Strategic Default, Investment and the Resolution of Financial Distress

Abstract

In recent years the U.S. experienced an increase in the share of default events that are resolved out-of-court, as well as a reduction in bankruptcy-related costs. This trend raises the question as to what drives the frequency with which defaults turn into bankruptcies. We propose a theory based on three pillars: first, bankruptcy is costlier than out-of-court restructuring; second, creditors cannot commit to take defaulting borrowers to court; third, firms have private information about the value of their assets, outside investors only learn them only upon bankruptcy. Creditor’s bargaining power upon default decreases with bankruptcy costs and it increases with the frequency of strategic default – that is, default by firms which could have honored their obligations. When bankruptcy costs decrease, creditors obtain higher recovery rates out-of-court and therefore firms have lower incentives to default strategically. As a result, bankruptcy can occur less frequently.

Keywords: strategic default; limited commitment; recovery rates; credit spreads; bankruptcy; out-of-court restructuring; costly-state-verification, security design; resolution of financial distress; investment

JEL Classification: G30; G33; G34; D82; D86