap and other derivative-security contracts entered into by the corporation. (The treasurer would be most directly involved.)

* Pension obligations under defined-benefit pension plans. (The chief pension officer would be most directly involved.)

In general, the efficient mix of the three methods described in Section II for managing corporate guarantees will depend on the specific circumstances.

A. Parent Guarantees of a Subsidiary

A prime case of the use of guarantees is when a parent company guarantees the debt or other contractual obligations of a subsidiary. Such guarantees are often quite important to the subsidiary firm. In some cases, suppliers or customers might not even be willing to do business with the subsidiary if they doubt that the parent company would honor the subsidiary's commitments. Sometimes a guarantee from the parent company constitutes the entire equity capital of the subsidiary. Such guarantees do not usually appear explicitly on the balance sheets of the parent or its subsidiary. Nonetheless, their economic value can be very large in relation to other corporate assets and liabilities. The management of those guarantees can therefore be an important part of the job of the parent company's financial managers.

To help in analyzing such guarantees, we begin with the reasons for companies to establish subsidiaries:

* To better control risk exposure of either the parent to the subsidiary or the subsidiary to the parent.(40)

* To enhance the company's ability to evaluate individual performance and to create different compensation systems for a diverse set of its businesses.

* To conform with regulatory requirements specific to a particular business environment.

An example that illustrates all three reasons for establishing subsidiaries is a multinational corporation that organizes itself into separate national subsidiaries. By doing so, the parent company can limit its exposure to country-specific risks, tailor its incentive and compensation systems to fit different cultural and political environments, and conform to different (sometimes contradictory) regulatory regimes.

In managing guarantees of its subsidiaries, a parent company may find it efficient to use management methods that would not be feasible for an external guarantor. Unlike an external party, the parent's management can have access to virtually all of the proprietary business information available to the subsidiary's management without jeopardizing the competitive position of the subsidiary. Such access greatly reduces problems of asymmetric information between the guarantor and the guarantee. The parent's management, for example, can decide to establish an internal mark-to-market accounting system to monitor its exposure from guarantees of its subsidiaries even though the resultant reports would not be available to outsiders. It is therefore likely that moral-hazard and other principal-agent problems are less severe here than they would be with an outside guarantor.

Subsidiaries often fall under different regulatory authorities from their parents, which may cause the efficient combination of methods for managing the guarantee to change. In an international context, for example, the different laws and regulations of the host countries may impose constraints on the combination of methods available to a multinational parent corporation to manage guarantees of its individual national subsidiaries.

B. Credit Risk of Swaps

Corporate treasurers have turned increasingly to the futures, options, and swap markets to manage their currency and interest-rate risks and to seek the lowest-cost financing globally available. Counterparty credit risk is often a major concern with these contracts, and corporate treasurers must decide the most appropriate mix of methods to manage those risks.(41)

A firm that enters a swap contract has essentially two ways to deal with counterparty credit risk:

* Require collateralization and manage the guarantee exposure itself.

* Require the purchase of a third-party performance guarantee (e.g., from a top-credit financial institution with an AAA credit rating).

If the first path is taken, the methods of management are the same as those described in Section II.

C. Corporate Pension Benefit Guarantees

Another economically significant example of guarantees in corporate finance arises in the context of defined-benefit pension plans sponsored by firms for their employees. According to U.S. law, the assets in the pension fund serve as collateral for the sponsor's benefit obligations to its employees. Thus, the assets in the pension fund are encumbered corporate assets securing a particular form of the corporation's nonequity liabilities. However, in some other countries, any pension fund surplus (i.e., the excess value of pension assets over contractual pension obligations, if any) must be used to increase pension benefits beyond the amount specified in the benefit formula.(42) In such situations, the pension fund is effectively a subsidiary in which the employees have an equity stake. However, unlike the usual "symmetric" pattern of gain and loss for equity, should the assets in the pension fund "subsidiary" be insufficient to pay the benefits promised to employees under the plan's benefit formula, then the firm must make up the difference.(43) The firm sponsoring the defined-benefit pension plan for its employees is thus a guarantor of the "debt" of this pension "subsidiary".(44)

IV. A Hypothetical Example

To illustrate how our analytical framework can be used by a corporation's managers, consider SubCo, a fictitious wholly owned subsidiary of PareCo, a $1 billion corporation which has an AAA credit rating. SubCo has assets worth $100 million and has issued zero-coupon bonds maturing in one year with a face value of $103 million. Without PareCo's guarantee, SubCo's bonds would be below-investment-grade and have a market value of $91 million. With the guarantee, SubCo's bonds are high-grade and have a market value of $98 million. The $7 million difference in value is due to PareCo's guarantee.(45) However, the guarantee does not appear on the conventional balance sheet of either corporation. Without it, it appears as if SubCo's capital structure is 98% debt and two percent equity, when, in fact, the guarantee provided by PareCo is an asset of SubCo which makes the "true" amount of equity capital correspondingly larger.

To see this, consider the "extended" balance sheets of PareCo and SubCo in Exhibit 3, Panels A and B, and contrast them with the conventional balance sheets in Exhibit 2, Panels A and B.(46) Exhibit 3 shows the guarantee of SubCo's bonds explicitly as an asset of SubCo and a liability of PareCo. Note that the consolidated balance sheet, shown in Panel C of Exhibit 2 and Panel C of Exhibit 3, is the same for both the conventional and the extended cases; it is unaffected by how we choose to record the guarantee.(47)

While for external users (e.g., security analysts), PareCo's consolidated balance sheet may be sufficient, PareCo's managers can make use of the unconsolidated "extended" balance sheets to run the business more effectively. As discussed in Section III.A, there are three main arguments in favor of such an internal management accounting scheme. Let us consider each:


(i) To better reflect PareCo's risk exposure through SubCo. The exposure of PareCo to SubCo risk is reflected in the difference between the extended balance sheet of PareCo in Exhibit 3, Panel A, and the conventional balance sheet in Exhibit 2, Panel A. In Exhibit 3, Panel A, the guarantee of SubCo's bonds appears explicitly as a liability of PareCo.

(ii) To more accurately allocate capital in performance evaluation and compensation systems. To see the distortions in reported performance that can result from ignoring the value of the parent's guarantee, suppose that PareCo uses ROE as a performance measure. Assume that during the year, SubCo's net income turns out to be $2 million. If based on the $2 million of conventional balance-sheet equity in Panel B of Exhibit 2, its reported ROE will be 100%. But if the $7 million value of the guarantee from PareCo is taken into account as in Panel B of Exhibit 3, SubCo's ROE is only 22.22%.(48)
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Title Annotation:Market Microstructure and Corporate Finance Special Issue
Author:Merton, Robert C.; Bodie, Zvi
Publication:Financial Management
Date:Dec 22, 1992
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