Credit Enhancement Loans

Overview. An unsecured loanis supported by a borrower’s revenues and assets, but does not include a specific lien or other security interest in any particular assets of the borrower.Thus, the borrower’s overall creditworthiness influences the lender’s proposed interest rate and repayment terms. In a secured loan, conversely, the borrower grants the lender a priority claim to a particular set of assets or revenue stream as security for the loan. A borrower may reduce the level of perceived risk of default by offering some form of credit enhancement, such as pledging collateral as security. Letters of credit and third-party guarantees are other types of credit enhancements borrowers can use to reduce perceived risk of default.

Because a secured loan or a loan benefiting from another form of credit enhancement (such as a letter of credit or third-party guarantee) is a less risky investment for the lender, the interest rate for such a loan may be lower. In determining the appropriate interest rate for a loan, the lender makes a risk assessment: the higher the perceived risk of default, the higher the interest rate. If a borrower anticipates that it may have more than one outstanding loan at a time, then it must carefully consider how credit enhancements are addressed in one loan and the impact on its ability to enter into other types of loans in the future. In some loan agreements, a lender may restrict the borrower’s ability to provide the same type or any type of credit enhancement to future creditors. Negative pledge clauses (also called restrictions on liens) are an example of this and constitute a standard feature of unsecured or partially secured loans. Because unsecured loans are based on the borrower’s general revenues and assets, a negative pledge representation and similar covenant often are included in unsecured loans to prevent the borrower from pledging certain types or amounts of assets it has available. The result is to prevent the borrower from obtaining future secured loans. Some lenders may opt to gain the benefit of a negative pledge clause through an affirmative covenant. In this scenario, the lender permits liens in favor of future lenders but requires the borrower to either (i) ensure the lender will share ratably and with equal priority in any lien posted to benefit a future creditor or (ii) provide additional, proportionate collateral to secure the lender’s loan. In the latter case, the additional collateral must be made subject to a lien that is of the same kind and priority as the lien posted to benefit the future creditor. Generally, when a borrower considers the terms of a negative pledge clause in an agreement, the borrower should make sure the terms provide for some exceptions and limitations to the negative pledge, so the borrower is not precluded from future secured borrowing. These exceptions or provisions are called carve-outs or baskets. For example, a good compromise might be to include language in a negative pledge clause that places a ceiling (or cap) on the amount of money or other property a borrower may pledge as security for future loans or that provides for a limited type of collateral for narrow purposes (such as purchase-money financing, which allows the purchase of an item on credit secured by the item itself). Such a provision gives lenders some assurances, while providing borrowers the flexibility needed for future secured borrowing. 

Collateral security. One form of credit enhancement is a pledge of assets as security for a loan. The assets serving as security are called collateral and can be in the form of cash, specific other assets of the borrower—either tangible or intangible—or all assets of the borrower.6 In the case of cash collateral, unless the borrower defaults on the loan,a lender can neither use nor dispose of the cash or other assets it holds in a fixed deposit

to ensure repayment. Many loan agreements contain a provision that grants the lender an automatic right of set-off in the case of default. This means the lender will have the right to take any money owed to it from the fixed deposit if the borrower defaults on its loan, without needing to seek a judicial determination or other remedy. Although the range of assets that can serve as noncash collateral is quite broad, an MFI’s loan portfolio (i.e., its pool of revolving microcredit loans entered into with its clients ) often is used. However, a lender who accepts a loan portfolio as collateral likely will also want the ability to restrict the kinds of loans the MFI makes to minimize the portfolio’s risk profile. This may not be appealing to an MFI concerned about preserving its autonomy. In any event, a borrowing MFI should consult with local counsel to deter-mine whether a loan portfolio pledge is possible under local law. The laws of a particular country might not readily provide for a legal framework to use intangible short-term assets, such as a microfinance loan portfolio, as security. If an MFI were to agree to pledge its loan portfolio in a jurisdiction whose legal framework does not recognize such pledges, its inability to do so (because of the legal framework) could trigger a default on the loan.Letter of credit. An alternative to securing a loan with collateral is to use a letter of credit issued by a third party to enhance a borrower’s credit. A letter of credit is a promise by the issuer of the letter of credit, typically a bank (referred to as the issuing bank), to pay a specified amount to the recipient of the letter of credit (referred to as the beneficiary) when the beneficiary presents a document to the issuing bank stating the conditions (most commonly, an event of default on a loan or other obligation) specified in the letter of credit have been met. A letter of credit is typically issued at the request of a party (referred to as the applicant) who, in turn, deposits cash in an account maintained at the issuing bank as collateral to secure the issuance by such bank of a letter of credit to the beneficiary.

Thus, in practical terms, a letter of credit is a mechanism that substitutes the creditwor-thiness of the issuer of the letter of credit for that of the borrowing MFI (the applicant). Ifthe borrowing MFI defaults on the loan, the lender (the beneficiary) will be entitled to be repaid a specified amount by the issuing bank. In short, a letter of credit ensures the lender that it will receive prompt payment of amounts owed to it under the underlying loan, even if the borrowing MFI encounters financial difficulties. The borrowing MFI, meanwhile, must reimburse the issuing bank for the amounts paid by the issuing bank and, furthermore, may be obligated to secure its reimbursement obligation to the issuing bank with collateral. Assuming, however, that the borrowing MFI does not default on the loan and repays the principal due at maturity, the letter of credit will expire without any payment being made by the issuing bank. At that point, the issuing bank will release to the MFI any cash deposited, along with any other items that may have been pledged to it. Using a letter of credit helps the borrower avoid some of the risks related to keep-ing cash collateral on deposit with a local lender. In some countries, for example, if a local bank goes bankrupt, the cash deposits kept with the bank as collateral may not be guaranteed by the government, and the deposits may not be recoverable. Another possibility is that the local government may decide to freeze local bank accounts, preventing or significantly delaying depositors from recuperating their own money. There nearly always will be a cost to using a letter of credit. The borrower typically must pay a fee charged by the issuing bank to maintain the letter of credit. Such costs may be partially offset, however, by the interest paid by the issuing bank to the borrower on any cash deposited as collateral for the letter of credit, by a lower interest rate, or by other favorable terms as a result of the credit enhancement. In addition, although the interest rate on a loan to a borrower supplying a letter of credit will be more favorable than the rate charged when no form of credit enhancement is made available, that rate may not be as favorable as the rate the local lending bank charges a borrower who keeps cash collateral directly with the local lending bank. Guarantee. A third-party loan guarantee is another form of credit enhancement. It is an agreement among the borrower (the MFI), the local bank, and the guarantor whereby the guarantor agrees to pay the local bank money owed to it by the borrower in the event the borrower defaults on the loan. A loan guarantee may be either complete, covering the entire loan amount, or partial, covering a specified percentage of the value of the loan, just interest, r just principal amounts, or even only certain (often later) payment installments, such as the last principal payments due. The advantages of a loan guarantee include the following: • It offers some of the same protections that a letter of credit does; a borrower can use it to avoid the risks associated with keeping cash collateral on deposit with the local bank.
• A guarantee may provide a borrower with the advantage of capital that it otherwise would be unable to obtain. If the borrower does not have money to offer as collateral for a local loan, a guarantee from a development bank or from an organization (such as the U.S. Agency for International Development) may be an acceptable substitute.  In cases where unsecured financing is available to an MFI, the guarantee, like other credit enhancements, should allow the MFI to borrow at a lower interest rate than that charged for an unsecured loan (although the cost of the guarantee, if any, also must be considered). There are several disadvantages to using a guarantee as a credit enhancement:  The guarantor may require the MFI to pay an initial and/or annual fee for the guarantee. The institution providing the guarantee may place certain restrictions on how the MFI may use the loan proceeds, such as prohibiting the MFI from engaging in any lend-ing that the guarantor considers high risk. 


• A guarantee may cover only a portion of the loan. 
• As with a letter of credit, the borrower may be able to obtain a lower interest rate
on a loan secured with cash collateral deposited directly with the lender, because the
lender is able to realize this collateral with much less effort and cost.
• The MFI will be obligated to reimburse the guarantor for any amounts paid under the
guarantee, for which the guarantor may require collateral as security.