Credit rationing, bankruptcy cost, and the optimal debt contract for small business

An examination of whether the costly random verification scheme affects the optimal debt contract for small business. It finds, contrary to Townsend (1979) and Williamson (1986, 1987), that the standard debt contract is the optimal debt contract with the costly random verification scheme.Discrimination in consumer credit ; Bankruptcy ; Debt ; Small business

Pricing Rare Event Risk in Emerging Markets

This paper solves the pricing problem of an merging market debt contract in which the borrower’s economy is subject to rare event risk. Our model combines elements of a reduced form and a structural model of debt pricing. Rare event risk is modeled as a sudden event in fundamentals, and we study the role of the debt contract in providing risk sharing between the borrower and the lender. The two main frictions under consideration in our equilibrium model are limited participation of the lender through the debt contract, and heterogeneous beliefs between the borrower and the lender about the likelihood of a rare event. We solve for the rate of interest, the credit spread, the risk premium, the write-off (recovery rate) in case of default, and the dynamics of the debt contract in non-default times. We find that limited participation combined with heterogeneous beliefs has strong e®ects on the level and variability of the debt contract propertiesRare Event Risk, Emerging Markets, Exchange Economy, Heterogeneous Beliefs, Incomplete Market

Incentive Effects of Funding Contracts: An Experiment

We examine the incentive effects of funding contracts on entrepreneurial effort decisions and allocative efficiency. We experiment with four types of contracts (standard debt contract, outside equity, non-monotonic contract, full-subsidy contract) that differ in the structure of investor repayment and, therefore, in the incentives for entrepreneurial effort provision. Theoretically the replacement of a standard debt contract by a repayment-equivalent non-monotonic contract reduces effort distortions and increases efficiency. We test this non-monotonic-contracts hypothesis in the laboratory as well. Our results reveal that the incentive effects of funding contracts need to be experienced before they reect in observed behavior. With sufficient experience observed behavior is consistent with the theoretical predictions and supports the non-monotonic-contracts hypothesis: we find that the replacement of a standard debt contract by a repayment-neutral non-monotonic contract increases entrepreneurial income by 170% and total surplus by 30% in our setting.hidden information, funding contracts, incentives, experiment, standard debt contract, non-monotonic contract

"Strategic Default Jump as Impulse Control in Continuous Time"

This paper presents a new approach for modeling an optimal debt contract in continuous time. It examines a competing contract design in a continuous-time environment with Markov income shocks and costly veri able information. It shows that an optimal contract has the form of a long-term debt contract that permits a debtor's strategic default and debt restructuring. The default is characterized by a recurrent, optimal impulse control beyond default. Numerical examples show that the equilibrium probability of the default is decreasing in the monitoring technology level when the default causes a big wealth loss.

Sovereign Debt Contract and Optimal Consumption-Investment Strategies

We present a model in which a sovereign country optimally decides on its consumption and investment policies as well as on the optimal time to default. In the paper we allow the sovereign borrower to keep the fraction of its augmented wealth in so-called international reserves. We further assume that these reserves can be deposited at the risk-free rate. In this framework, we obtain analytical solutions for optimal consumption and investment rules, as well as formulas for optimal default boundary and the value of the risky loan. In the paper we assume that in the case of default the lender can impose economic and political sanctions against the borrower and also can seize an implicit collateral. We show that when the country is getting very close to its default wealth level, then its relative risk aversion decreases and the country increases its consumption rate and the risky investment fraction at the expense of available liquid reserves.sovereign debt; international reserves; strategic default

Willingness to pay and the sovereign debt contract

This paper uses a contract theory model to argue that covenants ruling debt renegotiations are important to assure the sovereign willingness to pay. The model includes the following features: first, collective action clauses, exit consents, aggregation provisions and pari passu clauses play an important role in the post default “game” of negotiations and coalitions. These covenants are represented in reduced form by the endogenous probability of refinancing a defaulted sovereign debt. Second, the model has “endogenous bad luck” because the unfavorable state of nature where default occurs depends on the level of indebtedness, which is itself an endogenous variable. Third, “vultures”, contrary to conventional wisdom, tend to improve the access of emerging economies to capital markets because they might help to rule out strategic defaults. And fourth, under special assumptions the model is able to analyze the possibility of post default discrimination between domestic and foreign bondholders.debt, default, negotiation, vultures, Shapley-values

The case of the undying debt

The French government currently honors a very unusual debt contract: an annuity that was issued in 1738 and currently yields €1.20 per year. I tell the story of this unique debt, which serves as an anecdotal but symbolic summary of French public finances since the 18th century.Debts, Public

Debt overhang and credit risk in a business cycle model

We study the macroeconomic implications of the debt overhang distortion. In our model, the distortion arises because investment is non-contractible—when a firm borrows funds, the debt contract cannot specify or depend on the firm’s future level of investment. After the debt contract is signed, the probability that the firm will default on its debt obligation acts like a tax that discourages its new investment, because the marginal benefit of that investment will be reaped by the creditors in the event of default. We show that the distortion moves countercyclically: It increases during recessions, when the risk of default is high. Its dynamics amplify and propagate the effects of shocks to productivity, government spending, volatility and funding costs. Both the size and the persistence of these effects are quantitatively important. The model replicates important features of the joint dynamics of macro variables and credit risk variables, like default rates, recovery rates and credit spreads.Corporations - Finance ; Debt ; Business cycles ; Risk

Debt Contracts, Collapse and Regulation as Competition Phenomena

We study a credit market with adverse selection and moral hazard where sufficient sorting is impossible. The crucial novel feature is the competition between lenders in their choice of contracts offered. Qualities of investment projects are not observable by banks and investment decisions of entrepreneurs are not contractible, but output conditional on investment is. We explain the empirically observed prevalence of debt contracts as an equilibrium phenomenon with competing lenders. Equilibrium contracts must be immune against raisin-picking by competitors. Non-debt contracts allow competitors to offer sweet deals to particularly good debtors, who will self-select to choose such a deal, while bad debtors distribute themselves across all offered contracts. Competition of banks introduces three possibilities for a breakdown of credit markets that do not occur when a bank has a monopoly. First, average returns decrease since banks compete for good lenders which may make the lending altogether unprofitable. Second, banks can have an incentive to offer a debt contract and additional equity contracts to intermediate debtors. This combination, however, is in turn dominated by a simple debt contract that is only attractive for very good entrepreneurs. As a result no equilibrium in pure strategies exists. Existence can be restored, if the permissible types of contracts are limited by regulation resembling the separation of investment and commercial banking in the U.S. Third, allowing for random delivery on credit contracts leads to a break-down since all banks want to avoid the contract with the highest chance of delivery: that contract attracts all bad entrepreneurs.contract;debt contract;adverse selection;moral hazard;competition;financial collapse;regulation