Strategic Default, Investment and the Resolution of Financial Distress

49 Pages Posted: 11 Dec 2018

See all articles by Nika Koreli

Nika Koreli

University of Warwick, Faculty of Social Studies, Department of Economics

Giulio Trigilia

University of Rochester - Simon Business School

Date Written: November 19, 2018

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

Suggested Citation

Koreli, Nika and Trigilia, Giulio, Strategic Default, Investment and the Resolution of Financial Distress (November 19, 2018). Available at SSRN: https://ssrn.com/abstract=3285447 or http://dx.doi.org/10.2139/ssrn.3285447

Nika Koreli

University of Warwick, Faculty of Social Studies, Department of Economics ( email )

Coventry, CV4 7AL
United Kingdom

Giulio Trigilia (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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