Default near-the-default-point: the value of and the distance to default

We show that the default event defined by endogenous credit-risk models (i.e. low asset values) can likewise be described in terms of low equity prices and negative net cash-flows (high debt service and/or negative earnings). Specifically, distance-to-default (DD), a volatility-adjusted measure of leverage, is given by the ratio of equity prices to negative net cash flows. This implies that the probability of default is the probability of this ratio becoming small, which then depends on the path of these two variables. This helps to explain why just equity prices (price per share, past return, and volatility) and firm’s debt and profitability are significant in reduced-form models that predict default while Merton’s DD becomes redundant if we control for them [Campbell et al. (2008)]. In endogenous models, default is triggered by depressed equity prices and a negative flow to shareholders (rather than low asset value). And, inversely, default concerns are readily lessened by easing refinancing costs (e.g. sovereigns for which default is costly and which regularly roll over their debts), lowering the principal (underwater mortgages or subprime consumer loans, which increases equity value), or raising equity (troubled banks).