Posted: July 19th, 2023
What does the collapse of banks like Silicon Valley Bank and First Republic Bank have to do with appeal bonds? A lot actually and in this article we will highlight the key points attorneys and their clients should be aware of to help navigate the current environment.
Tighter Bank Credit
When providing appeal bonds, surety companies sometimes require collateral in the full amount of the bond when the appellant doesn’t meet the surety’s financial requirements for an unsecured bond. One of the common forms of collateral that sureties will accept is a letter of credit from a bank. A letter of credit is a guarantee from the bank to provide funds that can be drawn on-demand by the beneficiary, which in this instance would be the surety company. Letters of credit are underwritten by banks similar to loans even though the funds are not immediately being dispersed.
According to a report by the Federal Reserve, “Lending standards tightened notably, and several depository institutions opted to reduce loan volumes, especially for new clients, despite reporting ample liquidity.” The Federal Reserve is also considering increasing the capital banks are required to hold. Kevin Fromer, the head of the banking group Financial Services Forum, said in a statement that “Further capital requirements on the largest U.S. banks will lead to higher borrowing costs and fewer loans for consumers and businesses.” As a result, it may become more difficult for appellants to obtain letters of credit from the banks.
Banks sometimes require letters of credit to be secured with cash, which may become more prevalent as credit conditions continue to tighten. In these situations, it is usually more beneficial for the appellant to post the cash directly with the surety to avoid the unnecessary letter of credit fee. Furthermore, many sureties have programs that pay interest on cash deposits, which in today’s interest rate environment can be at attractive rates. For more information on the interest that sureties pay on cash collateral, click here.
As interest rates rise, it’s also important to consider that the cost for letters of credit also increase. Bond premiums, on the other hand, don’t fluctuate based on the interest rate environment.
Approved Banks
When using a letter of credit to collateralize an appeal bond, surety companies always have to approve the bank first, because the surety’s risk when using letters of credit is the bank failing and not being able to honor draws on the letter of credit. While the likelihood of a surety being stuck with a worthless letter of credit might seem remote, all one has to do is look back at the history of bank failures during the Great Recession to be reminded of the catastrophic potential.
Year | Number of Bank Failures |
|---|---|
2008 | 12 |
2009 | 139 |
2010 | 153 |
2011 | 91 |
Due to the recent bank failures this year, some sureties have limited the list of banks that they will approve. Large national banks generally are still acceptable to sureties, but we have seen more denials of local community banks than we did previously. Because we have access to 35 different surety companies, we are typically able to find a surety to accept smaller regional banks, but it can take a little more time than it used to and the terms vary. For this reason, it’s beneficial to start the process of applying for an appeal bond early to verify whether the bank being considered for the letter of credit is acceptable to the surety.
Conclusion
While the turmoil in the banking market has certainly created some challenges, there are many positives not the least of which is the significantly greater amount of interest that appellants can earn on their cash used to collateralize an appeal bond. Furthermore, the premium rate for using real estate collateral has remained unchanged at 4% per year and is well below the cost to refinance a property at mortgage interest rates.
