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Credit enhancement and loan default risk premiums
Canadian Journal of Administrative Sciences, Sep 2002 by Chuang-Chang Chang, Van Son Lai, Min-Teh Yu
Abstract
Using contingent claims analysis, we study the impact of private guarantees on the default risk premiums or credit spreads of discount loans. Specifically, we analyze the reduction of the default risk premium on a new junior loan by obtaining the numerical estimates under a stochastic interest rate. We demonstrate how the value of credit enhancement relates to the profitability and size of the new junior loan, as well as the leverage, asset risk, and debt seniority of the borrowing firm and the private insurer The main results show that (a) for the new junior loan, although the benefits of financial insurance are substantial with an AAA-rated private insurer, in general, default risk premiums can only be reduced to a minute amount; and (b) even with complete insurance coverage from an AAA-rated private insurer loan issues command default risk premiums that reflect not only the intrinsic values and risks of the insured and the insurer but also their covariance.
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A financial guarantee is a commitment by a third party to make payment in the event of default by a borrower in a credit or a loan agreement. Widespread thirdparty guarantees, public or private, include default insurance on corporate loans, municipal bonds, whole mortgages, and mortgage pools.1 Insurance companies and commercial banks as well as public agencies offer guarantees to a number of financial instruments such as letters of credit, loans, deposits, swaps, mortgages and municipal bonds insurance (e.g., Greenwald, 1998; Lonkevich, 2000; Merton & Bodie, 1992;). Guarantees can be implicit or explicit; for instance, subsidiaries often benefit from implicit guarantees by their parent companies with respect to their financial obligation, hence reducing their cost of capital.
Financial guarantees also play a major role in the development of international commerce. Financial guarantees improve access to international capital markets at lower costs, longer maturities and for larger amounts (e.g., Euromoney, Dec. 1997/Jan. 1998; World Bank, 1995). Furthermore, exporting firms often benefit from governmental or private insurance guarantees to assist them in expanding their activities overseas. For instance, the Insurance Bureau of Canada reports the increasing role a public agency, Export Development Canada, plays in the exported-related and credit insurance market (Journal de l'Assurance, 1999). Multilateral development banks, such as the World Bank, currently endorse several private investment projects in emerging countries (World Bank, 1995).
Financial guarantees have become a major tool for risk management and financial innovation facilitating credit enhancement and hedging. Recent financial crises in Asia and Eastern Europe underscore the importance of appropriate immunization against default risk (e.g., Euromoney, Dec. 1997/Jan. 1998).
In a financial-engineering perspective, Merton and Bodie (1992) show that the purchase of any loan is equivalent in both a functional and a valuation sense to the purchase of a pure default-free loan and the simultaneous issue of a guarantee for that loan. Merton and Bodie (1992) also show why guarantees are pervasive and why the analysis of guarantees has relevance to the evaluation of virtually all financial contracts, whether or not the guarantees are explicit. Ceteris paribus, in the absence of external guarantees, a corporate debt trades in the market at rates reflective of its private default risk.
With the exception of Lai (1992) and Lai and Gendron (1994), all studies which use contingent claims analysis focus on the valuation of loan guarantees by the federal government and its sister agencies, which may be considered default-free (as buttressed by the works of Merton, 1977; Jones & Mason, 1980; Sosin, 1980; Chen, Chen, & Sears, 1986; Selby, Franks, & Karki, 1988; and Duan & Yu, 1994, 1999). Lai (1992) presents a model of private loan guarantees when the insurer is subject to default risk, but does not examine either Merton's (1974) default risk premium, defined as the spread between the yield on the loan and the riskless rate, nor the reduction of default risk provided by third-party credit enhancement.
In the spirit of Merton's (1974) analysis of pure discount bonds2 and that in Chen et al. (1986), Doherty and Garven (1986), and Lai (1992), we use the risk-neutral valuation framework of Rubinstein (1976), Brennan (1979), and Stapleton and Subrahmanyam (1984). Without imposing a no-loss no-gain condition on the debtholders as does Sosin (1980), we analyze theoretically the impact of loan guarantees in terms of the reduction of the default risk premium on the new junior loan guaranteed by a private insurer. As no closed-form formula (1973) can be obtained, we perform a Monte Carlo simulation to derive comparative statics for the loan default risk premium of the new junior loan with and without a private credit enhancement under stochastic interest rates. As such, we combine the literature of the modeling of credit spreads with the one on financial guarantee insurance to study the impact of credit enhancement on the default risk of discount loans. Such a study has not appeared in the extant literature. Our simulation results indicate that there is a substantial reduction of the default risk premium of the new junior loan brought about by the private guarantee.
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