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

2. 2 Motivation Loan selling is important for banks and the economy Trading Volume: $154.8 billion in 2004 vs. $8.0 billion in 1991 Trading Volume: $154.8 billion in 2004 vs. $8.0 billion in 1991 Diversification; Comply with Risk-Adequacy Regulations Diversification; Comply with Risk-Adequacy Regulations Allows Origination even when Funding Constrained 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. 3 Main Issues Loan Sales Separate Origination from Funding Agency Problems Moral Hazard (Pennacchi 1988; Gorton & Pennacchi 1995) Moral Hazard (Pennacchi 1988; Gorton & Pennacchi 1995) Adverse Selection Adverse Selection How do banks overcome these problems? How do banks overcome these problems? ­Loan Contracting Access to Loans and Lending Relationships Harm? Harm? ­Reduce interaction that is critical to benefits (Diamond 1991) Help? Help? ­Increased Capital From Non-Banks ­Risk-Management Flexibility in Future Loan Origination

4. 4 Outline Data, Sample Selection, and Descriptive Statistics Data, Sample Selection, and Descriptive Statistics Loan Sales and Loan Contracting Loan Sales and Loan Contracting Secondary Market Sales and Covenants Secondary Market Sales and Covenants Agency Problems or Signaling? Agency Problems or Signaling? Loan Sales, Access to Loans, and Lending Relationships Loan Sales, Access to Loans, and Lending Relationships Current Loans Current Loans Lending Relationships and Future Loans Lending Relationships and Future Loans Summary Summary

5. 5 Data and Sample Selection Sample Period: 1999 - 2004 Data from four sources with some data matched by hand Loans & Lending Relationships (LPC DealScan) Loans & Lending Relationships (LPC DealScan) Identify Traded Loans (LSTA Mark-to-Market Pricing) Identify Traded Loans (LSTA Mark-to-Market Pricing) Borrower Financial Characteristics (Compustat) Borrower Financial Characteristics (Compustat) Equity Market Data (CRSP) Equity Market Data (CRSP) Sample Sizes (link) (link)

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

7. 7 Outline Data, Sample Selection, and Descriptive Statistics Data, Sample Selection, and Descriptive Statistics Loan Sales and Loan Contracting Loan Sales and Loan Contracting Secondary Market Sales and Covenants Secondary Market Sales and Covenants Agency Problems or Signaling? Agency Problems or Signaling? Loan Sales, Access to Loans, and Lending Relationships Loan Sales, Access to Loans, and Lending Relationships Current Loans Current Loans Lending Relationships and Future Loans Lending Relationships and Future Loans Summary Summary

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

9. 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 Dependent Variable: Indicator for Loan is Sold Key Independent Variables # of Financial Covenants (+) # of Financial Covenants (+) Net Worth Slack (-) Net Worth Slack (-) Control Variables Lender Market Share; Borrower and Loan Variables Lender Market Share; Borrower and Loan Variables

10. 10 Secondary Market Sales and Covenants Changes in Predicted Probabilities (link) (link) One Std. Dev Change Around the Mean (t-stats in parentheses) One Std. Dev Change Around the Mean (t-stats in parentheses) Key Results: More Covenants Increases Probability of Loan Sale More Covenants Increases Probability of Loan Sale Tighter Covenants Increases Probability of Loan Sale Tighter Covenants Increases Probability of Loan Sale

11. 11 Are Loans Structured to Sell to Others? Sold Loans are Nearly Always Syndicated (Primary Market) Loans are Sold Close to the Loan Origination Date (link) (link)

12. 12 Are Loans Structured to Sell to Others? Banks are not dumping poorly performing loans Distribution of Initial Sale Prices Performance of Sold Borrowers: Origination to Sale

13. 13 Agency or Signaling? Syndication: Primary Market Sales Additional Mechanisms for Mitigating Agency Problems Hold Larger Piece of Loan (e.g. Dennis & Mullineaux 2000) Hold Larger Piece of Loan (e.g. Dennis & Mullineaux 2000) Syndicate Structure and Composition (Lee & Mullineaux 2004; Sufi 2005) Syndicate Structure and Composition (Lee & Mullineaux 2004; Sufi 2005) Expect Smaller Agency Problems Expect Smaller Agency Problems Empirical Prediction # of Covenants / Tighter Covenants have LESS influence on probability of loan syndication (compared to loan sale) # 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) ((((

14. 14 Primary Market Sales and Covenants Changes in Predicted Probabilities (link) (link) One Std. Dev Change Around the Mean (t-stats in parentheses) One Std. Dev Change Around the Mean (t-stats in parentheses) Compared to Secondary Market Sales: More Covenants – Similar Effect More Covenants – Similar Effect Tighter Covenants – Weaker Effect Tighter Covenants – Weaker Effect Evidence is consistent with agency view

15. 15 Agency or Signaling? Lower Reputation Lender Increased Agency Problems Gorton & Haubrich (1987); Pichler & Wilhelm (2001) Gorton & Haubrich (1987); Pichler & Wilhelm (2001) Empirical Prediction Low Reputation Lender # of Covenants / Tighter Covenants have LARGER influence on probability of loan selling 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 Interact Reputation Indicators with Covenant Variables

16. 16 Lender Reputation Changes in Predicted Probabilities of Selling Loans (link) (link) One Std. Dev Change Around the Mean (t-stats in parentheses) 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 Tighter Covenants Increases Probability of Loan Sale when lenders have LOW REPUTATION Evidence is consistent with agency view

17. 17 Agency or Signaling? Does Restrictive Covenant Package Signal Borrower Quality? Empirical Prediction High Risk Covenants have LARGER influence on probability of loan selling 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 Interact Distance-to-Default Indicators with Covenant Variables KEY RESULTS: Largest Effect on Loan Sale Probability # of Financial Covenants: LOW RISK BORROWERS # of Financial Covenants: LOW RISK BORROWERS Net Worth Slack: MID RISK BORROWERS Net Worth Slack: MID RISK BORROWERS Evidence is NOT consistent with signaling view

18. 18 Outline Data, Sample Selection, and Descriptive Statistics Data, Sample Selection, and Descriptive Statistics Loan Sales and Loan Contracting Loan Sales and Loan Contracting Secondary Market Sales and Covenants Secondary Market Sales and Covenants Agency Problems or Signaling? Agency Problems or Signaling? Loan Sales, Access to Loans, and Lending Relationships Loan Sales, Access to Loans, and Lending Relationships Current Loans Current Loans Lending Relationships and Future Loans Lending Relationships and Future Loans Summary Summary

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

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

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

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

23. 23 Loan Sales and Lending Relationships Explore: Risk Management Lending Flexibility Do Loan Sales Increase Relationship Durability for High Risk Firms? High Reputation Lenders? 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. 24 Loan Sales and Lending Relationships Nested Logit Model (Table 10) (link) (link) Independent Variables: Borrow Again Borrower Characteristics; Year Fixed Effects Borrower Characteristics; Year Fixed Effects Independent Variables: Borrow Again and Keep Lender Loan is Sold; Lender Market Share; Prior Lending Relationship Loan is Sold; Lender Market Share; Prior Lending Relationship Borrow Again Dont Borrow Again KeepLender Dont Keep Lender

25. 25 Outline Data, Sample Selection, and Descriptive Statistics Data, Sample Selection, and Descriptive Statistics Loan Sales and Loan Contracting Loan Sales and Loan Contracting Secondary Market Sales and Covenants Secondary Market Sales and Covenants Agency Problems or Signaling? Agency Problems or Signaling? Loan Sales, Access to Loans, and Lending Relationships Loan Sales, Access to Loans, and Lending Relationships Current Loans Current Loans Lending Relationships and Future Loans Lending Relationships and Future Loans Summary Summary

26. 26 Summary Loan Selling Separates Origination and Funding Agency Problems Loan Contracting Agency Problems Loan Contracting Access to Loans and Lending Relationships Access to Loans and Lending Relationships Sold Loans Have Additional, Tighter Covenants Consistent With Covenants Used When Agency Problems Are Larger Consistent With Covenants Used When Agency Problems Are Larger Signaling Not Supported Signaling Not Supported Sold Borrowers: Debt-Dependent, Receive Additional Private Debt Benefit to Offset Costs of Restrictive Covenants / Loan Sales Benefit to Offset Costs of Restrictive Covenants / Loan Sales Sold Borrowers get Future Loans, Keep Lending Relationships Additional Capital and Flexibility for Lenders Additional Capital and Flexibility for Lenders

27. 27 Tables

28. 28 Table 1: Loan Sample Summary Statistics (link) (link)

29. 29 Table 2: Univariate Analysis- Sold Loans vs. Not Sold Loans )

30. 30 Table 2 (continued): Univariate Analysis - Sold Loans vs. Not Sold Loans (link) (link)

31. 31 Table 3: Sold Loans – Timing, Pricing, and Performance ) (link)

32. 32 Table 4: Probability of Selling Loans (link) (link)

33. 33 Table 5: Probability of Loan Syndication (link) (link)

34. 34 Table 6: Probability of Selling Loans - Lender Reputation (link) (link)

35. 35 Table 7: Probability of Selling Loans – Borrower Risk (link) (link)

36. 36 Table 8: Loan Sales and Debt Capital

37. 37 Table 9: Univariate Analysis - Keeping the Same Lender

38. 38 Table 10: Nested Logit Models- Keeping the Same Lender

39. 39 Table 10 (continued): Nested Logit Models – Borrowing Again (link) (link)

40. 40 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 More Covenants – Similar Effect Tighter Covenants – Weaker Effect Tighter Covenants – Weaker Effect Key Result (Table 6) (link) (link Tighter Covenants Increases Probability of Loan Sale when lenders have LOW REPUTATION Tighter Covenants Increases Probability of Loan Sale when lenders have LOW REPUTATION

41. 41 Do Restrictive Covenants Signal Borrower Quality? Empirical Prediction High Risk Covenants have LARGER influence on probability of loan selling 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 # of Financial Covenants: LOW RISK Net Worth Slack: MID RISK – (insignificant for HIGH RISK) Net Worth Slack: MID RISK – (insignificant for HIGH RISK)

42. 42 Signaling? Changes in Predicted Probabilities of Selling Loans (link) (link) One Std. Dev Change Around the Mean (t-stats in parentheses) One Std. Dev Change Around the Mean (t-stats in parentheses) Largest Effect on Loan Sale Probability # of Financial Covenants: LOW RISK BORROWERS # of Financial Covenants: LOW RISK BORROWERS Net Worth Slack: MID RISK BORROWERS Net Worth Slack: MID RISK BORROWERS

43. 43 Loan Sales and Lending Relationships Changes in Conditional Probability of Keep vs. Dont Keep (link) (link) Loan Selling Improves Relationship Durability for Risky Borrowers Risky Borrowers High Reputation Lenders High Reputation Lenders