Thread: Contingent Liabilities - Question

I have a question about contingent liabilities. FAS 5 par. 12 states:

12. Certain loss contingencies are presently being disclosed in financial statements even though the possibility of loss may be remote. The common characteristic of those contingencies is a guarantee, normally with a right to proceed against an outside party in the event that the guarantor is called upon to satisfy the guarantee. Examples include (a) guarantees of indebtedness of others, (b) obligations of commercial banks under “standby letters of credit,” and (c) guarantees to repurchase receivables (or, in some cases, to repurchase the related property) that have been sold or otherwise assigned. The Board concludes that disclosure of those loss contingencies, and others that in substance have the same characteristic, shall be continued.

It says that "Standby Letters of Credit" are contingent liabilities, however, it seems like Standby Letters of Credit are more like contingent assets. If a bank holds a standby LoC, and the standby LoC is activated, then the bank will pay on behalf of the borrower. Then the bank will convert the amount it pays out into a loan, which the original party of the standby LoC will be obligated to pay back.

This is my understanding. Does anybody know why FASB classifies standby LoC as contingent liabilities?

Here is a link where I learned about Standby LoC:

Here's one example.

Think of the LC's an insurance policy. They are a promise to pay if the other party doesn't. They are issued for fee income (sometimes without a collateral requirement).

The last time I used one was with a client acquiring 30 retail sites where the local utility wanted deposits of around 60K. So instead of tying up cash, the client purchased a bank LC payable to the utility if called. The fees obviously vary but at the time it seems like the rate was about 2% annually in this instance.

So the issuing bank may have to payout 60K while receiving only 1,200 per year in related revenue. If they (the bank) is called upon to pay then their client company is in some type of distress and there may be little or no recovery possible. So there is a danger that payouts will exceed fee income with an ultimate loss. Maybe not probable perhaps but at least possible depending on the underwriting standards and client financial condition/performance.

Interesting.

Another question though. The person that initiated the LC w/ the bank. Was he responsible to repay the 60K if the bank made payment on his behalf?

Sure but they don't always have the money. How much recovery can be expected when a LC is called to pay for past due utilities? A lot depends on the underwriting standards and monitoring.

Very nice, that makes sense. Thanks for the response