Moral hazard models do explain the use of personal guarantees

Existing studies, e.g., Berger and Udell (1995) and Brick and Palia (2007), find that personal guarantees have no (or even positive) relation with loan spreads. While this result can be closely replicated, it is due to considering firms with already unlimited liability and restricting the sample to credit lines. Reexamining all loan contracts in limited liability firms, we find that loan spreads decline with personal guarantees. This negative relation almost doubles when borrower risk is controlled for. Spreads also decline with guarantor wealth, especially when the loan amount is high relative to guarantor wealth. Consistent with moral hazard models, our results provide fresh insight into the role that owner wealth plays in the features of loan contracts.