Guarantee Fee Research Articles

A Catalytic Partial Credit Guarantee for a Renewable Energy Project in India

This article estimates the fee for a credit guarantee that can enhance a renewable energy project bond to a targeted rating and discusses the risk exposure assessment of a participating financial institution, a development finance institution (DFI), and an institutional investor under the guarantee structure. A solar power developer in India is operating a solar power project through a special purpose vehicle (SPV). An institutional investor, operating within the Solvency II framework, wants to invest in the project bond to be issued by this SPV, but only if the bond is domestically rated at least AA. By improving the green bond’s risk–return profile, the partial credit guarantee will catalyze the participation of investors who otherwise would not have participated. The guarantee fee is estimated using two different approaches: 1) the equivalence premium principle using the simulated cash flows and 2) the expected cost methodology using the default rates and loss given default obtained from the credit ratings. The cost of a counter guarantee provided by the DFI is estimated using the loss costs by layer of guarantee coverage. <b>TOPICS:</b>Fixed income and structured finance, ESG investing, emerging

AMP Expenditure, Location Savings and Guarantee Fee Aspects of Transfer Pricing

This article examines the AMP expenditure, location savings and guarantee fee elements of the transfer pricing debate. In particular, the authors discuss the three components in the context of United States and Indian jurisprudence, various government pronouncements, recent BEPS developments and changes to the OECD transfer pricing guidelines.

Evaluating Alberta cattle feeders’ loan guarantee program

Purpose – The purpose of this paper is to evaluate Alberta’s cattle loan guarantee program. It measures the risk premiums on lending that would accrue to banks participating in the program, estimates the value (price) of the loan guarantee, and estimates the interest subsidy provided by the program. Design/methodology/approach – A cash flow model of cattle feeding is used. The model estimates a measure of risk that is applied to option pricing models to estimate the value of the guarantee. Findings – Insurance premiums for the credit risk to lenders are 0.20 percent of the value of the loan for the entire feeding period, and 0.41 percent for backgrounding but negligible for finishing. The price of the loan guarantee estimated by the Black-Scholes model is 4.43 percent of the value of the loan and is comparable to prices estimated by the binomial model. The program provides a subsidy rate of 4.58 percent. Research limitations/implications – Charging a guarantee fee can potentially eliminate the interest subsidy inherent in the program. But this would necessitate determining the impact of the guarantee fee on the additional access to credit that has been achieved through the program. Practical implications – Different levels of risk for backgrounding and finishing imply different risk premiums on cattle loans. Therefore interest on cattle loans should reflect not only the individual farmer’s risk profile but also the nature of the feeding operation. Originality/value – This is the first paper to simultaneously estimate risk premiums on cattle feeding loans, the value of the loan guarantee provided by the Alberta Feeder Association Loan Guarantee Program, and the inherent interest subsidy.

Valuation of guaranteed minimum maturity benefits in variable annuities with surrender options

We present a numerical approach to the pricing of guaranteed minimum maturity benefits embedded in variable annuity contracts in the case where the guarantees can be surrendered at any time prior to maturity that improves on current approaches. Surrender charges are important in practice and are imposed as a way of discouraging early termination of variable annuity contracts. We formulate the valuation framework and focus on the surrender option as an American put option pricing problem and derive the corresponding pricing partial differential equation by using hedging arguments and Itô’s Lemma. Given the underlying stochastic evolution of the fund, we also present the associated transition density partial differential equation allowing us to develop solutions. An explicit integral expression for the pricing partial differential equation is then presented with the aid of Duhamel’s principle. Our analysis is relevant to risk management applications since we derive an expression of the delta for the sensitivity analysis of the guarantee fees with respect to changes in the underlying fund value. We provide algorithms for implementing the integral expressions for the price, the corresponding early exercise boundary and the delta of the surrender option. We quantify and assess the sensitivity of the prices, early exercise boundaries and deltas to changes in the underlying variables including an analysis of the fair insurance fees.

Cost of funds indexed mortgage contracts with government-backed catastrophic insurance (COFI-Cats): A realistic alternative to the 30-year fixed-rate mortgage?

We analyze the feasibility an adjustable-rate mortgage product tied to a nationwide bank cost of funds index (COFI) that is equal to the total interest expense divided by the total liabilities for all domestic commercial banks. This mortgage product also includes actuarial-based government-backed tail-risk insurance provided either to bankers directly or to investors who purchase pools of these mortgages. We refer to a COFI mortgage with this form of catastrophic insurance as a “COFI-Cat” contract. The costs and benefits associated with these contracts are considered from the perspective of households, bankers, investors and policymakers using estimates of COFI-Cat rates constructed from historical data over 2000–2014, inclusive.For households, monthly mortgage payment cost savings for COFI-Cat mortgages compared to 30-year fixed-rate mortgages are substantial, estimated to average more than $100 per month at issuance over the period considered and to accumulate to more than $11,000 over a typical six-year period, the average tenure a household spends in a home. Thus, cost savings could be substantial for homeowners who expect rates to fall or who have a higher moving probability.For bankers, hedging costs for COFI-Cat mortgages are lower than for either 30-year fixed-rate mortgages or adjustable-rate mortgages based on short-term market-based rates. Because banking organizations have cost of funds that generally move in sync with each other, mortgage-backed securities (MBS) based on pools of COFI-Cat mortgages potentially provide much needed geographic diversification, particularly for smaller U.S. banks, while still being relatively easy to hedge compared to fixed-rate and other adjustable-rate mortgages.For investors, such as asset managers, banks, thrift institutions, pension funds and central banks, COFI-Cat MBS could provide lucrative opportunities for stable returns. Historically, we demonstrate LIBOR funded investors could have hedged such MBS and maintained positive returns even when LIBOR rates blew out in 2008. Moreover, credit risk transfer transactions structured in a manner that the government backs only catastrophic risks are shown to result in guarantee fees that are lower than those actually charged by the GSEs during 2012–2014.For policymakers, replacing fixed-rate mortgages with adjustable rate mortgages, such as COFI-Cat mortgages, could improve monetary policy pass-through when market rates are lowered; households would not need to refinance when interest rates drop, thereby benefiting a broad range of households, including those with little or no home equity and/or low credit scores. As a result, the need for special federal programs such as the Home Affordable Refinance Program or FHASecure is potentially reduced. In a rising interest rate environment, depository institution COFIs tend to adjust at a slower pace than other indexes typically tied to adjustable-rate mortgages. Consequently, the distributional consequences associated with tighter monetary policy are less with COFI-based mortgage contracts than with other adjustable-rate mortgage contracts.

Corporate Guarantee: Computation of Guarantee Fees at Arm’s Length Price

The most recent controversy surrounding Indian tax courts, pertains to the issue of international transactions with respect to intra-group financing. It includes short as well as long term borrowing and lending, guarantees etc. The debate centres around transfer pricing (herein after referred to 'TP') provisions and how the computation of arm’s length price is to be done. The article has focussed on one aspect of intra group financing, that is, the provision of corporate guarantee. The paper first describes the meaning of guarantee and then highlights various provisions relating to corporate guarantee, under the Companies Act, 2013 and the Foreign Exchange Management Act, 1999. The article then describes various legislative provisions relating to the transfer pricing issue and how guarantees fit into such provisions. It is ambiguous, as courts have not provided for a settled principle, in this regard. The author, thus, highlights various approaches the Indian tax courts have adopted when the issue of corporate guarantee came before them. The paper provides an answer to the issue of whether the guarantee fee can be computed at arm’s length price, using compared uncontrolled price as the method for computation. The author concludes by stating that while the courts have attempted to resolve these ambiguities, there is still scope for further reform.

Valuation of Guaranteed Minimum Maturity Benefits in Variable Annuities with Surrender Options

We present a numerical approach to the pricing of guaranteed minimum maturity benefits embedded in variable annuity contracts in the case where the guarantees can be surrendered at any time prior to maturity that improves on current approaches. Surrender charges are important in practice and are imposed as a way of discouraging early termination of variable annuity contracts. We formulate the valuation framework and focus on the surrender option as an American put option pricing problem and derive the corresponding pricing partial differential equation by using hedging arguments and Ito's Lemma. Given the underlying stochastic evolution of the fund, we also present the associated transition density partial differential equation allowing us to develop solutions. An explicit integral expression for the pricing partial differential equation is then presented with the aid of Duhamel's principle. Our analysis is relevant to risk management applications since we derive an expression for the sensitivity of the guarantee fees with respect to changes in the underlying fund value (called the "delta"). We provide algorithms for implementing the integral expressions for the price, the corresponding early exercise boundary and the delta of the surrender option. We quantify and assess the sensitivity of the prices, early exercise boundaries and deltas to changes in the underlying variables including an analysis of the fair insurance fees.

Transfer Pricing Aspects of Intra-Group Financial Guarantees in Light of the BEPS Action Plan

The main objective of this article is to provide an overview of the transfer pricing aspects of intra-group financial guarantees. It discusses the current approach to the determination of the arm’s length level of the guarantee fee outlined in the OECD Guidelines and the Canadian court case General Electric. The article analyses the approach proposed in the 2014 Deliverable on Action 8 of the BEPS Action Plan “Guidance on TP Aspects of Intangibles”, including its compatibility with the authoritative statement of the arm’s length principle, as well as the practical considerations in the post-BEPS environment and the potential suggestions for further improvements to be made to the OECD Guidelines.

Guarantee Fees—An Art, Not a Science

This article examines the potential impact of increasing the guarantee fees that Fannie Mae and Freddie Mac (the government-sponsored enterprises [GSEs]) charge lenders. The authors argue that guarantee fees are very assumption driven. They then identify the three most important assumptions made in determining the fees. They conclude that transparency regarding these assumptions is critical and that, under any reasonable set of assumptions, the fees should not be increased for the least risky loans. The authors also argue that guarantee fees should be set high enough to cover expected losses under a stress scenario plus expenses. Beyond that, the GSEs’ mission should be taken into account in determining the required return on capital.

Assessment of the Supply Chain Factors and Classification of Inventory Management in Suppliers’ Level of Fresh Vegetables

Inventory policy decisions at each tier in the supply chain of fresh vegetables is considered significantly regarding to th e short period shelf life (perishable) factor and cost efficiency of the product distribution. The object of this study is su ppliers of fresh vegetable and its supply chain in the Yogyakarta Province, Indonesia .T he evaluation of the i mportance factors of supply chain performance is analyzed based on the combination of methods Analytical Hierarchy Process (AHP) and the Supply Chain Operations Reference (SCOR). The result shows that the most in fluencing factory to the supply chain performance is factor of attribute costs (31.04%) with a sub-attribute product gua rantee fee (48.90%). Meanwhile, the most preferred alternatives is modern m arket as weighted at 34.6%, followed by regular-restaurants (32.5%), and franchise-restaurants (18.4%), and traditional markets (15.4%) is the least pref erred. In case of inventory management, there are two types of inventory: inventory speculation for non-unique produ cts, and inventory postponement for unique products of fresh vegetables.

Investment and Financing for SMEs with a Partial Guarantee and Jump Risk

Many SMEs and young entrepreneurs experience financing constraints due to their low credibility and information asymmetry. To this end, a partial guarantee agreement is popular with Chinese entrepreneurs. In this paper, we consider an SME with a funding gap, who wants to invest in a project, of which the cash flow follows a double exponential jump-diffusion process. In contrast to traditional corporate finance theory, we assume the SME is unable to get loan directly from banks because of its high project risk, strong information asymmetry and low credibility of SMEs. To overcome such financing constraints, the SME turns to an insurer and enters into a partial guarantee agreement, where a bank lends cash to the SME with the insurer promising to undertake a fraction (guarantee level) of debt once the SME defaults. In return, the SME (borrower) allocates a fraction of equity and a fixed guarantee fee rate per unit time to the insurer. We assume the investment is irreversible and can be postponed. Utilizing a real options approach, we develop an investment and financing model with the partial guarantee. We explicitly derive the pricing and timing of the option to invest for the cash flow with both diffusion and jump risk. The two sources of project risk increase the value of the option and postpone investment. More importantly, we reveal that larger funding gaps or higher guarantee levels lead to a later investment and generally a slightly less value of the option to invest. Interestingly, raising the guarantee level can effectively reduce the borrower's moral hazard to increase equity values at the expense of the lender. Meanwhile, an increase in the guarantee level does not add disincentive for the SME to replenish its equity.

A Look at Freddie Mac’s Loan-Level Credit Performance Data

In March 2013 Freddie Mac released loan-level credit performance data on 15.7 million fully documented, amortizing 30-year fixed-rate mortgages purchased over the last 13 years. This is the first time loan level agency data has been provided; it is part of the broader effort to promote risk-sharing initiatives with the private market. In this article, we take a first look through the data, highlight the importance of FICO and LTV, and discuss the implications for risk sharing and guarantee fees going forward. <b>TOPICS:</b>MBS and residential mortgage loans, legal/regulatory/public policy

The First GSE Risk-Sharing Deal: An Effective Risk Transfer Mechanism?

The first government-sponsored enterprise (GSE) risk-sharing transaction, Freddie Mac’s STACR (Structured Agency Credit Risk) 2013-DN, in which private investors bear some of the credit risk, priced on July 23, 2013. These transactions were a cornerstone of the FHFA’s strategic plan. The thought was these transactions could be used not only to transfer risk but also to validate guarantee fee pricing. In this article, the authors first describe the transaction structure and collateral. They argue that with good quality collateral the default and losses will be low, at 66 basis points of default and about 10 basis points of loss in the Amherst base case. The authors then examine the risk–return on the securities themselves, arguing that the M-1 tranche is unlikely to ever take a loss. The M-2 tranche is more “cuspy” but has value at initial pricing levels. Finally, they investigate whether this transaction has been an effective risk transfer for Freddie Mac. The authors’ view is that it is generally very effective but provides insufficient protection in high-prepayment/high-default environments. <b>TOPICS:</b>MBS and residential mortgage loans, legal/regulatory/public policy

The Capital Structure and Governance of a Mortgage Securitization Utility

We explore the capital structure and governance of a mortgage-insuring securitization utility operating with government reinsurance for systemic or “tail” risk. The structure we propose for the replacement of the GSEs focuses on aligning incentives for appropriate pricing and transfer of mortgage risks across the private sector and between the private sector and the government. We present the justification and mechanics of a vintage-based capital structure, and assess the components of the mortgage guarantee fee, whose size we find is most sensitive to the required capital ratio and the expected return on that capital. We discuss the implications of selling off some of the utility’s mortgage credit risk to the capital markets and how the informational value of such transactions may vary with the level of risk transfer. Finally, we explore how mutualization could address incentive misalignments arising out of securitization and government insurance, as well as how the governance structure for such a financial market utility could be designed.

Study on Mechanism Design of Rural Drinking Water Safety Engineering Project Financing Guarantee

As more and more non-public fund entering rural drinking water safety engineering project market; it becomes very necessary to built rural drinking water safety engineering project guarantee mechanism. This paper proposes three steps of mechanism design. Firstly, history data is used to fit multivariate linear equation set up describing relationship between bank loss and key risk factors. Secondly, guarantee fee is calculated through model regression, which is threefold of possible bank loss. Thirdly, guarantee fee is adjusted according to variety of key risk factor in the process of project construction and operating.

Guidance on Intercompany Guarantee Transactions: Amendment of Law for Coordination of International Tax Affairs

This article describes some recent efforts by the Korean tax authorities to enact statutory provisions setting out the standards in determining arm’s length guarantee fees.

Transfer Pricing Issues in Financial Services

A typical piece on financial services transfer pricing issues may cover audit challenges in head-office services cost recharges, investment management fees, guarantee fees and so on. Whilst all these audit risks are real, the author examines some of the more fundamental structural reasons why financial services transfer pricing differ from transfer pricing in other industries including the challenges confronting an in-house financial services transfer pricing manager.

Discussion of a Proposed Single Agency Security

This article is the American Securitization Forum’s response to the Strategic Plan issued by the Federal Housing Finance Agency, which, among other things, proposes to build a new infrastructure for Fannie Mae and Freddie Mac. It outlines the ASF’s various originator, investor, and dealer member views on a unified agency security (Single Agency Security) that could be substituted for Fannie Mae mortgage-backed securities (MBS) and Freddie Mac participation certificates (PCs), including recommended steps to minimize, or even eliminate, some of the pricing inefficiencies that currently exist in the market. The article presents industry views on current TBA market inefficiencies, items that would have to be standardized for Single Agency Securities to be fungible, and proposed characteristics of a Single Agency Security, including pooling, delivery, and remittance requirements; guidelines and underwriting systems for the origination and servicing of mortgage loans; disclosure and reporting standards; how guarantee fee pricing should be calculated; the nature of the guarantee; how existing Fannie Mae MBS and Freddie Mac PCs will be affected by the development of a Single Agency Security; and how the TBA market should function in a Single Agency Security regime. <b>TOPICS:</b>MBS and residential mortgage loans, legal and regulatory issues for structured finance

Outsourcing Bank Loan Screening: Evidence from Third-Party Loan Guarantees

We derive a model and provide empirical evidence on the role of loan guarantee. Using a proprietary database of third-party loan guarantees, we find strong evidence that guarantors and banks disagree on loan credit risk, which appears puzzling but is consistent with our model predictions. Given the low collateralization and high default risk of guaranteed loans, the divergence in risk assessment results from guarantors taking collateral and over estimating borrower credit quality. Additionally, we show that guarantors and banks share rents from guaranteed loans, supported by the positive relation between guarantee fee and loan rates. Different from existing theories which focus on guarantor information advantage, risk sharing and regulatory arbitrage, our findings suggest that the main rationale for third-party guarantors is to screen SME loans outsourced by lending banks, given guarantors’ comparative advantages in screening small borrowers.

General Electric Capital Canada Inc. v. The Queen: Guarantee Fees and the Arm’s Length Standard

This article reviews the General Electric Capital Canada decisions (Tax Court and Federal Court of Appeal) and discusses the useful commentary contained in these judgments about the application of the arm’s length principle to financial services.