Spousal guarantees

Abstract

Lenders often require of small investors that they sign a personal guarantee before forwarding funds, and if the borrowers own funds or assets are insfficient backing for a guarantee, then a third party may be asked to sign. Since strangers do not guarantee each others debts, it is in the nature of such guarantees that they straddle the private and business worlds within any relationship. Important relationship assets (such as the family home) are often at stake, and courts struggle with the policy tradeoffs inherent in such deeds or contracts between freedom of contract and a concern with the potential for coercion of the one signing. This paper explores the nature of the optimal third party guarantee within the incomplete contracting environment inaugurated by Grossman and Hart (1986). The optimal contract trades off the ex post amount of relationship asset to be foreclosed by a bank against the desirability of ensuring the ex ante release of funds to promote the exploitation of viable investment opportunities. The role of ex post bargaining power, as a proxy for coercion is examined and it is found that for certain parameter values in the model increased coercion, while freeing more funds ex ante, simultaneously lowers social welfare.