The informational wedge between insiders and outsiders is most acute for relatively smaller borrowers (like small businesses and even consumer loans) where the potential lender is unable to readily verify project quality (an adverse selection problem). Not surprisingly, a significant body of empirical research exists in documenting the various ways such adverse selection can be attenuated. However, to examine the borrower-lender loan dynamics in its fullest sense requires the inclusion of those potential borrowers who might want a loan for their businesses but choose to not formally apply because they are sure they will be refused by the bank – otherwise known as “discouraged” borrowers.
While the current body bank lending research, exemplified by the citations in footnote 2, have not included discouraged borrowers in their analysis, there is now a growing body of evidence that appears to suggest that owners of small businesses from certain demographic groups are systematically discouraged from applying for a loan (see, for example, Blanchflower, Levine, and Zimmerman, 2003; and Cavalluzzo, Cavalluzzo, and Wolken, 2002). Given the significant numbers of discouraged borrowers in the population, they cannot be thought of as mere random samples and, thereby, safely ignored from analysis. Ignoring discouraged borrowers from any analysis of credit availability or of the cost of credit is, in fact, likely to bias the relevant parameter estimates since the self selection of applicants may induce lenders to adopt different screening rules than those that would prevail if the discouraged borrowers were to apply.
The US sub-prime mortgage crisis which started from August 2007 has been transformed into a worldwide financial turmoil. The slump in housing prices increased the default on mortgages, the negative effect further amplified by asset securitization. Not only were the US banks suffered, nearly all financial institutions around the world were affected because of their investments in Mortgage Backed Securities (MBS). The US Federal Reserves responded swiftly to rescue the market through cutting interest rates and extending financial support to house buyers and mortgage lenders.
The most dramatic action taken by the US government was the takeover of Fannie Mae and Freddie Mac, two of the most powerful mortgage companies in the US, announced by the Bush administration on 8 September 2008. This move is designed to forestall a collapse in house prices that could plunge America into a new Great Depression and trigger chaos on the world’s financial markets (The Independence, 8 September 2008). Fannie Mae and Freddie Mac together are responsible for half for the US mortgage market which is worth over $10 trillion. The seizure of these two companies puts a federal guarantee behind a $5 trillion of outstanding mortgage debt.
In an interesting article, Fama and French (2001a) document a dramatic decline in the propensity to pay dividends over the last two decades. They find that while 66.5% of listed firms paid dividends in 1978, only 20.8% did so in 1999. Part of this decline in dividend paying propensity is explained by the changing characteristics of listed firms. New lists over the last two decades tend to be smaller firms with more growth opportunities, less history of profitability, and more distant payoffs. Such characteristics make firms less likely to be dividend paying. Even after controlling for changing characteristics, however, the propensity of firms to pay dividends still declined over the last two decades, a phenomenon that Fama and French call “disappearing dividends.”
The Fama and French (2001a) findings are striking and demand an explanation. Why did dividends lose their popularity between the 1970s and the 1990s? DeAngelo, DeAngelo, and Skinner (2004) show that the dollar supply of dividends, which is concentrated among large payers, has not declined over the period that dividends have disappeared. Thus, the declining propensity to pay dividends mainly reflects the decreasing interest in attaining dividend paying status by smaller firms who initiate and pay small dollar dividends. The puzzle is why the desire of such firms to attain dividend paying status lost popularity between the 1970s and the 1990s.
