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THE ECONOMICS OF THE PRIVATE MARKET

Collateral

Some private placements are asset-backed securities, such as leveraged leases, collateralized trust certificates, and collateralized mortgage obligations.  Also, a significant fraction of traditional private placements of straight and subordinated debt, such as first and second mortgage bonds, are secured. Approximately one-third of the private placements in Kwan and Carleton's sample were secured. Similarly, 6 percent of the volume of private issues in 1989 was asset-backed, and 21 percent was otherwise secured, for a total of 27 percent secured (see table 2). ³⁴  Asset-backed securities are more common in the public market, whereas collateral is much less common in other forms of public debt. In 1989, 24 percent of public issuance was asset-backed, and only 4 percent was otherwise secured. ³⁵  A much larger fraction of bank loans is secured. Statistics from the Federal Reserve's Survey of Terms of Bank Lending and the Federal Reserve/Small Business Administration's National Survey of Small Business Finance indicate that about two-thirds of commercial bank loans to nonfinancial businesses are secured. ³⁶

Conventional wisdom suggests that bank loans frequently involve collateral because bank borrowers are relatively risky; collateral is less often used in the private placement market because private placements tend to be less risky on average than bank loans; and collateral is infrequently used in the public debt market because of the high quality of the average issuer. As we argue in the last section of part 1, collateral is useful not only for controlling observable risks but also for solving information problems. Collateral in debt contracts helps minimize the incentives of firm owners to act in ways that are detrimental to lenders.  Because these incentives are more acute in smaller, more information-problematic firms, collateral is widespread in the bank loan market but rare in the public bond market. ³⁷

34. The fraction secured rises to 31 percent if floating and variable rate instruments, ''loans,'' industrial revenue or development bonds, and medium-term notes are omitted from the computations. The IDD sample results probably understate the percentage of private placements with collateral attached, because collateral status must be inferred from listed security type. Kwan and Carleton's finding that about one-third of private placements have collateral is probably the best available estimate.

35. Federal National Mortgage Corporation (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) obligations were not included in the computations yielding public market percentages.

36. A distinction should be made between bank credit facilities extended to large and those extended to small firms.  Large firms with access to the commercial paper market and the public bond market obtain their bank credit facilities (usually lines of credit backing up their commercial paper) on an unsecured basis. However, of those borrowers that depend on commercial banks for their funding, the majority borrow on a secured basis. These borrowers drive the statistics reflected in the Survey of Terms of Bank Lending and the National Survey of Small Business Finance.

37. There is also empirical evidence that within the bank loan market riskier borrowers are more likely to pledge collateral (see Berger and Udell, 1990, 1993a, and 1993b).

Summary

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