The week of March 9th is a week that will be permanently burned into the collective American’s consciousness for a long time. It’s the week that the NBA shut down following positive tests from multiple Jazz players prior to the Jazz-Thunder game on March 11th. COVID-19 had been sloshing around in the financial and general news media for some time, but this was the week it began to take center stage for normal Americans not buried in the twenty-four hour news cycle.
That week, I was in Palm Beach Gardens, Florida at an industry golf tournament. The event is an annual tradition where colleagues and business associates descend on PGA National for a three-day Ryder Cup style tournament. We finished our practice round on Tuesday afternoon and came into the bar area to see CNBC running their tried and true ‘Markets in Turmoil’ graphic. The S&P had dropped 7.6% that day. The next day while we were on the first tee, Travelers announced that it was grounding its employees. No more business related travel until further notice. The S&P dropped 1.3% that day. By the time we finished our round on Thursday morning, the S&P had dropped another 9.5%, for a total of 18.4% across the three-day event.
The equity markets were far from the only financial asset class in turmoil. The credit market was at a standstill. The Feds Primary Market Corporate Credit and Secondary Market Corporate Credit Facilities and the Trump Admin’s Coronavirus Aid, Relief, and Economic Security Act bill wouldn’t be announced for another two weeks. Raising cash via equity or debt was not an option in that moment and reports of different companies drawing down on their revolvers, whether they needed it or not, were surfacing daily. Cash is always king and prudent liquidity management is a staple of any well run business, but during a pandemic-fueled liquidity crunch, CASH RULES EVERYTHING.
March and April of 2020 were unlike anything the world has experienced in recent memory. Most of the world was rightfully focused on making sure their families were safe. Some were taking extraordinary measures to ensure that their homes had toilet paper. The business owners I spoke with at the time were focused on keeping the lights on and avoiding layoffs. Crises have a way of crystallizing priorities and optimizing surety programs for many businesses were nowhere near the top of the list.
As always though, there were exceptions. Jack Welch is credited with saying “a recession is a terrible thing to waste.” He’s not wrong and in that moment we had something people needed: a mechanism for increasing liquidity without raising equity, selling assets, or tapping the credit markets.
In many cases Letters of Credit and Surety Bonds are competing products. Beneficiaries (or obligees as we refer to them in the surety world) will frequently accept a surety bond or a letter of credit to guarantee a certain obligation/commitment. As an example, when developing projects Real Estate Developers are frequently required by local municipalities to post LCs or Surety Bonds to guarantee certain site improvements (sidewalks, water/sewer utility upgrades, traffic light installations, roadwork) will be completed over the course of the project. Some municipalities will accept only bonds, some will accept only LCs, but frequently the developer is free to choose a preferred method of financial guarantee.
While it’s not always the case, LCs are frequently issued through a firm’s secured credit facility, meaning there’s a dollar for dollar reduction in liquidity should a developer choose to post a letter of credit to satisfy the municipality’s financial assurance requirement. Surety Bonds are unsecured credit instruments and Treasurers should think of posting bonds in place of Letters of Credit, as a form of maximizing liquidity.
As I mentioned though, not all beneficiaries will accept surety bonds. As someone who works in the surety industry for a living it is incredibly frustrating when one pipeline company will accept a bond to collateralize a commodity supply agreement, while another will only accept a Letter of Credit. Fortunately, the surety industry is evolving to solve for this issue via bank-fronted surety. The name provides an apt description of the product, but let me paint a scenario to flesh this out.
Township A wants Developer B to post a letter of credit to guarantee certain site-improvements. Developer B wants to use a bond because the company’s CFO wants to perpetually maximize available liquidity and the company’s surety is willing to write the bond, but Township A’s controller is a banker and will only accept a Letter of Credit. Fortunately, Developer B’s surety has a bank that will front a letter of credit on the surety’s behalf. In this scenario, the surety bond is backing the letter of credit. The product creates a win-win as the Township A gets its desired Letter of Credit and Developer B gets to maximize its liquidity by posting a surety bond that is unsecured instead of a cash or revolver backed letter of credit. Should the developer default and fail to perform the site improvements and the township draws on the LC, the bank will pay the township and the surety will reimburse the bank.
Over the past 12 months, R&P has replaced +$175mm worth of LCs, +$150mm of which have been bank-fronted where the beneficiary would not accept a bond. While the liquidity crunch driven by the pandemic has come and gone, COVID has left a distinct impression on many of the Treasurers, Risk Managers, and CFOs with whom we work. Maximizing liquidity remains top of mind and bank-fronted surety bonds are a capital-intensity and cost efficient mechanism that should be in every company’s toolkit.