Bankruptcy & Insolvency Flashcards
What is the difference between insolvency and illiquidity?
Insolvent firms have equity value equal to zero. Illiquid firms have cash flow problems making them unable to cover payments to creditors
What are the pros and cons of a creditor-friendly system?
Advantages:
Increases access to capital markets
Disadvantages:
Excessive inefficient liquidation, underinvestment and too little risk-taking
What are the pros and cons of a debtor-friendly system?
Advantages:
More efficient bankruptcy resolution and restructurings. Less underinvestment
Disadvantages:
Reduce corporate borrowing capacity and provide little incentive for insiders to avoid bankruptcy
What is an example of a pro-debtor system?
United states before 1990s. Especially under Chapter 11.
What is an example of a pro-creditor system?
United Kingdom before 1986. Very easy to seize collateral
Who has bargaining power in the Harris and Raviv model?
More complicated than other models. Security contracts are priced such that investors break even in expectation (i.e. no bargaining power). But take-it-or-leave-it offers under repudiation can be made by either the debtor or creditor to model either creditor or debtor friendly systems
Is there information asymmetry in the Harris and Raviv model?
No. States are observable, but non verifiable.
What payment will debtors be willing to accept if repudiating in a creditor-preferred system?
The state-dependent payment d_s must satisfy:
R_1_s + ( R_2_s / L_s ) * (d_s - R_1_s) = R_2_s
The payment must be equal to the state two cash flow
You pay as much as possible by the state 1 cash flow and the rest by liquidating investment which will lower state 1 cash flows
What are the steps to solving a Harris-Raviv type model?
1) Assuming debtors will repudiate, determine the acceptable payments (depending on creditor/debtor preferred regime)
2) Determine Face value such that creditor expects to break even. Debtor pays Min(F, d_s) in state s. Sometimes there will be no Face-value satisfying this, and the credit market will collapse
Will face value be lowest in a debtor or creditor preferred system?
Face-value will be tend to be lower in a creditor preferred system, since the debtor will tend to repudiate less often
What are the social consequences of each type of system?
As long as there is sufficient debt capacity, the debtor preferred system is social optimal, as it minimizes liquidation costs, since there will tend to be more restructuring when debtors are cash constrained
However, debtor preferred system decreases debt capacity and can hence lead to underinvestment
How can security design alleviate some of the problems of distress resolution?
Can try design securities such that payment in state 1 (where cash is not constrained) is higher. I.e. bundling an option on the equity with the debt
How can overlending help decrease distress costs?
This makes the debtor need to pay back more. He wants to deposit the money since it saves him from liquidation, so it becomes an incentive. “You make them rich enough so they have something to lose”
