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 returns and profitability, please read How does the math work?