Going for Broke: Restructuring Distressed Debt
Posted: 17 Jul 2012 Last revised: 27 Jun 2014
Date Written: November 23, 2013
How should governments and financial intermediaries restructure and optimize portfolios of distressed debt? What are the gains from doing so, and where do the gains come from? This paper shows that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that (a) it requires optimization over all moments, not just mean and variance, and (b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to fixed-income investors, with risk-adjusted certainty equivalent yield pick-ups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current debate regarding the use of eminent domain in mitigating real estate failures.
Keywords: distressed debt, restructuring, pooling, debt overhang, eminent domain
JEL Classification: G11, G13, G33
Suggested Citation: Suggested Citation