A New Paper on Debt Overhang

Tue, 05 May 2009 15:29:46 +0000

A new NBER Working Paper, "Efficient Recapitalization," by Thomas Phillipon and Phillip Schnabl has moved to the top of my must-read pile of research. The paper focuses on how the government might overcome the problem of debt overhang in distressed institutions subject to the constraints that the government cannot alter the priority structure of financial contracts and that the equity holders must agree to participate. The consider asset buy backs, capital injections, and debt guarantees. Here's what they find:

The comparison of government interventions delivers two main results. First, if banks and the government have the same information, all interventions are equivalent. By equivalent, we mean that two interventions implement the same level of bank lending at the same expected cost for tax payers. Second, if banks have an informational advantage over the government, asset buy backs and debt guarantees are equivalent and equity injections dominate both asset buy backs and debt guarantees. By dominance, we mean that one intervention dominates another intervention if the former intervention has a lower expected cost than the latter intervention and both interventions implement the same level of investment.

Some intuition for the result is presented as follows:

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It turns out that asset buy backs and debt guarantees are equivalent because both interventions charge a fixed price independent of the future bank equity value.

Equity injections are di¤erent because the price of participation depends on the future bank equity value. The government takes an equity stake in the bank and participates in the upside of future investment opportunities. For a fixed size of the government program, the same low quality banks participate in equity injections as in the case of asset buy backs or debt guarantees. However, some firms with good investment opportunities but low-quality assets do not participate because they do not want to share the upside with the government and rather invest alone. As a result, there is less inefficient participation in equity injections than other interventions and the expected cost of equity injections is lower.

Read the whole thing.