Asymmetric Valuations and the Role of Collateral in Loan Agreements

Abstract

LOAN CONTRACTS WITH PROVISION for collateral are of two general types. In one, the collateral may be an existing asset of the borrowing firm which is pledged to a lender in the event of default. In this case, collateral does not increase the assets that the borrower would lose if there is default, since all the borrower's assets are attachable; therefore, the expected marginal cost to the borrower of providing an additional unit of collateral includes, principally, transactions costs associated with the collateral. l This describes the usual type of commercial loan arrangement with the collateral being either equipment, real estate, accounts receivable, or inventories. In the other type of loan contract, the collateral is an additional asset that is given up by the borrower if there is default; that is, in addition to the usual assets that are available to its lenders, the borrower assigns as collateral to a creditor an asset that would normally not be legally attachable. This arrangement is more common in small business loans that are secured by a personal asset (e.g., a house) of the entrepreneur. Likewise, debt issued by a legally separate subsidiary may be secured by an asset of the parent firrn. In these cases, the expected marginal cost to the borrower (the owner/manager of the small firm or the parent corporation in the latter example) of providing an additional unit of collateral