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Formal Bankruptcy: Strategic Debt Service with Senior and Junior Creditors

  • Adriana Breccia

    (University of York)

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    A crucial aspect of debt restructuring is the redistribution of value among many diverse interests, differing in priority, collateral and bargaining power. Focusing on renegotiable debt contracts in a continuous-time framework, we characterise the U.S corporate bankruptcy renegotiation (Chapter 11) in a game-theoretic framework. In formal bankruptcy, the equity holders can renegotiate with one creditor at a time. Unlike previous studies, this allows us to endogenise not only the bankruptcy threshold but also the impairment strategy. Moreover, our game-theoretic setting allows us to explicitly introduce and accommodate varying bargaining powers of claimants. First, we show that there exists a unique sequence of equilibrium restructuring plans and impairment strategies which allows us to derive simple and intuitive closed-form solutions for pricing different classes of debt. Secondly, the model provides a theoretical explanation for cases of seniority reversal. Thirdly, we derive sufficient conditions for the senior credit spread to be smaller than the junior one at all levels of the state variable.

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    File URL: http://www.bbk.ac.uk/ems/research/wp/PDF/BWPEF0411.pdf
    File Function: First version, 2004
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    Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 0411.

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    Date of creation: Nov 2004
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    Handle: RePEc:bbk:bbkefp:0411
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    1. Welch, Ivo, 1997. "Why Is Bank Debt Senior? A Theory of Asymmetry and Claim Priority Based on Influence Costs," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1203-36.
    2. Fan, Hua & Sundaresan, Suresh M, 2000. "Debt Valuation, Renegotiation, and Optimal Dividend Policy," Review of Financial Studies, Society for Financial Studies, vol. 13(4), pages 1057-99.
    3. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-56, June.
    4. Rajan, Raghuram & Winton, Andrew, 1995. " Covenants and Collateral as Incentives to Monitor," Journal of Finance, American Finance Association, vol. 50(4), pages 1113-46, September.
    5. Suresh M. Sundaresan, 2000. "Continuous-Time Methods in Finance: A Review and an Assessment," Journal of Finance, American Finance Association, vol. 55(4), pages 1569-1622, 08.
    6. Brown, David T, 1989. "Claimholder Incentive Conflicts in Reorganization: The Role of Bankruptcy Law," Review of Financial Studies, Society for Financial Studies, vol. 2(1), pages 109-23.
    7. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
    8. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474.
    9. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    10. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    11. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
    12. Leland, Hayne E, 1994. " Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 49(4), pages 1213-52, September.
    13. Sundaresan, S.M., 2000. "Continuous-Time Methods in Finance: A Review and an Assessment," Papers 00-03, Columbia - Graduate School of Business.
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