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Credit Risk, Default Loss, and the Economics of Bankruptcy

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  • John F. Crean
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    Abstract

    The negotiating strategies of parties to a corporate bankruptcy are shaped by the rules and procedures of bankruptcy law. The rules have an asymmetric impact on the debtor and its creditors. To analyze the effect of this asymmetry, the paper develops a model of bankruptcy negotiation based on a binomial process for firm value. The analysis produces five novel results. First, bankruptcy rules are shown to produce incentives which lead to significant deviations from strict priority even when the costs of bankruptcy are negligible. This result is consistent with observed high levels of deviation from strict priority. Under conditions of pure risk with no uncertainty, the model predicts that a ‘pre-packaged’ bankruptcy plan incorporating deviations from strict priority will negotiated before any filing. Deviations from strict priority – and creditor losses – are seen to be highly sensitive to firm volatility and to the maximum protection period allowed by bankruptcy rules. Second, in the presence of bankruptcy costs, risk free (or martingale) pricing for claims on the bankrupt corporation is shown to be inappropriate since the requisite hedges cannot be formed. Third, the introduction of uncertainty produces conditions where pre-pack negotiations will fail and where periods of protection will be prolonged. Fourth, the model identifies a shareholder interest in postponing many opportunities for restructuring even where such reorganization raises the value of the firm. Longer allowable protection periods increase the significant deadweight costs arising from this mechanism. Finally, when applied to the pre-filing period, the model allows the timing for a filing to be treated as a choice variable for both the debtor and its creditors. The choice is shown to be crucially dependent on the likely results of any bankruptcy filing, and hence on the volatility and trend in firm value. The model identifies the essential interdependence of bankruptcy strategies of the debtor and its creditors which is typical of most bankruptcies.

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    File URL: http://www.economics.utoronto.ca/public/workingPapers/tecipa-354.pdf
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    Bibliographic Info

    Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-354.

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    Length: 51 pages
    Date of creation: 30 Mar 2009
    Date of revision:
    Handle: RePEc:tor:tecipa:tecipa-354

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    Keywords: Bankruptcy; Default; Loss; Recovery; Bond Pricing;

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    References

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    1. Fisher, Lawrence, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 625-27, July.
    2. Easterbrook, Frank H., 1990. "Is corporate bankruptcy efficient?," Journal of Financial Economics, Elsevier, vol. 27(2), pages 411-417, October.
    3. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    4. Sanjiv Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2006. "Common Failings: How Corporate Defaults are Correlated," NBER Working Papers 11961, National Bureau of Economic Research, Inc.
    5. Baird, Douglas G & Picker, Randal C, 1991. "A Simple Noncooperative Bargaining Model of Corporate Reorganizations," The Journal of Legal Studies, University of Chicago Press, vol. 20(2), pages 311-49, June.
    6. Franks, Julian R & Torous, Walter N, 1989. " An Empirical Investigation of U.S. Firms in Reorganization," Journal of Finance, American Finance Association, vol. 44(3), pages 747-69, July.
    7. Mooradian, Robert M, 1994. " The Effect of Bankruptcy Protection on Investment: Chapter 11 as a Screening Device," Journal of Finance, American Finance Association, vol. 49(4), pages 1403-30, September.
    8. Robert Gertner & David Scharfstein, 1991. "A Theory of Workouts and the Effects of Reorganization Law," NBER Technical Working Papers 0103, National Bureau of Economic Research, Inc.
    9. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    10. Eberhart, Allan C & Sweeney, Richard J, 1992. " Does the Bond Market Predict Bankruptcy Settlements?," Journal of Finance, American Finance Association, vol. 47(3), pages 943-80, July.
    11. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
    12. John, Kose & Lang, Larry H P & Netter, Jeffry, 1992. " The Voluntary Restructuring of Large Firms in Response to Performance Decline," Journal of Finance, American Finance Association, vol. 47(3), pages 891-917, July.
    13. Michael C. Jensen, 1991. "Corporate Control And The Politics Of Finance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(2), pages 13-34.
    14. Daigle, Katherine H & Maloney, Michael T, 1994. "Residual Claims in Bankruptcy: An Agency Theory Explanation," Journal of Law and Economics, University of Chicago Press, vol. 37(1), pages 157-92, April.
    15. Aivazian, Varouj A. & Callen, Jeffrey L., 1983. "Reorganization in bankruptcy and the issue of strategic risk," Journal of Banking & Finance, Elsevier, vol. 7(1), pages 119-133, March.
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