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Setting Up Guarantee Types

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Like collateral, guarantees on loans represent an additional source of mitigation against borrower credit risk in that, if the obligor defaults on the loan, the bank has additional recourse against the guarantor in order to recover all outstanding amounts owed.

To account for the economic impact of guarantees, PrecisionLender allows the bank to set up specific Guarantee Types to reflect the different kinds of guarantees that are commonly part of commercial loan opportunities.

In this article we will look at:

Defining Your Guarantee Types

PrecisionLender gives the bank complete flexibility to define as many unique guarantee types as are necessary.  Common types include but are not limited to the following:

  • Government Guarantees – Typical government guarantees would include SBA or USDA programs (or similar programs), whereby the federal government is providing a guarantee to the bank against loss from loans originated under the auspices and criteria of these programs. State and local governments may have similar programs as well.  Government guarantees generally are considered to be “riskless” as governments have several means at their disposal to satisfy obligations that arise under these programs.
  • Corporate Guarantees – this may be a guarantee from a publicly traded or privately held corporation. In most cases, corporate guarantees are generally used when the corporate parent is guaranteeing the debt obligation(s) of a subsidiary.  Corporate guarantees are considered “risky” in that the credit worthiness, balance sheet strength and other qualitative factors should be considered in determining the quality and expected economic impact on credit risk mitigation.
  • Personal Guarantees – the most common type of guarantee for banks is personal guarantees provided by the business owner(s) or principals of the obligor. Like corporate guarantees, personal guarantees are “risky” and require the bank to consider the financial strength, liquidity and other qualitative factors when evaluating the expected economic impact on credit risk mitigation.  Some common things to consider when evaluating personal guarantees include (but are not limited to):
    • Correlation - The degree of correlation of the guarantor’s assets, income and net worth relative to the obligor should be considered. If the guarantors’ financial wherewithal is highly dependent on the success of the obligor this would reduce the quality and expected recovery of the guarantee in the event of a default.  For example, assume the bank loans money to the local small business in town and in turn gets a personal guarantee from the business owner.  The business owner’s personal assets, income and net worth are primarily derived from his ownership in his small business.  Therefore, if the business fails and defaults on the loan the likelihood the business owner will meet his obligations under his personal guarantee are low because his source (e.g. the small business) of assets, income and net worth has failed.  He was highly correlated to the obligor.
    • Liquidity – The composition of the guarantors’ assets should be reviewed in order to gauge the level of liquidity. More liquid assets are generally preferred as they can be more easily converted to cash.  For example, assume there are two guarantors – Guarantor A and Guarantor B – and both A and B have the same total net worth of $1.0 million each.  However, A’s net worth is tied up in illiquid real estate holdings, while B’s net worth is in liquid marketable securities.  B may be considered a better quality guarantor because of higher liquidity, despite the fact that B and A have the same total net worth.
    • Total Assets / Net Worth – The size of the guarantors’ total balance sheet (e.g. assets and net worth) relative to the size of the loan guarantee is important. Generally, the higher the ratio of the guarantors’ assets and net worth to the loan guarantee the better. For example, assume a guarantor has personally guaranteed a $1.0 million loan obligation.  However, upon review their net worth totals $0.5 million or 0.5x.  In the event of default, this guarantor will not be able to satisfy the full obligation and the bank will still be exposed.  Alternatively, if the guarantors’ net worth totaled $2.0 million or 2.0x the likelihood of a sufficient recovery in the event of default is much higher.

 

Expected Recovery Rates

A key input when setting up guarantees is the expected recovery rate.  The recovery rate is applied to the guarantee to estimate how much of the guarantee the bank reasonably expects to recover from the guarantor in the event of default.

For example, assume the bank has a personal guarantee for $1.0 million from a guarantor with less than ideal qualitative factors as discussed above.  The bank assigns a 10% recovery rate to this type of personal guarantee.  This means that in the event of default, the bank expects to actually recover, net of expenses, approximately $100,000 from the guarantor.

The table below shows how to calculate the recovery rates for different guarantee types. 

 

In calculating the net recovery rate on guarantee types, it is preferable for the bank to review as many actual defaults as possible and capture the total nominal amount of guaranteed value (the “Guaranteed Value $”) and the nominal amount recovered after all fees and expenses incurred in the recovery process (the “Recovery $”).  This produces the “Nominal Recovery %”.  When calculating Nominal Recovery % it is important to only the guaranteed amount the bank sought to be recovered.  For example, assume there was a remaining $40,000 exposure at default and the total guarantee was for $100,000.  If the bank successfully collects the $40,000 from the guarantor this would result in a Nominal Recovery of 100% because the bank only sought $40,000 in Guaranteed Value and recovered $40,000.  Finally, using actual data where possible, estimate the “Average Time to Recovery”.  This value is used to discount back for time value the Nominal Recovery % using a discount rate ranging from 15-20%.

In addition to setting the recovery rate for each guarantee type, thought should be given to whether or not incremental origination costs or services costs are required for handling and monitoring these guarantees.

For more information on how guarantees impact the calculation of ROE and profitability, please read “How the Math Works?”

 

Adding A Guarantee Type

To add or edit a Guarantee Type:

  • Navigate to the Administration section in the bottom left-hand corner of the application.
  • Select Products from the side-bar menu on the left.
  • Select the commercial loan product that you would like to add a Guarantee Type to.
  • Click the “Edit” button in the upper left corner.
  • Click on the “Guarantee Types” section of the product.
  • Click the "Add New Guarantee Type" button.
  • Fill in the details as appropriate.
  • Remember to save the product when you are done editing.

Guarantee Types

  

Name

  • This is the name that will show up for lenders when selecting a Guarantee Type

Is Government

  • Check this box if the Guarantee is considered a riskless government guarantee

Method

  • The method cannot be changed, it can only be defined when the Guarantee Type is first created
  • Available Method Types:
    • Dollar Amount
      • Lenders will input the dollar amount of the guarantee.
      • This is a fixed dollar amount that will not change over the life of the loan.
    • Percent of Exposure
      • Lenders will input the percentage of the exposure amount that the guarantor is obligated to
      • The amount of exposure, and thus the amount guaranteed, may change over time as the balance of the loan changes.
    • Unlimited
      • The guarantor is obligated to guarantee 100% of the exposure.

Recovery Factor

Origination Expense

  • Here you can choose to add additional origination expenses over and above the standard allocation of costs assigned by the Origination Channel. This might be appropriate if negotiating and underwriting the guarantee will require more time and effort than usual or require specific additional costs to obtain.

Monthly Servicing Expense

  • Here you can choose to add additional servicing expenses over and above the standard allocation of costs assigned by the Servicing Channel. This might be appropriate if monitoring and maintaining the guarantee will require more time and effort than usual or require specific additional costs to service.

Description

  • Here you can enter a brief description of the guarantee type along with any policy guidance as needed

 

Deleting a Guarantee Type

To delete an existing guarantee type simply click the trashcan icon icon to the left of the guarantee type you would like to remove.

 

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