On Loan Sales, Loan Contracting, and Lending Relationships

1
On Loan Sales, Loan Contracting, and Lending
Relationships

• Authors Steven Drucker and Manju Puri
• Discussant Haluk Unal

• FDIC-CFR Workshop, October 27, 2006

2
Central Issue

• How do banks reduce agency problems that arise
  from selling loans?
• How do loan sales affect lending relationships?

3
Data

• Matching the LSTA mark-to-market pricing database
  (7372 loans May98/Sep05) with DealScan
  (Jan99/Dec04) gives 3182 sold facilities among
  the 24,823 (13) DealScan loans.
• Keep only those loans where DealScan reports the
  existence of at least one general or financial
  covenant.
• The final sample is 7261 facilities of which
  1,075 are sold in the secondary market. Could
  there be sold loans in the (7261-1075) sample?
• Net Worth Sample 2470 sold 204 not sold.
  Borrower must maintain a minimum level of net
  worth or tangible net worth.
• Current Ratio Sample 561 loan facilities of
  which 17 are loan sales. Must maintain a minimum
  current ratio.

4
Findings

• 1. Characteristics of the borrowers of the
  sold-loans
• Sold-borrowers are over 1.5 times larger than
  borrowers whose loans are not sold
• 90 of sold-loans have borrowers with a public
  debt credit rating.
• 2. Characteristics of the sold-loans
• Term-loans are more likely to be sold than credit
  lines.
• Loans originated by lead banks with higher loan
  market shares are more likely to be sold.
• 3. Design characteristics of sold loans
• More restrictive covenant packages than loans
  that are not sold and are held by the original
  banks.

5
Findings

• 4. Impact of design characteristics
• Tighter covenants improve the likelihood of
  selling loans in the secondary market but less
  impact on facilitating loan syndication (sales at
  origination).
• Tighter covenants increase the likelihood of sale
  when lenders are not reputable.
• CONCLUSION Sold loans are structured to reduce
  buyer-seller agency problem.
• 4. Impact on borrowers
• Borrowers whose loans are sold are growing
  companies with high leverage ratios.
• During the origination year of the sold loan,
  private debt issuance more than doubles
  increasing firms interest-bearing debt levels
  and leverage ratios.
• Loan sales increase relationship durability for
  risky borrowers.
• Loan selling improves lending relationships when
  lenders have more reputational capital at risk.
• CONCLUSION Borrower benefits from loan sale.

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Front-end of the paperTradeoffs in choice of
covenants

• Pricing
• Lower yields vs. higher number of covenants.
  Number of covenants might increase the likelihood
  of sale but does it cost the lender?
• Lender
• Reputation vs. number of covenants.
• Borrower
• High number of covenants vs. improved
  relationship.
• Optimization of the number of covenants?

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What do these Covenants look like?

• Max Debt to EBITDA
• Min Fixed Charge ratio
• Min (tangible) net worth
• Min Interest Coverage
• Max Capital Expenditure
• Min EBITDA
• Max Leverage Ratio
• Max Senior Debt to EBITDA
• Max Debt-to-Tangible NW
• Min Debt Service Coverage
• Min Current Ratio
• Min Quick Ratio
• Min Cash Interest Coverage
• Max Debt-to-Equity
• Max Senior Leverage
• Max Loan to Value
• Quality differences, repetitions. For example,
  why would one add Max Debt-to-Equity and Maximum
  Leverage Ratio over and above Max Debt to EBITDA?
  What is the cost?

8
Further Questions

• Sold loans have 3.4 covenants as opposed to only
  2.7 covenants for loans that are not sold.
  Furthermore, an increase in the number of
  covenants from 2.1 to 3.1 increases the
  probability of selling loans 12.41. One could
  say what is one additional covenant between
  friends? Adding Max leverage to Max
  debt-to-assets has this impact? Any
  non-linearity?
• Reputation Covenant package is an important
  determinant of loan sales than lender reputation.
  Is there a trade-off here? Do low reputation
  lenders have high number of covenants?
• Cost of including covenants? Reduced flexibility.
  Okay, thats fine but then can we show whether
  loan rates differ as we increase the number of
  covenants? There should be some sort of an
  explicit cost of including covenants. Otherwise,
  since it is such a good thing. (since the paper
  shows that more covenants lead to higher
  probability of sale and loan sale benefits the
  borrower and lender) why not increase the number.
  
• If these covenants have such importance then it
  should be priced somehow.

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Suggestion

• Change the title
• On Loan Sales and Covenants
• Introduce Lending Relationship section part of
  the tradeoff analysis.
• Expand Covenants discussion (more institutional
  information, pricing, etc.)