In this paper we present circumstances under which the possibility of high leverage can lead to widespread default and national crises. In models with incomplete markets, default and production, there will almost always be a mismatch between firm output across states of nature and asset promises. Default mechanisms are crucial institutions in allowing trade to go forward. We suppose that defaulters are forced to pay for as much of their debt as they can out of the money and goods they have on hand, and they are not punished. No provision is made for goods in process that might be worth more later if the firm were not required immediately to sell all its assets but instead were permitted to continue to produce even after defaulting. We thus assume that default incurs liquidation costs. If a firm is a debtor and finds that it must default in some state of the world because its productivity is unusually low, these liquidation costs will magnify the productivity shock. But if a firm anticipates that in some state of the world many of its competitors will default and go out of business, then it will anticipate that its output will sell for a much higher price in that state. The firm would thus try hard to adjust its production plan to remain in business in that state, and national crises will be curtailed. However, if through some mechanism (e.g. dollar denominated debt in developing countries) the debt burden to a firm that remains in business in the state where many firms default will also grow, a typical firm may find that remaining in business in the state is more expensive, not more profitable. Thus the firm will not try to avoid the kinds of loans that lead to default in that state. In short, a borrowing firm does not take into account the externality that leveraging its debt makes it more likely that other firms in the same industry will default. Since lenders and borrowers will then rationally anticipate higher defaults even for high collateral loans, they will be led to agree to loans with lower collateral (higher leverage) and widespread default cannot be avoided.
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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number
557.
Length: Date of creation: 2004 Date of revision: Handle: RePEc:red:sed004:557
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Find related papers by JEL classification: D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models