Also known as a letter of guarantee, a guarantee of payment is a legally binding document that is issued by a bank or similar financial institution on behalf of a client. The letter is essentially a contract that confirms that, in the event that the bank client should default on a specific debt obligation, the bank will settle the outstanding balance owed. This type of guarantee is often used as a means of allowing the client to obtain goods and services from a vendor that he could not get based on his current credit rating or other criteria the vendor uses to qualify their customers.
In many cases, the bank issuing the guarantee has access to the client's securities, which may be claimed and used to settle the debt if necessary. For example, the bank may hold the mortgage on a piece of real estate owned by the client. Should that client default on the contract with the vendor, the bank acts on the promises made in the guarantee, and settles the balance due on the vendor contract. The bank then seeks to work out terms of payment with the client. If the client is unable or unwilling to arrange terms of repayment to the bank, the institution calls the mortgage due, claims the property, and sells it to retire both debts.
There are also instances where the text of a guarantee of payment will simply confirm that the bank owns the asset pledged as security, and will deliver that asset to the creditor in the event of a default. This creates a situation where the creditor must then take steps to liquidate the asset in order to settle the balance owed on the defaulted account. Types of guarantees of this nature are often structured to comply with the preferences of the creditor, the policies and procedures of the financial institution that is extending the guarantee, and any current laws or regulations that may apply to the content of the guarantee.
There are a few instances where a guarantee of payment may be used other than in the event of a default. One application has to do with guaranteeing the delivery of a payment for an underlying asset connected with a call option. In the event that the brokerage does not hold that asset, the letter is obtained from the owner and forwarded to the buyer, assuring that the asset will be delivered by a specific date. A similar strategy may be used with imports, where the bank of the buyer extends the guarantee to the seller that payment will be remitted within a specific number of working days after the purchased items have been received, the shipment checked, and the order accepted.