Loan Sales, Recourse, and Reputation: An Analysis of Secondary Loan Participations

Secondary loan participations, or loan "stripping," is a recent innovation in banking. In a secondary loan participation, or loan sale, a bank makes a loan and then sells the loan, without recourse, to a third party. Bank loans hitherto were nonmarketable securities which could only be removed from the balance sheet by creating, at least, a contingent liability. Consequently, the recent practice of loan sales raises fundamental questions about the uniqueness of banks relative to markets as mechanisms for allocating capital. In particular, are banks continuing to perform unique services, such as enforcing loan covenants, or are these activities now performed by other economic agents, in markets? If banks are still performing these activities, what incentives to perform do they face if the loans can be sold without recourse? This paper seeks to clarify these issues in a nontechnical way. We present the available quantitative evidence on the growth of the loan sales market, the identity of buyers and sellers, the types of loans sold, and the characteristics of the participation contracts. Qualitatively, loan participations are distinguished contractually from other bank asset contracts both legally and economically. A set of stylized facts about loan sales contracts, based on a sample of blank secondary loan participation contracts (and associated contracts with the underlying borrower), collected from money center banks, is presented. Two hypotheses to explain the existence and the recent appearance of loan sales are briefly presented. In particular, we examine the extent to which a bank’s "reputation" can substitute for the bank’s taking a position in the loan to maturity (i.e., equity) as an incentive device for ensuring bank performance of monitoring loan covenants. We consider how reputations are obtained, and informally argue that the recent trend of securitization can be usefully viewed in this way.