A Theory of Debt Overhang and Buyback

sovereign debt, sovereign default, debt overhang, buyback

Equilibrium Default Cycles

This paper analyzes Markov equilibria in a model of strategic lending in which (i) agents cannot commit to long-term contracts, (ii) contracts are incomplete, and (iii) incumbent lenders can coordinate their actions. Default cycles occur endogenously over time along every equilibrium path. After a sequence of bad shocks, the borrower in a competitive market accumulates debt so large that the incumbent lenders exercise monopoly power. Even though the incumbents could maintain this power forever, they find it profitable to let the borrower regain access to the competitive market after a sequence of good shocks. Equilibria are computed numerically, and their attributes are qualitatively consistent with numerous known empirical facts on sovereign lending. In addition, the model predicts that a borrower who accumulates debt overhang will regain access to the competitive credit market only after good shocks. This prediction is shown to be consistent with data on emerging market economies.

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Impatience vs. Incentives ∗

This paper studies the long-run dynamics of Pareto-optimal self-enforcing contracts in a repeated principal-agent framework with differential discounting. In such a setting, impatience concerns encourage contracts to favor the patient player in the long run and incentive concerns encourage contracts to favor the agent in the long run. When these two forces are aligned or one is relatively strong, we show that every Pareto-optimal self-enforcing contract converges to a steady state in the long run in a well-behaved way. In particular, the results of Ray (2002) and Lehrer and Pauzner (1999) can be recovered as limiting cases. However, when the forces are opposed and of comparable strength, our main result is that some Paretooptimal self-enforcing contracts deterministically oscillate between agent-preferred and principal-preferred states. Oscillation may be damped- so that in the long run a steady state is reached; or explosive until the allocation reaches one of the participation constraints and then alternates between a pair of states forever

Who Should Pay for Credit Ratings and How? ∗

This paper analyzes a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on the unobservable effort exerted by a credit rating agency (CRA). We analyze optimal compensation schemes for the CRA that differ depending on whether a social planner, the firm, or investors order the rating. We find that rating errors are larger when the firm orders it than when investors do. However, investors ask for ratings inefficiently often. Which arrangement leads to a higher social surplus depends on the agents ’ prior beliefs about the project quality. We also show that competition among CRAs causes them to reduce their fees, put in less effort, and thus leads to less accurate ratings. Rating quality also tends to be lower for new securities. Finally, we find that optimal contracts that provide incentives for both initial ratings and their subsequent revisions can lead the CRA to be slow to acknowledge mistakes