Using a large sample of small-to-medium size firms that defaulted on their bank debt in France,
Germany, and the UK, we find that large differences in creditors' rights across countries lead
banks to adjust their lending and reorganization practices to mitigate the expected creditor-unfriendly
aspects of bankruptcy law. In particular, French banks respond to a creditor-unfriendly code by
requiring more collateral than lenders elsewhere, and by relying on particular collateral forms that
minimize the statutory dilution of their claims in bankruptcy. Despite such adjustments, bank recovery
rates in default remain sharply different across the three countries, reflecting different levels of
creditor protection. Notwithstanding the high level of creditor protection and low expected losses
from default, pre-distress loan spreads in the UK are not lower than elsewhere. We conclude that,
despite significant adjustments in lending practices, bankruptcy codes still sharply affect default outcomes.
Do strategic actions of borrowers and lenders affect corporate debt values? We find higher bond spreads
for firms that can renegotiate debt contracts relatively easily. Consistent with theories of strategic
debt service, the threat of strategic default depresses bond values ex ante, even though there may be
efficiency gains from renegotiation ex post. However, the economic significance of the net effect is small,
suggesting that bondholders have considerable bargaining power. The effect of strategic actions is higher
when creditors are particularly vulnerable to strategic threats, including risky firms with high managerial
shareholding, simple debt structures, and high liquidation costs.
When calculating a company’s weighted average cost of capital, or WACC, common
practice in estimating the expected cost of debt is to use the promised yield on
new bonds. Although this practice makes sense in the case of investment-grade
issuers with low probabilities of default, the use of yields in the case of risky,
high-yield issuers could materially overstate the cost of debt and, along with it,
the WACC. To avoid this distortion, the promised yields on risky debt should be
adjusted downward to account for the probability of default and the expected
losses associated with it.
To make this adjustment, this article recommends and illustrates the use of Robert
Merton’s model of risky debt to decompose promised yield spreads into two
components: expected return premiums and compensation for expected default losses.
The advantage of the proposed approach is that all inputs are easily observed,
consistent with current market conditions, and commonly used
in calculating the cost of capital.
This paper studies whether default is triggered by low market asset values or
by liquidity shortages, corresponding to economic versus financial distress.
Default is often assumed to occur when market assets fall below a certain boundary.
Consistent with this hypothesis, some low-value firms default despite sufficient
liquidity. However, liquidity shortages can precipitate default at high asset
values when firms are restricted from accessing external financing. Moreover,
many distressed firms do not default for years. As a result, even though
boundary-based default predictions can match observed average default frequencies,
they misclassify a large number of firms in cross-section.
Intuition suggests that firms with higher cash holdings are safer and should
have lower credit spreads. Yet empirically the correlation between cash and spreads is robustly
positive, and higher for lower credit ratings. This puzzling finding can be explained by the
precautionary motive for saving cash. In our model endogenously determined optimal cash reserves
are positively related to credit risk, resulting in a spurious positive correlation between cash
and spreads. By contrast, spreads are negatively related to the "exogenous" component of cash
holdings independent of credit risk factors. Similarly, although firms with higher cash reserves
are less likely to default over short horizons, endogenously determined liquidity may be
positively related to the longer term probability of default. Our empirical analysis
confirms these predictions, suggesting that endogenous precautionary savings are central to
understanding the effects of cash on credit risk.
Using a sample of distressed firms worth more dead than alive, we find that most of them
continue operations long after the optimal exit time. The failure to liquidate costs the typical
sample firm over three years 8.7% of its assets in lost earnings relative to the industry median.
Excessive continuations are financed by reductions in working capital, and are facilitated by
low current debt payments, high proportions of public bonds, and the absence of covenants
prohibiting asset sales. Unlike bank covenants, bond covenants increase the probability of exit,
but for many inefficient firms they may not be restrictive enough.
"Using Yield Spreads to Estimate Expected Returns on Debt and Equity" (with Ian Cooper)
This paper develops and tests a method of extracting expectations about default losses
on corporate debt from yield spreads. It is based on calibrating the Merton (1974) model to yield
spread, leverage and equity volatility. For rating classes, the approach generates forward-looking
expected default loss estimates similar to historical losses, and is also applicable for
individual bonds. The information content of the estimate is superior to linear ex ante functions
of the variables it uses as inputs. We also find that estimates of equity risk premia consistent
with historical default experiences range from 3.1% to 8.5% depending on rating.
"A Comparative Analysis of the Recovery Process and Recovery Rates for Private
Companies in the U.K., France, and Germany" (with Julian
Franks and Arnaud de Servigny), Standard & Poor's Risk Solutions, 2004
Standard & Poor's Risk Solutions conducted an analysis of more than 8,000 defaulted companies in the U.K.,
France, and Germany, based on data provided by 10 leading banks in the region.
We believe this is the most comprehensive study ever conducted regarding loan
recovery experiences in Europe for defaulted small and medium size enterprises.
