The Expected Cost of Default

The sample of observed defaults significantly understates the average firm's true expected cost of default due to a sample selection bias. To quantify this selection bias, I use a dynamic capital structure model to estimate firm-specific expected default costs. The average firm expects to lose 45% of firm value in default, a cost higher than existing estimates. However, the average cost among defaulted firms in the estimated model is only 25%, a value consistent with existing empirical estimates from observed defaults. This substantial selection bias helps to reconcile the levels of leverage and default costs observed in the data.</p

Contagion in the European Sovereign Debt Crisis

<p>We use a network model of credit risk to measure market expectations of the potential spillovers from a sovereign default. Specifically, we develop an empirical model, based on the recent theoretical literature on contagion in financial networks, and estimate it with data on sovereign credit default swap spreads and the detailed structure of financial linkages among thirteen European sovereigns from 2005 to 2011. Simulations from the estimated model show that a sovereign default generates only small spillovers to other sovereigns. These results imply that credit markets do not demand a significant premium for the interconnectedness of sovereign debt in Europe.</p

Corporate Taxes, Leverage, and Business Cycles

This paper evaluates quantitatively the implications of the preferential tax treatment of debt in the United States corporate income tax code. Specifically, we examine the economic con- sequences of allowing firms to deduct interest expenses from their tax liabilities on financial variables such as leverage, default decisions and credit spreads. We conduct a series of policy experiments in which the tax deductibility of the corporate interest expense is eliminated. As expected, this results in a substantial decrease in the equilibrium level of leverage. However, contrary to conventional wisdom, we find that eliminating interest deductibility results in an increase in the default frequency and average credit spreads in the economy. The intuition for this lies in the fact that this policy change makes external financing more costly, resulting in riskier firms and higher credit spreads.</p