Agency Costs and the Demand and Supply of Secured Debt and Asset Securitization

Abstract

Current accounts of the demand and supply of secured debt and asset securitization are in stark contrast with observed debtor behavior. Whereas current theories predict a strong preference for secured debt, debtors borrow on an unsecured basis whenever possible. In addition, the purported theoretical similarities between secured debt and asset securitization, that both forms of financing generate savings by pledging collateral, conflict with the significant disparity in the popularity and signals associated with use of asset securitization and secured debt. This Article addresses the disconnects between current theories and observed practices by considering the effects of the agency costs associated with corporations and the risk-aversion associated with non-corporate forms of business enterprises on the demand for secured debt. Integrating agency costs and risk-aversion into the debtor decision between secured and unsecured debt suggests a strong bias against secured debt because free assets serve as a safety mechanism for managers similar to Jensen's theory with respect to free cash flow. An analysis of the supply of secured debt and asset securitization illustrates that a significant, if not primary, element of both species offinancing is the radically different way in which secured debt and asset securitization attempt to decrease the likelihood of debtor insolvency. Focusing on this crucial difference explains the disparity in popularity between the forms of financing by suggesting that secured debt is ideally suited for financially marginal debtors but ill-suited for financially healthy debtors. Introduction