Chapter 44 states that post loss funding guarantees that in exchange for a commitment fee, funding will be provided on the occurrence of a specified loss. What i dont understand is where the notes went further to state that: 'The funding is often a loan on pre-arranged terms or equity' Since it is a loan, it means it would 'certainly' be repaid. How is this a risk transfer mechanism?
The notes are just making it clear that the funding is not always a loan: The funding is often a loan on pre-arranged terms OR equity If it is a loan, then it will usually be set up on pre-arranged terms i.e. the terms of the loan will be decided before the money is actually required. So for example the parties may agree that, if a loan is required, it will be an interest only loan at LIBOR + 5% and the principal will be repaid in 10 years. If it's equity, then the bank may simply take a % stake in the company in return for the funding. In reality these deals are very complex, with lots of clauses and options on either side in the event of different situations arising.
Thanks cjno1, Although i get the point that the terms of the loan would be pre-arranged. May be my confusion stems from comparing this mechanism with contingent loan whose repayment is contingent on something. If it is not, then i dont think the company has transfered any risk. It has only made sure it can get money as and when needed, but the money would be paid back. I may be missing something out though, but it still doesnt seem like an effective risk transfer mechanism.
It's not a contingent loan in the sense that it is only repaid if ... Taking out the loan in the first place is the contingent bit (they'd only take the loan out if something bad happened). You're right in saying that they have to pay it back. They have transferred risk though. If they didn't agree the terms of this loan in advance then the chances are that when the "bad thing" happened, that they wouldn't be able to raise any finances at all and then might end up going insolvent. So they've transferred away that possible insolvency risk!
