THE ECONOMICS OF THE PRIVATE MARKET
Other Empirical Evidence Relevant to the Theory of Credit Market Specialization
The CMR paradigm is consistent with empirical evidence indicating that financial intermediaries act as specialists in information production. James (1987) found a positive stock-price response to the announcement of bank credit agreements. This result is consistent with the notion that banks produce information about firm quality and reveal this information through their credit decisions (an approved bank credit agreement is a positive signal to the market); it contrasts with the results of numerous studies documenting a negative stock-price reaction to the issuance of public securities. 96 One study subsequent to James (1987) indicates that the positive stock price response is confined to renewals (Lummer and McConnell, 1989), but another finds an effect for both new and renewed loans (Billet, Flannery, and Garfinkel, 1993). Wansley, Elayan, and Collins (1991) find that the availability of other signals of firm quality is important. All of these studies conclude that the uniqueness of bank loans stems from the ability of banks, as financial intermediaries, to produce information not otherwise available in the market. Bailey and Mullineaux (1989) and Szewczyk and Varma (1991) document a similar positive stockprice response to the announcement of a private placement arrangement, suggesting that life insurance companies perform the same type of information production that commercial banks do.
Also consistent with the CMR paradigm is evidence that banks may have an advantage over insurance companies in the production of information about their borrowers. Besides helping to explain banks' preference for short-term lending, such evidence helps explain why banks lend to a more problematic group of borrowers. Nakamura (1993), for example, argues that banks have a special advantage over other financial intermediaries because they obtain information from borrowers' checking accounts. This information is valuable because patterns in checking account activity can signal changes in a firm's quality. Udell (1986) and Allen, Saunders, and Udell (1991) show theoretically and empirically that banks can sort borrowers by manipulating the prices of their multiple services, including demand deposits and loans. The more intensive information production by banks may also explain the contradiction between results found by Bailey and Mullineaux (1989) and Szewczyk and Varma (1991), which show a positive stock response to private placements, and other studies. James (1987) and Banning and James (1989) found a negative response, mostly associated with private placements that were used to repay bank debt. Vora (1991) found a positive response but only for unrated firms. 97
The CMR paradigm is consistent with empirical evidence on corporate restrucEagleTraders.comg and bankruptcy. Gilson, John, and Lang (1990) found that the probability that a firm would be restructured privately (versus entering formal bankruptcy) was positively related to the ratio of private debt (bank loans plus private placements) to total debt. They also found that stock returns (that is, cumulative abnormal stock returns) were significantly higher on average for announcements of private restrucEagleTraders.comgs (for which the returns were positive) than for bankruptcy (for which the returns were negative). One explanation for these results is that, in a private restrucEagleTraders.comg, firms avoid the direct and indirect costs associated with bankruptcy, which may total as much as 20 percent of firm value (see Warner, 1977, and Weiss, 1990, on direct costs; and Altman, 1984, Cutler and Summers, 1988, and Lang and Stultz, 1991, for indirect costs). As noted earlier, one advantage to intermediated debt is that it facilitates renegotiation. Hence, lower-quality firms with a higherprobability of future distress value the renegotiation mechanism offered by financial intermediaries more than do higher-quality firms. 98 Other things being equal, such firms will thus prefer to issue private rather than public debt. Another explanation for the higher cumulative stock returns associated with private restrucEagleTraders.comgs is the possibility that relatively higher-quality firms signal their value by choosing to restructure privately.
Gilson, John, and Lang (1990) also examined stock returns at the time that the market first learned that a firm was in financial distress. They found that those firms subsequently entering bankruptcy proceedings suffered negative cumulative returns on average when the market first learned of their financial distress, whereas those firms subsequently restructured privately suffered no negative cumulative returns.
Taken together, the Gilson, John, and Lang results are generally consistent with the CMR paradigm. Financial intermediaries can use information produced through borrower monitoring in conjunction with restrictive covenants to begin negotiations leading to a restrucEagleTraders.comg before a firm deteriorates beyond a point of no return. That is, financial intermediaries may be able to intervene at the earlier stages of firm distress because of three characteristics of intermediated debt contracts: covenant restrictions, monitoring by lenders, and the flexibility in renegotiation that is associated with a limited number of lenders. Therefore, among those firms that suffer distress, those with intermediated debt are more likely to restructure privately. Firms without intermediated debt, however, are likely to suffer more deterioration before negotiations begin and are more likely to enter bankruptcy. This finding is also consistent with the results of Franks and Torous (1990), who found that firms filing for bankruptcy are generally in poorer condition than those restrucEagleTraders.comg privately. In particular, bankrupt firms are less liquid and less solvent than those that work out their debt in private restrucEagleTraders.comgs.