Supporting Performance Obligations with a Letter of Credit

last updated on Monday, March 22, 2021 in Letters of Credit

The Federal Home Loan Bank of Des Moines offers irrevocable letters of credit that provide members a low-cost and effective way to enhance customer relationships, optimize their balance sheets and generate fee income. Many members are familiar with applying “Aaa/AA+” rated FHLB Des Moines Letters of Credit to back uninsured portions of public unit deposits or bond enhancement. Less understood, however, but just as valuable is the ability to use letters of credit to support performance obligations on behalf of both members and their customers.  

Benefits of Using FHLB Des Moines Letters of Credit for Supporting Performance Obligations

Timely issuance

No need to unnecessarily pledge and monitor securities

Fee income opportunities for the member

Ability to enhance your customer relationships

Letter of credit structures involving the support of performance obligations by FHLB Des Moines are relatively straightforward. Typically, the main parties that are involved in a letter of credit transaction are: i) the confirming irrevocable LOC issuer (FHLB Des Moines), ii) the direct LOC issuer (the member), and iii) the beneficiary (the member’s customer or obligee). FHLB Des Moines underwrites performance obligation letters of credit based on the credit and collateral availability of the member. FHLB Des Moines Letters of Credit are designed to confirm a direct letter of credit that may be issued by a FHLB Des Moines member on behalf of its customer. 

Here are some examples of situations involving performance obligation confirming letter of credit uses:

1. Establishing Self-Insurance Programs for Workers Compensation, Unemployment, Liability or Other Forms

In cases involving self-insurance, carriers and/or governmental authorities often require payment guarantees, generally in the form of either pledged securities or letters of credit issued by an acceptable counterparty. Companies typically engage insurance companies to administer self-insurance programs. FHLB Des Moines Letters of Credit can be applied on a confirming basis in support of a member’s customer. The letter of credit solution is superior to the option of pledging securities that can unnecessarily consume capital and require frequent monitoring.

2.  Guaranteeing Contract Performance, Including: Lease Payment, Construction Bids and Project Completion  

There may be situations in which lease, construction bid or project beneficiaries/ counterparties may require the ultimate backing of a ‘AAA” rated institution. Under this scenario, a FHLB Des Moines member typically issues a letter of credit on behalf of a customer and in favor of a beneficiary. In turn, the member’s letter of credit is confirmed or “wrapped” by a FHLB Des Moines Letter of Credit. The letter of credit may be exercised in the event the underlying contract is in default or subject to a draw event, and if the member institution is not capable of satisfying the draw request. 

3. Supporting Interest Rate, Credit Default and Other Swap Transactions

Over-the counter swaps or futures obligations are often used by members as well as their customers to help hedge their business risks. It’s common to see contractual provisions that require third-party or collateral support needed to address counterparty risk associated with underlying price variability. For instance, a contract could specify a threshold level for requiring collateral or additional support in the event of market variation of counterparty credit deterioration. Rather than negotiating the delivery of cash or securities should a threshold break, the margin requirement may be satisfied by a letter of credit in favor of the swap or futures counterparty. Depending upon the specific swap situation, the backing of a FHLB Des Moines Letter of Credit could even altogether eliminate the need for a contractual margin requirement. Moreover the “Aaa/AA+” backing of FHLB Des Moines on a swap transaction may enhance execution and the all-in swap rate. In these situations, FHLB Des Moines could issue a letter of credit directly for a member’s benefit, or as a confirming letter of credit that supports a letter of credit that a member issues on behalf of its customer.

Most FHLB Des Moines members are aware of the benefits of using standby letters of credit to provide municipal depositors’ coverage beyond FDIC insurance thresholds. Still, it’s important to remember that FHLB Des Moines Letters of Credit can also support many other types of performance obligations – on behalf of both members and their customers.

Contact your relationship manager for more information and to qualify any specific situations. Applying for a quickly turned-around “Aaa/AA+” rated letter of credit is only an e-mail or a phone call away.

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