Explaining the Pattern of Secured Credit
Granting collateral to secure loans is a prominent feature of the U.S. economy, but, surprisingly, we do not understand how borrowers and lenders decide whether to engage in a secured or an unsecured transaction. In this Article, Professor Mann argues that existing theories of secured lending are inadequate because the theories' predictions have not been tested against empirical data. To understand the actual pattern of secured credit, Professor Mann interviewed more than twenty borrowers and lenders in various sectors of the economy. Based on the evidence gathered in these interviews, as well as on preexisting empirical studies, this Article develops a model of the borrower's decision to grant collateral that focuses on the borrower's perceptions of the costs and benefits of secured and unsecured transactions. Granting collateral lowers the aggregate costs of a lending transaction by lowering the pre-loan perception of the risk of default. Secured credit can do this not only by increasing the lender's ability to collect the debt forcibly through liquidation of the collateral, but also in less direct ways: by decreasing the borrower's ability to obtain subsequent loans; by increasing the lender's leverage over the borrower's activities; and by repairing the loan-induced differentiation of the incentives of the borrower and the lender. Conversely, a grant of collateral can increase the costs of a lending transaction by increasing the costs of entering the transaction as well as the costs of administering the loan. In the Article's final section, Professor Mann uses the decision-based model to explain three separate aspects of the pattern of secured credit: the relatively infrequent use of secured credit by companies with strong financial records, the relation between the use of collateral and the duration of the debt, and the apparently low rate of retention of security interests by suppliers.