On Loan Sales, Loan Contracting, and Lending Relationships Steven Drucker Columbia Business School & Manju Puri Fuqua School of Business, Duke University October 2006

2 Motivation Loan selling is important for banks and the economy  Trading Volume: $154.8 billion in 2004 vs. $8.0 billion in 1991  Diversification; Comply with Risk-Adequacy Regulations  Allows Origination even when Funding Constrained Loan Selling Fundamentally Alters Lending Borrower Screening, Monitoring, Funding Lender Upfront Fees, Interest Payments Borrower Loan Buyer Interest Payments Loan Seller Monitoring, Funding Screening Upfront Fees

3 Main Issues Loan Sales Separate Origination from Funding Agency Problems  Moral Hazard (Pennacchi 1988; Gorton & Pennacchi 1995)  Adverse Selection  How do banks overcome these problems? ­Loan Contracting Access to Loans and Lending Relationships  Harm? ­Reduce interaction that is critical to benefits (Diamond 1991)  Help? ­Increased Capital From Non-Banks ­Risk-Management  Flexibility in Future Loan Origination

4 Outline  Data, Sample Selection, and Descriptive Statistics  Loan Sales and Loan Contracting  Secondary Market Sales and Covenants  Covenants and Agency Problems  Loan Sales, Access to Loans, and Lending Relationships  Current Loans  Lending Relationships and Future Loans  Other Issues and Summary

5 Data and Sample Selection Sample Period: Data from four sources with some data matched by hand  Loans & Lending Relationships (LPC DealScan)  Identify Traded Loans (LSTA Mark-to-Market Pricing)  Borrower Financial Characteristics (Compustat)  Equity Market Data (CRSP) Sample Sizes (link) (link)

6 Sold Loans and Information Asymmetry Sold Borrowers are larger and rated (link) (link)  Information Transparency Sold Loans are Term Loans instead of Credit Lines  Monitoring Lead Lender on Sold Loan has Higher Market Share  Reputation

7 Outline  Data, Sample Selection, and Descriptive Statistics  Loan Sales and Loan Contracting  Secondary Market Sales and Covenants  Covenants and Agency Problems  Loan Sales, Access to Loans, and Lending Relationships  Current Loans  Lending Relationships and Future Loans  Other Issues and Summary

8 Secondary Market Sales and Covenants Selling Loans Can Induce Agency Problems Financial Covenants Reduce Reliance on Seller’s Information  Monitoring Mechanism  Buyer Exercises Control When Firm Performs Poorly Borrower Loan Buyer Interest Payments Loan Seller Monitoring, Funding Screening Upfront Fees

9 Secondary Market Sales and Covenants Univariate Relationship Between Covenants and Loan Sales Multivariate Logit Model (Table 4) (link) (link)  Dependent Variable: Indicator for Loan is Sold Key Independent Variables  # of Financial Covenants (+)  Net Worth Slack (-) Control Variables  Lender Market Share; Borrower and Loan Variables

10 Table 4: Probability of Selling Loans

11 Secondary Market Sales and Covenants Changes in Predicted Probabilities (link) (link)  One Std. Dev Change Around the Mean (t-stats in parentheses) Key Results:  More Covenants  Increases Probability of Loan Sale  Tighter Covenants  Increases Probability of Loan Sale

12 Are Loans Structured to Sell to Others? Sold Loans are Nearly Always Syndicated (Primary Market) Not all Syndicated Loans are Sold Loans are Sold Close to the Loan Origination Date (link) (link)

13 Are Loans Structured to Sell to Others? Banks are not selling poorly performing loans Distribution of Initial Sale Prices Performance of Sold Borrowers: Origination to Sale

14 Covenants and Agency Problems Syndication: Primary Market Sales Additional Mechanisms for Mitigating Agency Problems  Hold Larger Piece of Loan (e.g. Dennis & Mullineaux 2000)  Syndicate Structure and Composition (Lee & Mullineaux 2004; Sufi 2005)  Expect Smaller Agency Problems Empirical Prediction  # of Covenants / Tighter Covenants have LESS influence on probability of loan syndication (compared to loan sale) Empirical Model: Probability of Syndication (Table 5) link) link) ((((

15 Primary Market Sales and Covenants Changes in Predicted Probabilities (link) (link)  One Std. Dev Change Around the Mean (t-stats in parentheses) Compared to Secondary Market Sales:  More Covenants – Similar Effect  Tighter Covenants – Weaker Effect Covenants play less of a role in the primary market

16 Covenants and Agency Problems Lower Reputation Lender  Increased Agency Problems  Gorton & Haubrich (1987); Pichler & Wilhelm (2001) Empirical Prediction  Low Reputation Lender  # of Covenants / Tighter Covenants have LARGER influence on probability of loan selling Modify Loan Sales Model (Table 6) (link) (link)  Interact Reputation Indicators with Covenant Variables

17 Lender Reputation Changes in Predicted Probabilities of Selling Loans (link) (link)  One Std. Dev Change Around the Mean (t-stats in parentheses) Key Result:  Tighter Covenants  Increases Probability of Loan Sale when lenders have LOW REPUTATION Evidence is consistent with agency view

18 Outline  Data, Sample Selection, and Descriptive Statistics  Loan Sales and Loan Contracting  Secondary Market Sales and Covenants  Covenants and Agency Problems  Loan Sales, Access to Loans, and Lending Relationships  Current Loans  Lending Relationships and Future Loans  Other Issues and Summary

19 Loan Sales and Access to Loans Restrictive Covenants / Loan Sales Impose Costs on Borrowers  Managerial Flexibility  Additional Lenders  Renegotiation Costs Why do Borrowers Agree to Restrictive Covenants / Loan Sales? EXPLORE: Access to Private Debt Capital  Anecdotal Evidence Suggests that Loan Buyers are Usually NonBanks  Additional Capital

20 Current Loans Key Results  Sold Borrowers are Growing and Debt-dependent  Sold Year: Increase in Private Debt Issuance

21 Loan Sales and Lending Relationships Loan Sales Separate Origination from Monitoring / Funding Harm Access to Future Credit / Relationships?  Reduced Ongoing Interaction (Diamond 1991; Boot & Thakor 1994) Help Access to Future Credit / Relationships?  New Source of Capital  Reduced Exposure to Individual Borrowers  Flexibility Borrower Loan Buyer Interest Payments Loan Seller Monitoring, Funding Screening Upfront Fees

22 Loan Sales and Lending Relationships Univariate Results (Table 9) Sold Borrowers are  More Likely to Receive Future Loans  More Likely to Continue Lending Relationships

23 Loan Sales and Lending Relationships Explore: Risk Management  Lending Flexibility  Do Loan Sales Increase Relationship Durability for High Risk Firms? High Reputation Lenders? Univariate Results (Table 9): Conditional on Receiving Another Loan, % that Keep Same Lead Bank

24 Loan Sales and Lending Relationships Nested Logit Model (Table 10) (link) (link) Independent Variables: “Borrow Again”  Borrower Characteristics; Year Fixed Effects Independent Variables: “Borrow Again” and “Keep Lender”  Loan is Sold; Lender Market Share; Prior Lending Relationship Borrow Again Don’t Borrow Again KeepLender Don’t Keep Lender

25 Loan Sales and Lending Relationships Changes in Conditional Probability of “Keep” vs. “Don’t Keep” (link) (link) Loan Selling Improves Relationship Durability for  Risky Borrowers  High Reputation Lenders

26 Outline  Data, Sample Selection, and Descriptive Statistics  Loan Sales and Loan Contracting  Secondary Market Sales and Covenants  Covenants and Agency Problems  Loan Sales, Access to Loans, and Lending Relationships  Current Loans  Lending Relationships and Future Loans  Other Issues and Summary

27 Other Issues Timing of Loan Sales  Limit Analysis to Loans with quotes within 3/6/12 months of origination Loan Trades v. Loan Quotes  Limit Analysis to Loans with Multiple Market Makers Seniority / Secured Lending  Seniority: Almost all loans are senior or missing classification  Secured loans are more likely to be sold; covenant results still hold

28 Summary Loan Selling Separates Origination and Funding  Agency Problems  Loan Contracting  Access to Loans and Lending Relationships Sold Loans Have Additional, Tighter Covenants  Consistent With Covenants Used When Agency Problems Are Larger Sold Borrowers: Debt-Dependent, Receive Additional Private Debt  Benefit to Offset Costs of Restrictive Covenants / Loan Sales Sold Borrowers get Future Loans, Keep Lending Relationships  Impact Strongest for High Risk Borrowers  Additional Capital and Flexibility for Lenders

29 Tables

30 Table 1: Loan Sample Summary Statistics (link) (link)

31 Table 2: Univariate Analysis- Sold Loans vs. Not Sold Loans )

32 Table 2 (continued): Univariate Analysis - Sold Loans vs. Not Sold Loans (link) (link)

33 Table 3: Sold Loans – Timing, Pricing, and Performance ) (link)

34 Table 4: Probability of Selling Loans (link) (link)

35 Table 5: Probability of Loan Syndication (link) (link)

36 Table 6: Probability of Selling Loans - Lender Reputation (link) (link)

37 Table 7: Probability of Selling Loans – Borrower Risk (link) (link)

38 Table 8: Loan Sales and Debt Capital

39 Table 9: Univariate Analysis - Keeping the Same Lender

40 Table 10: Nested Logit Models- Keeping the Same Lender

41 Table 10 (continued): Nested Logit Models – Borrowing Again (link) (link)

42 Are Restrictive Covenants Used to Mitigate Agency Problems? Primary Market Sales  Lower Agency Problems Lower Reputation Lender  More Agency Problems Evidence is consistent with agency view Compared to Secondary Market Sales (Table 5): link) link)  More Covenants – Similar Effect  Tighter Covenants – Weaker Effect Key Result (Table 6) (link) (link  Tighter Covenants  Increases Probability of Loan Sale when lenders have LOW REPUTATION

43 Do Restrictive Covenants Signal Borrower Quality? Empirical Prediction  High Risk  Covenants have LARGER influence on probability of loan selling Evidence is NOT consistent with signaling view Results (Table 7): Largest Effect on Loan Sale Probability (link) (link)  # of Financial Covenants: LOW RISK  Net Worth Slack: MID RISK – (insignificant for HIGH RISK)

44 Agency or Signaling? Does Restrictive Covenant Package Signal Borrower Quality? Empirical Prediction  High Risk  Covenants have LARGER influence on probability of loan selling Modify Loan Sales Model (Table 7) (link) (link)  Interact Distance-to-Default Indicators with Covenant Variables KEY RESULTS: Largest Effect on Loan Sale Probability  # of Financial Covenants: LOW RISK BORROWERS  Net Worth Slack: MID RISK BORROWERS Evidence is NOT consistent with signaling view

45 Signaling? Changes in Predicted Probabilities of Selling Loans (link) (link)  One Std. Dev Change Around the Mean (t-stats in parentheses) Largest Effect on Loan Sale Probability  # of Financial Covenants: LOW RISK BORROWERS  Net Worth Slack: MID RISK BORROWERS