The benefits of subprime bonding

The economy made this a bigger
issue, and one you need to know about

NBY NICK DELGUYD

Bonding is the lifeblood of any contractor performing work for any governmental agency, or government-funded project. It is also becoming a more common requirement for private jobs. However, as the economy dove headfirst into a recession, the bonding market tightened. The issue at hand is the nature of bonding. Surety bonds may not be a secured product, and in the event of a default on the part of a contractor, the surety companies rarely come out ahead in the end.
Combine the recession’s effects on contractors’ financial results with the amount of surety bond defaults (which were climbing even before the recession began) and you are left with a less than optimistic underwriting environment. The tightening of the credit market for bank lines of credit and term debt (both secured products) has created a domino effect. As access to capital (one of the three C’s in bonding along with capacity and character) has dried up, so in turn have the surety companies reduced the amount of bonding available to their clients.
One avenue that contractors should be willing to explore is non-standard (subprime) bonding. While the phrase “subprime” has become a four-letter word to the average reader, most if not all financing and insurance products have a subprime market of some sort. Subprime bonding often can be used as a replacement of traditional bonding markets.
Why would a company choose subprime bonding?
1. The financial strength of the company may be questioned because of recent losses, the company may have difficulty obtaining access to lines of credit or the company is highly leveraged.
2. If the company is entering a new market, either geographically or in the type of work, a subprime bond may
be necessary.
3. A company may turn to a subprime bond if it is for a contract that is much larger than the company has ever worked with in the past.
The general premise is the same between traditional and subprime markets; both markets can provide bid bonds, performance bonds, payment bonds, etc. In addition, subprime bonds can be obtained on an application basis (job-by-job) or can be obtained through the standard bonding program (for example, a $5 million cumulative program with a max per job limit). However, contractors should be aware that there are significant differences on the administrative and execution side of these bonds.
Rates: The first change that contractors will notice when obtaining a subprime bond is the bonding rate. Traditional bonding programs charge anywhere from .5% - 1.5% for performance bonds, and many times bid bonds are free of charge. Subprime sureties will charge between 2% and 3% for their product. Collateral: Depending on the bond request, and the financial stability of the contractor and its owners, the subprime surety company may require collateral as a guarantee. Each surety will have different requirements for different bonding programs, and collateral can be given by the company, or by its owners individually. The majority of the time, subprime sureties will want personal guarantees from the owner. In addition, most sureties will request that collateral be given in the form of cash deposited in a bank of the surety’s choice. This is because the economic value of cash does not change, and it is easily obtained by the surety in event of default.
There are other forms of collateral. Those that are harder to liquidate include marketable securities and investment accounts, unique pieces of unencumbered equipment, letters of credit from a financial institution, and real estate. Real estate is rarely, if ever, given full credit for collateral purposes, and each surety has different methods for valuing real estate.
Escrow: In extreme circumstances the surety may require the use of an escrow agent. Just as in other circumstances, an escrow agent acts as a middle man. All invoices paid by the owners are submitted to the escrow agent. In addition, all invoices submitted by subcontractors are paid by the escrow agent. Any residual profits are remitted back to the contractor. In the event that the contractor self performs work, the escrow agent may be required to oversee payroll as well.
It should be noted that not all contractors will have to incur all three of these issues. All will see an increase in rates and will have to obtain collateral, but only in some instances will the escrow option be employed.
While all contractors would prefer to be in a traditional bonding program, some don’t have a choice. The subprime market is a great option for those that are attempting to weather the storm. Working with a trusted advisor who has strong relationships with bonding agents and sureties in the subprime markets will help ensure the best results. BXM
Nick Delguyd is a member of Skoda Minotti’s Real Estate and Construction Group. Reach him at 440.449.6800 or ndelguyd@skodaminotti.com.