Debt Write-Downs and Debt-Equity Swaps in the Two Sector Model
26 Pages Posted: 18 Apr 2007 Last revised: 14 Jul 2010
Date Written: September 1989
"Debt overhang" models have motivated the possibility of Pareto-improving "market-based debt-reduction schemes" under an assumption of creditor seizure in bad states. These models usually reach the conclusion that while pure debt forgiveness is in the interest of debtor nations, debt repurchase programs are not. This paper introduces a "safe sector" into the debtor nation which is unexposed to seizure during default states. Two important results which emerge are that debt forgiveness is not necessarily in the interest of all debtors, and the potential for Pareto-improving debt-equity swaps is magnified.
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