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THE ECONOMICS OF THE PRIVATE MARKET

Private Placements in a Theory of Credit Market Specialization

The CMR paradigm illuminates the differences among the commercial bank loan market, the private placement market, and the public bond market. Because their liabilities have short terms, banks prefer to invest in short-term assets. Such a preference naturally leads them to specialize in (among other things) lending to quite informationproblematic, generally small firms. The optimal contract for such borrowers has a short maturity because renewal can be based on nonverifiable information. It still includes tight covenants because the borrowers are so problematic. These are frequently violated for reasons not associated with increases in expected losses or risk, and so bank loans tend to be renegotiated frequently.  Quite problematic borrowers accept restrictive terms because banks maintain a reputation for fair dealing and flexibility in renegotiation, because the covenant constraints have short terms, and because bank loans can typically be prepaid without penalty. 92

Because their liabilities have long terms, life insurance companies prefer to invest in long-term assets such as private placements, with fixed interest rates and call protection. Since the renewal-refusal mechanism for controlling risk is absent in such loans, life insurance companies rely more than banks on their ability to demand payment based on covenant violations, that is, on verifiable events. However, covenants are also less effective as a risk-control mechanism in long-term debt. Thus, in equilibrium, issuers of private placements tend to be less problematic, and covenants in private placements tend to be looser than in bank loans. 93  As a result, private placement covenants are less frequently violated and renegotiated. With less frequent renegotiation, borrowers are more willing to rely on a lender's reputation for fair dealing, rather than on an ability to prepay without penalty if renegotiations go sour. Since reputation is important, the equilibrium can work only if private placements are fairly illiquid so that borrowers are assured of continued dealings with good lenders. 94  Thus the public bond market is not well suited to information-intensive lending. Although renegotiation occurs less frequently than in bank loans, not uncommonly a private placement is renegotiated several times during its life span. Life insurance companies invest significant resources in monitoring capacity (although not so many as banks do).

Public market borrowers pose relatively few information problems for lenders. Thus, publicly issued bonds can have long terms, and a relatively few, loose covenants are adequate. Intensive monitoring is unnecessary, and renegotiation is infrequent. Given these characteristics, ownership of public debt can be diffuse rather than concentrated, and the contracts can be liquid. 95

The CMR paradigm is not inconsistent with the traditional view of market segmentation, which focuses on transactions costs and regulation in explaining the institutional structure of credit markets. The traditional view is simply incomplete. In a sense, the traditional view emphasizes the liability side of bank and life insurance company balance sheets and largely ignores the asset side. The CMR paradigm focuses on the asset side. Consistent with the traditional view, the CMR paradigm indicates that long-term (shortterm) loans appeal to life insurance companies (banks) because they match the maturity of their liabilities. However, it emphasizes that in equilibrium long-term and short-term lenders will tend to serve different classes of borrowers and to use somewhat different risk-control technologies.

  1. See Berlin (1991) and Hart and Moore (1989) for a formal model of the maturity structure of loans and the verifiability of information.

  2. Of course, private placement borrowers typically obtain their short-term working capital from commercial banks. They may also have other short-term credit facilities with commercial banks.

    As noted, there are differences between the bank debt and the private placement contracts of private placement issuers (bank debt contracts have more restrictive maintenance covenants).  Such differences may arise from specialization by intermediaries. However, a short-term callable bank loan is not comparable to a long-term noncallable private placement because the bank loan can always be paid off and refunded whereas a private placement locks in a borrower for a substantially longer time. Therefore, a private placement that has the same covenants as a bank loan will be much more restrictive, in effect, than the bank loan because it is noncallable and has a longer maturity. The issue of simultaneously outstanding bank debt and private placements notwithstanding, the principal distinction we are drawing in the CMR paradigm is between those borrowers that depend strictly on the bank loan market (and have no access to long-term debt in the private placement market) and those firms that have access to the private placement market. That is, we are principally comparing the bank debt contract of bank-dependent borrowers with the private placement contracts of borrowers who are not bank dependent.

  3. There are additional reasons that information-intensive debt is illiquid. When selling such debt contracts, originators must do so at a discount because buyers in the secondary market have to be compensated for their due diligence at the time of purchase and such compensation cannot come from fees charged to the borrower. Also, borrowers may be less cooperative in assisting due diligence at resale than at origination.

  4. Berlin and Loeys (1988) demonstrate theoretically that lower-quality firms (that is, firms with a higher probability of deteriorating) are likely to prefer an intermediated loan with tight covenants because the incremental value of hiring a delegated monitor to produce information about their true condition is higher. Monitoring is inefficient, however, if debt of a lower-quality firm is publicly held because each bondholder will have an inadequate incentive to monitor after weighing the private gains from monitoring against benefits.  That is, holders of public bonds do not enjoy the economies of scale of information production available to a financial intermediary.  Consequently, publicly issued debt tends to be most attractive to issuers of high quality and to firms about which much information related to their financial condition is publicly available.

Other Empirical Evidence Revelant to the Theory of Credit Market Specialization

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