Theory and Evidence on the Resolution of Financial Distress

Abstract:     
This paper models financial distress of an owner-managed project. As a result of a negative shock to project value, financial distress occurs in three stages: default-no-default, reorganization-foreclose, sell the foreclosed asset immediately-delay the asset sale. Factors that impact equilibrium outcomes include the severity of the shock to project fundementals, the quality of asset management, and the liquidity of outside investors. Borrower default is endogenous in our model, in the sense that the anticipated outcome of default can determine whether or not default occurs in the first place. Model predictions include that the reorganization-foreclosure decision depends crucially on the interaction between project value and industry liquidity and that the lender waits for the industry to recapitalize before selling assets obtained through foreclosure. An empirical analysis of a large sample of defaulted commercial real estate loans supports many of the predictions of the model, including the existence of endogenous borrower default, significant underinvestment on foreclosed assets, and delayed asset sales in response to weak industry conditions.

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