Credit enhancement and loan default risk premiums

Using contingent claims analysis, we study the impact of private guarantees on the default risk premiums or credit spreads of discount loans. Specifically, we analyze the reduction of the default risk premium on a new junior loan by obtaining the numerical estimates under a stochastic interest rate. We demonstrate how the value of credit enhancement relates to the profitability and size of the new junior loan, as well as the leverage, asset risk, and debt seniority of the borrowing firm and the private insurer. The main results show that (a) for the new junior loan, although the benefits of financial insurance are substantial with an AAA-rated private insurer, in general, default risk premiums can only be reduced to a minute amount; and (b) even with complete insurance coverage from an AAA-rated private insurer, loan issues command default risk premiums that reflect not only the intrinsic values and risks of the insured and the insurer, but also their covariance.