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Samenvatting economics of insolvency 15/20
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THE ECONOMICS OFISOLVENCY
,Inhoud
1. Class 1 ................................................................................................ Error! Bookmark not defined.
1.2 Some stylized facts ........................................................................................................................ 4
1.2.1 Financial distress & bankruptcy.............................................................................................. 4
1.2.2 Recent developments............................................................................................................. 6
1.2.3 The Rise of Zombies................................................................................................................ 6
1.2.4 Industry differences................................................................................................................ 7
1.2.5 Costs ....................................................................................................................................... 7
1.3 An economic perspective on bankruptcy& insolvency ................................................................. 8
1.3.1 Financial & Economic distress- terminology .......................................................................... 8
1.3.2 Reasons of Financial Distress.................................................................................................. 9
1.3.3 Ways to resolve Financial Distress ......................................................................................... 9
1.3.4 The Goals of a bankruptcy procedure .................................................................................. 10
1.3.5 The need for a formal bankruptcy procedure ...................................................................... 10
1.4 Some key features of US Bankruptcy Law ................................................................................... 11
1.4.1 Important features of US bankruptcy law (Ch7 &11)........................................................... 11
1.4.2 Life-cycle of a Chapter 11 ..................................................................................................... 12
1.4.3 Ch 7 vs Ch 11 ........................................................................................................................ 12
1.4.4 Private vs court-supervised restructuring in the US............................................................. 13
1.5 A law and finance perspective on bankruptcy ............................................................................ 13
1.5.1 The bankruptcy code as a corporate governance mechanism............................................. 13
1.5.2 The law and finance view ..................................................................................................... 13
1.6 Determinants of private credit .................................................................................................... 14
1.6.1 A Simple model of Contigent Control ................................................................................... 14
1.6.2 A simple Lemons problem .................................................................................................... 20
1.7 Debt enforcement around the world .......................................................................................... 22
2. Optimal capital structure & costs of distress ................................................................................ 25
2.1 Perfect markets ..................................................................................................................... 26
2.2 Modigliani Miller- Capital structure&value ........................................................................... 26
2.3 Trade-off theory I adding taxes ............................................................................................. 27
2.3.1 The interest tax deduction ............................................................................................ 28
2.4 Trade-off theory II: Adding Financiel Distress Costs.............................................................. 30
2.4.1 Optimal leverage with financial distress costs .............................................................. 30
2.4.2 Financial distress and optimal capital structure............................................................ 30
2.4.3 Costs of bankruptcy & financial distress .............................................................................. 31
2.4.4 Direct costs ........................................................................................................................... 31
1
, 2.4.5 Indirect costs ........................................................................................................................ 32
2.4.7 Who pays of financial distress costs ..................................................................................... 35
2.4.8 Optimal leverage .................................................................................................................. 36
2.5 Bond valuation and costs of distress ..................................................................................... 36
3. Agency costs and benefits of debt ................................................................................................ 36
3.1 Outline ................................................................................................................................... 36
3.2 Security payoffs in a levered firm .......................................................................................... 37
3.2.1 Equity as a call option .................................................................................................... 37
3.2.2 Debt as an option portfolio .................................................................................................. 38
3.2.3 From risky to riskless debt .................................................................................................... 39
3.2.4 The Empty creditor problem ................................................................................................ 39
3.3 Equity holder conflicts ........................................................................................................... 39
3.4 Risk shifting and asset substitution ....................................................................................... 40
3.4.1 An example .................................................................................................................... 40
3.4.2 Exercise: credit rationing ............................................................................................... 42
3.4.3 The role of limited liability............................................................................................. 42
3.5 Debt overhang ....................................................................................................................... 43
3.5.1 Example ................................................................................................................................ 43
3.5.2 Under-investment ................................................................................................................ 44
3.5.3 Cashing out ........................................................................................................................... 44
3.5.4 Debt covenants..................................................................................................................... 45
3.6 Strategic default .................................................................................................................... 45
3.6.1 Strategic vs liquidity defaults ........................................................................................ 45
3.6.2 Summary........................................................................................................................ 45
3.7 Reluctance to liquidate.......................................................................................................... 46
3.7.1 Continue, restructure, liquidate .................................................................................... 46
3.7.2 The reluctance to liquidate problem ............................................................................. 48
3.7.3 Exercise: The Reluctance to liquidate problem ............................................................. 48
3.8 Motivating managers- the agency benefits of leverage........................................................ 49
3.8.1 Manager- Investor agency problems............................................................................. 49
3.8.2 Agency benefits of leverage .......................................................................................... 49
7.9 The Trade-off Theory Revisted .................................................................................................... 50
4. Bankruptcy negotiations ............................................................................................................... 51
4.1 Outline of lecture .................................................................................................................. 51
4.2 Asset restructuring ................................................................................................................ 51
4.2.1 Background reading....................................................................................................... 51
2
, 4.2.2 Restructuring assets to resolve financial distress ......................................................... 51
4.2.3 Fire Sales ........................................................................................................................ 52
4.3 Debt restructuring ................................................................................................................. 53
4.3.1 Background reading....................................................................................................... 53
4.3.2 Restructuring Debt to Resolve Financial Distress .......................................................... 53
4.3.3 The Holdout problem- Basic Intuition ........................................................................... 53
4.3.4 The Holdoutproblem: Remedies ................................................................................... 54
4.4. Bargaining theory ....................................................................................................................... 55
4.4.1 Cooperative Bargaining ........................................................................................................ 55
4.4.2 A generic bargaining problem .............................................................................................. 55
4.4.3 Nash bargaining solution ...................................................................................................... 56
4.4.4 Generalized Nash bargaining solution.................................................................................. 56
4.4.5 Bargaining in Default ............................................................................................................ 57
5. Bankruptcy negotiation game ....................................................................................................... 58
5.1 The Setup............................................................................................................................... 58
5.2 Bargaining game- discussion ................................................................................................. 60
5.2.1 Possible Outcomes ........................................................................................................ 60
5.2.2 Cram-down options ....................................................................................................... 60
5.2.3 Take-away points........................................................................................................... 60
6. ............................................................................................................................................................ 61
1. Introduction
• Selected chapters from textbooks:
• Altman, Hotchkiss, and Wang (2019), Corporate Financial Distress, Restructuring, and Bankruptcy,
Wiley 4th edition
• Berk, DeMarzo (2020), Corporate Finance, Pearson 4th or 5th edition
• Both available as ebooks via the library
• Articles:
• Hotchkiss, John, Mooradian, and Thorburn (2008), Bankruptcy and the Resolution of Financial
Disstress, Ch. 14 in Handbook of Empirical Corporate Finance Vol. 2
• Further articles mentioned in syllabus and on slides
3
,1.2 Some stylized facts
1.2.1 Financial distress & bankruptcy
High Yield Bond Market = bonds who have a risk of default → promise high return to investors to
compensate this
Probality of default of B-rating bond: 2.5% default rate in longrun average <-> recessions: 8%
➔ There is a huge volume of bonds that are traded that carry risk of default
➔ Insolvency is very relevant and this market increased a lot in recent years
Lehman Brothers biggest bankruptcy case in US → based on the amount of liabilities you have
(697,846) = having a lot of liabilities is a part of the business model of banks
Lehman Brothers had more liabilities than the BBP of Belgium
Can cause economic disrupters
Bankruptcy: there was a legal procedure
4
,Time clustering: bankruptcy’s happen together lots of time
(happened in railroad companies)
Why is the financial crisis not that much a big spike: not enough data in this graphic (not all
companies are included)
At which times bankruptcies are high? ➔ Great depression: recessions <-> booms
Zoom in on last spikes (here the financial sector is added)
Second spike is financial crisis
Relation to economic circumstances (negative correlation)
A part of credit risk is systematic (more defaults in times where it goes bad economically)
5
,1.2.2 Recent developments
During COVID: not a big spike
1) government help
2) not a period of high interest rate
-Bankrupcties went down during COVID (30%)
= is it just a delay of the problem
<-> sharp increase in 2022
Bankrupcties have a negative correlation: but is it really a bad thing: is it a bad thing that a company
with a bad bussiness plan dissapears?
GEV: whether you want to continue the company and restrecture or do you liquidate → use active in
a more useful way?
1.2.3 The Rise of Zombies
Reading: Banerjee and Hofmann (2018, link)
“The corporate landscape, it is said, has turned from one filled with red-blooded creatures of creative
destruction to a grey zone of the living dead, incapable of innovation or dynamism.”
= the risk of going bankrupt provides incentives to innovatie, to produce good quality products,
6
,wheras if you know you never can go bankrupt this kills all creativity
If a stakeholder knows he will not get his money back → no use of putting effort in the company
➔ keeping this companies alive affects productivity
= it cannot survive with outside support (the cash flow is not enough to cover the debts) = its just
kept alive by buying new money all the time so you can pay your debtors
Firm with good business model but there is financial distress → can be profitable again in the future
→ maybe good idea to keep them alive
Banks don’t want to write off there previous investments so they want to keep these firms alive (they
want to be paid self)
CONLC: Bankruptcy isn’t necessary bad
1.2.4 Industry differences
- energy (light blue bar): high risk: did you find the gold or oil? No : bankruptcy
<-> insurance: low risk
Concentration of bankruptcy in certain industries: transportation in 2021 due to the Covid Crisis (no
tourism → problem for airlines)
1.2.5 Costs
• Bankruptcy is costly:
• Direct costs (e.g., for lawyers, accountants, turnaround specialists, …) estimated at 1-3% of firm
value (lots of money if you apply this to Lehman Brothers)
• Indirect costs (e.g., loss of customers, suppliers, key employees, …) estimated at 10-20% of firm
value
• Huge variation depending on sample/estimation and with bankruptcy procedure, size, creditor
structure …
A lot of firm value is destroyed: the reason is not the financial distress perse, but just the costs if
you apply for a bankruptcy procedure (see next week)
= its not because you cannot repay your debts
7
,1.3 An economic perspective on bankruptcy& insolvency
1.3.1 Financial & Economic distress- terminology
• Firms facing economic distress are characterized by low or negative operating profitability and
have questionable going concern value even in the absence of leverage.
= low operating performance: questionable going concern value
= not valuable anymore: assets are worth more in other ways → liquidation is a good idea
= the workers would perform better somewhere else
! this does not depend on the financial structure of the firm
• Firms facing financial distress can be viable as going concerns, but are currently having difficulty
repaying debts (or face imminent risk of getting into such difficulties).
= you cannot repay your debts, but can realise extreme high cash flow in 2-3 years
= liquidity problems, but they are profitable in an economic sense
• Cash flow insolvency: When a firm cannot meet its current (debt) repayment obligations due to
the lack of liquid assets.
= lots of assets for example but you don’t have enough cash flow
= lot inliquid assets can be worth a lot
• Balance sheet insolvency: When a firm’s total liabilities exceed the fair valuation of its total assets.
→ Implies financial distress when debt is at / close to maturity.
total assets < total liabilities
= from economic point of view this is where we look at → this shows that you really will go bankrupt
eventually
• Default occurs when a debtor violates a condition of an agreement with a creditor.
• Bankruptcy: Sometimes used akin to insolvency. Mainly refers to the legal status of an entity
unable to repay its outstanding debts (initiated by debtor and imposed by a court).
= you go to a court and you initiate the formal process and you get the protection of this procedure
In the US bankruptcy and insolvency are used for the same thing
= usually initiated by the debtor
This legal construction exits not that long <-> debts slavery: you and your family have to work off the
debts
= bankruptcy is also protection: you are protected against the creditors
• Bankruptcy/insolvency law is written in terms of present cash (“liquidity”) and not in terms of (the
value of) future cash flows.
➔ The main question for efficiency: should it continue to exits
no: liquidation can be a good idea
Present cash is the most important: not present cash now → you go default <-> even if you have a
good future perspective
<-> for the validation of a firm people will look more to the future cash flow
➔ Value aspect (economic distress: is the value of economic cash flow high enough) <-> financial
distress
= but most of the time they go hand in hand: having a bad business model will also result in financial
distress
8
, Which decision gives the highest value
• A company with a bright outlook (agreement?) might face insolvency today.
• Financial distress (difficulty to honor debt payment) and economic distress (non-viable business
model) are different concepts.
• Empirically, financial and economic distress often occur simultaneously.
1.3.2 Reasons of Financial Distress
• Economic distress, e.g., low operating performance due to
• competitive pressure,
• lack of technological innovation,
• demand shocks, deregulation, input price shocks, …
• Financial reasons such as
• high leverage,
• rollover risk, (one dead contract is running out, you want to replace it with another one: can
depend on market conditions)
• funding and liquidity shocks, …
= if these shocks affect the capital -> the value of your corporation increases (so also has effect on
the economic side)
• Bad management decisions?
→ Mechanisms to resolve financial distress can aim at restructuring assets or financial contracts.
The manager can affect these things: investment in the wrong R&D, structured debts badly
<-> incentives: managers want to avoid bankruptcy because there job is linked to the firm: the threat
of going to financial distress creates incentives to avoid this
= sometimes it turns out management took the wrong decision <-> ex ante creation of incentives
1.3.3 Ways to resolve Financial Distress
• Asset restructuring: Usually complete or piecemeal sale of assets (“liquidation”).
= use the proceeds of the liquidation to pay the debtors
= you don’t have to liquidate the whole firm: some assets can be enough
Liquidation does not mean that the firm stops to operate (continuitation)
• Financial restructuring:
• Restructure existing debt – lower interest or principal payments, extend maturity,
= approach the debts holders
• Distressed exchange: Replace debt with equity securities (or new debt),
= you approach debts holders: are you fine with selling contract and exchange it for an equity share
(or a new debt: but this is the same as restructuring existing debt)
= usually done by a market instead of approaching the debtor itself
Why is this useful? A debt contract specifies hard repayments: ‘you have to repay this’ <-> the equity:
whatever is left after debtors are paid (can be zero or very low): contract with no legal rights to do
hard repayments
• Capital injection: Issue new claims to raise current liquidity
= to raise new money
= is what the Zombie Firms do
(not that easy in reality)
9
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