Pricing and Performance of Loans Bundled with Underwriting

Banks provide loans and underwriting services to the same corporate customer with increasing frequency. Previous literature finds that loans that are bundled with underwriting deals carry lower interest rates, consistent with either strategic behavior by banks (“pay to play”) or informational economies of scope. However, I find that there is no interest rate discount in bundled loans after adjusting for endogeneity arising from a bank’s decision to manage its risk exposure to a client. My results support the story that banks choose to provide bundled lending and underwriting services to higher-quality customers. Tests of subsequent performance show that borrowers receiving bundled services perform better than other borrowers in terms of future changes in credit risk (proxied using KMV’s distance to default measure and Altman’s (1968) Z-score). Such borrowers are also significantly less likely to default or receive credit rating downgrades. The effects are stronger for smaller and unrated companies. Moreover, using a new database of secondary market loan prices, I find that bundled loans have better return performance in the secondary market. * Department of Finance, Stern School of Business, New York University, 44 West 4th Street, Suite 9-193, New York, NY 10012-1126. Phone: 212-998-0716. E-mail: ylu1@stern.nyu. edu. I would like to thank my Ph.D. committee members Anthony Saunders, Alexander Ljungqvist, Yakov Amihud, Kose John and Daniel Wolfenzon for constant encouragement and support. I also thank Edward Altman, Steven Drucker, Amar Gande, Bill Greene, Victoria Ivashina, Michael Roberts, Rik Sen, Andre de Souza, Ingo Walter, Johnathan Wang and seminar participants at NYU and FDIC for help and comments. Finally, I thank Brooks Brady, Steven Miller, and Matthew Sanderson from Standard & Poor’s for help with the data. All errors are mine. The appropriate scope of banking activities has long been controversial in both academic and regulatory circles. 1 The debate has been especially heated because of recent changes in the industry. Consolidation among banks in the late 1990s alongside the repeal of the Glass-Steagall Act in 1999 have increased banks’ ability to compete for corporate customers by offering them both commercial loans and investment banking services. For instance, between 1995 and 2004, the incidence of bundling loans with underwriting services tripled, from 5% to 15% of corporate loans. The fraction was even larger in terms of dollar value. This greater freedom raises the concern that commercial banks might “discount” their loans to support their investment banking affiliates, which might distort the competitive structure of underwriting markets. There are also concerns that in bundled transactions, banks might lower their lending standards and extend loans to otherwise unqualified clients in the pursuit of underwriting fees. If true, such behaviors could increase the risk of large defaults and potentially hurt the stability of the banking system. Despite its apparent importance to the banks, their customers, and the financial system, we know relatively little about the economic consequences of this aspect of banking deregulation. This paper examines these consequences by studying the pricing and performance of loans that are bundled with underwriting deals. The following questions from Congressman John D. Dingell to the Federal Reserve Board and the Office of the Comptroller of the Currency in 2002 illustrate the concerns: “. since it appears that credit is being offered as a loss leader by commercial banks to facilitate or leverage the extension of their investment banking business, what are the implications of such mispricing on the supply of and demand for credit? What are the implications of this underpricing for the financial health of the smaller banks who participate in these syndicated facilities? To what degree is this tying activity a cause of the increased losses being realized by large banks on loans to borrowers such as Enron who were 1 See Drucker and Puri (2005) for an excellent survey on this topic.