Cordelia Returns: Using Letters of Credit to Reduce Borrowing Costs

Abstract

Letters of credit are used in hundreds of billions of dollars of financing annually. Although they are presumed to reduce borrowing costs, there is limited guidance on how they create this economic value. This paper explores the mechanisms through which letters of credit reduce borrowing costs. The paper then discusses another form of credit enhancement, bond insurance. After exploring the history and popularity of bond insurance, the instrument is compared with letters of credit. This paper proposes that bond insurance is riskier than letters of credit because (a) it is more susceptible to pricing error, (b) insurance companies are branching out into risky product lines, (c) courts are less likely to enforce a bond insurer's promise and (d) bond insurers may be less effectively regulated.

Keywords: Letter of credit, certification effect, underwriting, monitoring, collection, tax, institutional isomorphism, corruption, enforcing promises, bond insurance, guaranty, surety, monoline, actuarial pricing, insurance, regulation, reserves, Basel I, Basel II, rating agencies, credit enhancement

JEL Classification: G20, G21, G22, G28, K23