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Credit Risk, Default Loss, and the Economics of Bankruptcy

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  • John F. Crean

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.

Suggested Citation

  • John F. Crean, 2009. "Credit Risk, Default Loss, and the Economics of Bankruptcy," Working Papers tecipa-354, University of Toronto, Department of Economics.
  • Handle: RePEc:tor:tecipa:tecipa-354
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    File URL: https://www.economics.utoronto.ca/public/workingPapers/tecipa-354.pdf
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    References listed on IDEAS

    as
    1. 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 611-625, July.
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    More about this item

    Keywords

    Bankruptcy; Default; Loss; Recovery; Bond Pricing;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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