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THE ECONOMICS OF THE PRIVATE MARKET

Private Market Efficiency

In considering the efficiency of the private placement market, we focus on whether lenders or agents earn either subnormal or supranormal profits. Quantitative data on which precise judgments might be based are not available, but the comments of market participants suggest that the market is relatively efficient.

With regard to lenders' profits, one major insurance company stated recently in a public forum that interest rates on its private originations during 1989-91 were, on average, 31 basis points higher than rates on comparable public issues and that 18 basis points of this differential were spent on costs of origination and monitoring. These numbers leave 13 basis points for profit and for compensation for the reduced liquidity of private placements relative to that of publicly issued bonds. Another major company displayed proprietary data during interviews indicating that recent historical net loss rates due to defaults on private placements have been similar to loss rates on comparably rated public issues.

Presuming that these data are accurate and reasonably typical of private market lenders' experience, and assuming that lenders do not make subnormal or supranormal profits on their public bond market activities, the data place rough boundaries on the degree of private market inefficiency that may exist. The key question is the size of the differential required to compensate lenders for the relative illiquidity of private placements. If this differential is near zero, then private lenders may be making modest excess profits. 144  If the differential is near 13 basis points, then lenders are taking a modest loss at the margin. Regardless, the dollar sums involved apparently cannot be large enough to represent extraordinary inefficiencies that would be a major concern to policymakers.

Agents' profits are even harder to estimate, as no information is available about their costs.  Based on market participants' remarks about fees and staff sizes and on publicly available information about the volume of issues assisted by particular agents, the largest agents may be earning substantial marginal profits on the staff and overhead costs of their private placement groups alone. However, portions of these profits must be attributed to the actions of relationship officers and other divisions of commercial banks and investment banks, so actual profit rates may not be unusual.

Smaller agents may also be able to make profits if their flow of business is reasonably steady. As noted, smaller agents will find maintaining their knowledge of market conditions more expensive and difficult, and they will face minimum fixed costs of maintaining a staff.

We have no reason to think that agents make large excess profits, and many market participants remarked on the substantial competition that exists. On the whole, the private placement market appears to be reasonably efficient, although it may not always react quickly to changes in conditions.

  1. Computing profit rates is difficult because the capital at risk is hard to identify. If at the margin the only capital at risk is the staff and overhead costs of origination and monitoring, lenders' marginal rate of return on equity in private market operations may be as high as 70 percent. But that estimate is almost surely far too high because private market lending is, on the whole, probably riskier than buying public bonds, so more equity must be allocated to such lending than to public bond market lending.

Private Placements without an Agent

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