Debt Overhang in a Business Cycle Model
42 Pages Posted: 24 Apr 2010 Last revised: 15 Dec 2010
Date Written: December 9, 2010
We study the macroeconomic implications of the debt overhang distortion. In our model, the distortion arises because investment is noncontractible - when a firm borrows funds, the debt contract cannot specify or depend on the firm's future level of investment. After the debt contract is signed, the probability that the firm will default on its debt obligation acts like a tax that discourages its new investment, because the marginal benefit of that investment will be reaped by the creditors in the event of default. We show that the distortion moves countercyclically: It increases during recessions, when the risk of default is high. Its dynamics amplify and propagate the effects of shocks to productivity, government spending, volatility, and funding costs. Both the size and the persistence of these effects are quantitatively important. The model replicates important features of the joint dynamics of macro variables and credit risk variables, like default rates, recovery rates and credit spreads.
Keywords: Debt Overhang, Default, Credit Risk, Financial Frictions, Financial-Accelerator
JEL Classification: E32, E44
Suggested Citation: Suggested Citation