Credit Risk, Default Loss, and the Economics of Bankruptcy
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.
|Date of creation:||30 Mar 2009|
|Contact details of provider:|| Postal: 150 St. George Street, Toronto, Ontario|
Phone: (416) 978-5283
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- 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.
- 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 449-470, May.
- 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.
- 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 311-349, June.
- 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 747-769, July.
- Sanjiv R. Das & Darrell Duffie & Nikunj Kapadia & Leandro Saita, 2007. "Common Failings: How Corporate Defaults Are Correlated," Journal of Finance, American Finance Association, vol. 62(1), pages 93-117, 02.
- 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.
- Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
- Easterbrook, Frank H., 1990. "Is corporate bankruptcy efficient?," Journal of Financial Economics, Elsevier, vol. 27(2), pages 411-417, October.
- 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.
- Michael C. Jensen, 1991. "Corporate Control And The Politics Of Finance," Journal of Applied Corporate Finance, Morgan Stanley, vol. 4(2), pages 13-34.
- Gertner, Robert & Scharfstein, David, 1991. " A Theory of Workouts and the Effects of Reorganization Law," Journal of Finance, American Finance Association, vol. 46(4), pages 1189-1222, September.
- 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.
- 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.
- Fisher, Lawrence, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 625-627, July.
- Eberhart, Allan C & Sweeney, Richard J, 1992. " Does the Bond Market Predict Bankruptcy Settlements?," Journal of Finance, American Finance Association, vol. 47(3), pages 943-980, July.
- 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 157-192, April.
- 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 1403-1430, September. Full references (including those not matched with items on IDEAS)
When requesting a correction, please mention this item's handle: RePEc:tor:tecipa:tecipa-354. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (RePEc Maintainer)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.