Study Finds Corporate Loans on Borrowed Time

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Time will tell: Economists predict the U.S economy will continue to feel effects of the mortgage crisis until 2010.

The mortgage crisis of 2008 that turned Wall Street upside down and left Main Street reeling isn’t over yet. Economists are predicting the U.S economy will continue to feel the effects at least until 2010.

In the meantime, another financial disaster may be on the horizon, according to a new study by researchers at Case Western Reserve and Carnegie Mellon universities.

This new threat, they say, stems from corporate, not residential, borrowing and lending. It is the result of a recent shift from the traditional banking model in which a single bank lends to a single borrower. In this new model, called originate-to-distribute, the original lending institution creates the loan and sells it to a third-party investor, who takes over the loan. This secondary loan market has become the largest source of corporate financing in the United States.

"This new paradigm has important implications for our financial institutions and markets," says Anurag Gupta, Ph.D., co-author of the study and associate professor of banking and finance at Case Western Reserve’s Weatherhead School of Management. Gupta and his colleague, Antje Berndt, Ph.D., examined the performance of borrowers whose loans were sold by banks to a third-party investor.

What they found was concerning.

Borrowers whose loans were sold in the secondary market underperformed other borrowers by 8 to 14 percent per year over a three-year period. Those borrowers at greater risk included companies in manufacturing, business services, entertainment, finance and hotels. In addition, these borrowers’ total asset value decreased by nearly 15 percent when compared with their traditional bank-borrowing peers.

The researchers offer two possible explanations. First, traditional banks may be selling the loans of borrowers they deem risky. Second, banks have fewer incentives to monitor borrowers once a third party is introduced and this may cause borrowers to be more likely to make poor investment and operating decisions.

"This implies that banks are cherrypicking the good loans for themselves and selling the bad loans," says Berndt, assistant professor of finance at Carnegie Mellon’s Tepper School of Business. She adds: "This is remarkably similar to events that have unfolded in the current subprime mortgage crisis."

To avoid a second financial crisis, Gupta and Berndt offer potential solutions. They suggest imposing certain restrictions on the sale of loans originated by banks, such as requiring them to hold a percentage of the loan.

Banks may be less likely, then, to originate bad loans. Gupta and Berndt also suggest additional disclosure requirements that would be required of banks, lenders and third-party investors, leading to greater transparency.

Finally, they call for establishing a loan trading exchange, which could further improve transparency and regulatory oversight in the secondary loan market.

"The negative effects on borrowers in the originate-to-distribute banking model are of great importance," says Gupta. "If ignored, the effects could aggravate an already dire economic situation."