Distressed Debt Research Articles

How do reservation prices impact distressed debt rescheduling?

This paper is the first to investigate rescheduling of distressed corporate debt when both the representative shareholder and the creditor face reservation prices. Parties expect from rescheduling both recovery and growth, but reservation prices are key dimensions to consider in the analysis in order to assess the opportunity and to design the new financial set-up. For reservation price, the creditor may have in mind the liquidation value of the firm he can get by a strict enforcement of his contractual rights in court. The shareholder requires from rescheduling the recognition of her risky, specific and important (financial and intangible) involvements in the future. To shed light on rescheduling with reservation prices, we develop first a general parsimonious distribution-free structural framework. We derive sufficient conditions for rescheduling to take place and highlight situations where no rescheduling can occur. We characterize cases where rescheduling is for the creditor possible but sub-optimal. So the shareholder's reservation price can dramatically restrict the set of possible extensions and it does matter for the creditor. We then restrict our setting to undertake numerical analysis, our benchmark being the canonical rescheduling model of Longstaff (1990). Here, we can explore with simulations feasibility and optimality of rescheduling for different magnitudes of reservation prices and different firms' profiles. We finally investigate various concerns related to rescheduling such as agency costs, exit from no-rescheduling situations and bargaining between stakeholders. We also discuss different ways to lower the shareholder's reservation price.

A Strategy for Resolving Europe's Problem Loans

Europe’s banking system is weighed down by high levels of non-performing loans (NPLs), which are holding down credit growth and economic activity. This discussion note uses a new survey of European country authorities and banks to examine the structural obstacles that discourage banks from addressing their problem loans. A three pillared strategy is advocated to remedy the situation, comprising: (i) tightened supervisory policies, (ii) insolvency reforms, and (iii) the development of distressed debt markets.

The Financial Returns from Oil and Natural Gas Company Stocks Held by American College and University Endowments

In recent years, some climate activists have called on colleges and universities to divest themselves of stocks held in oil and natural gas companies. In this context, this study analyzes the performance of American college and university endowments based on their asset allocations, with special reference to the returns from oil and natural gas industry stocks. We tracked the returns of the major asset classes held by college and university endowments over the most recent year (June 2010-June 2011), the most recent five-year period (June 2006-June 2011), and the most recent ten-year period (June 2001-June 2011). Depending on the period, different classes of assets produced relatively higher returns for college and university endowments. However, over all three periods, U.S. shares of oil and natural gas companies outpaced both the overall performance of these endowments and every other asset class examined here.Over the five-year period 2006-2011, for example, fixed income securities and distressed debt far outperformed all U.S. equities, foreign equities, and real estate securities. However, the oil and gas company stocks held by colleges and universities produced average annual returns of 7.9 percent, compared to average annual five-year returns of 2.9 percent for all U.S. stocks, 2.0 percent for global equities, 6.5 percent for bonds, 1.6 percent for real estate securities, 0.0 percent for commodities, 4.7 percent for distressed debt, and 2.0 percent for three-month Treasury bills. Similarly, over the ten-year period 2001-2011, real estate, distressed debt, commodities and foreign equities far outperformed all U.S. equities, fixed income instruments, and Treasury bills. However, oil and natural gas company stocks held by colleges and universities produced average annual ten-year returns of 11.5 percent, compared to 2.7 percent for all U.S. stocks, 6.1 percent for global equities, 5.7 percent for bonds, 10.4 percent for real estate, 6.6 percent for commodities, 9.4 percent for distressed debt, and 2.1 percent for three-month Treasury bills. And over the most recent year when this analysis was performed, June 2010-June 2011, real estate securities, all U.S. equities and foreign equities outperformed bonds, distressed debt, and cash and Treasury bills. However, oil and natural gas company stock produced returns of 52.8 percent, while the returns on all U.S. publically-traded stocks were 30.7 percent, foreign equities returned 30.3 percent, bonds generated 3.9 percent, real estate-based securities returned 35.2 percent, commodities produced returns of 25.9 percent, distressed debt generated 11.8 percent, and three-month Treasuries returned 0.2 percent.

The Role of Prospect Theory in the Perceived Moral Reprehensibility of Strategic Mortgage Default

Defaulting on a mortgage is widely viewed as being immoral, but no prior study has examined the intervening roles of Prospect Theory and default intent. We find that the public is significantly more accepting of a defaulting borrower who earns a zero or negative return on his investment than one who earns a positive return. This moral viewpoint changes significantly when the default is strategic in nature. Defaulters are judged significantly less harshly by those who more so blame the lender for the current financial crisis, those who have previously strategically defaulted, and males. When asked to suggest a “morally appropriate” settlement offer to lenders to resolve the distressed debt, beyond the prospect theory and default intent remaining significant, we further find that those who more so blame the lender, those who view their home as more of an investment rather than a consumption good, those who have previously strategically defaulted, those with lower income levels, and minorities suggest significantly lower settlement offers.

Going for Broke:Restructuring Distressed Debt Portfolios

This article discusses how to restructure a portfolio of distressed debt and what the gains are from doing so, and attributes these gains to restructuring and portfolio effects. This is an interesting and novel problem in ?xed-income portfolio management that has received scant modeling attention. We show that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that a) it requires optimization over all moments, not just mean and variance, and b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to ?xed-income investors, with risk-adjusted certainty equivalent yield pickups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current policy debate regarding the use of eminent domain in mitigating real estate foreclosures. <b>TOPICS:</b>Fixed income and structured finance, portfolio construction

Going for Broke:Restructuring Distressed Debt Portfolios

Going for Broke:<i>Restructuring Distressed Debt Portfolios</i>

The Return/Volatility Trade-Off of Distressed Corporate Debt Portfolios

This article analyzes the returns of distressed high-yield corporate bond portfolios based on the volatility characteristics of their corresponding option-adjusted spreads (“OAS”). Applying Capital Asset Pricing Model (“CAPM”) theory to a portfolio of distressed bonds generates different results depending on whether overall high-yield market OAS volatility is considered. CAPM expectations (higher risk investments demand higher expected returns) are not generally fulfilled in both time-independent and time-dependent space after normalizing the data for overall high-yield market OAS volatility, i.e. the lowest OAS volatility portfolios outperform the highest volatility portfolios. We provide evidence that this phenomenon is a result of the idiosyncratic characteristics of the securities that comprise the lowest OAS volatility portfolios, which generate higher returns because they experience lower default rates and higher terminal values relative to the securities in the highest OAS volatility portfolios. Alternatively, we find that CAPM generally holds under two conditions: 1) in time-independent space where no consideration is given to the OAS volatility of the overall high-yield corporate debt market; and, 2) in time-dependent space where an investor possesses market timing skills. Because persistent market timing skill is rare, investing based on a buy-and-hold strategy, comprised of portfolios of the lowest OAS volatility distressed bonds, may be a practical solution for the long-term distressed debt investor.

Corporate Defaults, Workouts and the Rise of the Distressed Asset Investment Industry

This paper examines corporate distress episodes for the United States, Western Europe, and Asia during the late twentieth century, and charts the emergence and growth of new actors in the corporate restructuring process – distressed asset investment firms. We analyse the formation and growth of these firms; including their investment focus, geographic and product expansion strategies. We find that the distressed asset investment industry is dominated by firms based in the United States, is relatively concentrated in terms of number of firms and assets under management, due in large part to early movers developing distinctive investment capabilities through participation in landmark transactions, relationship-specific resources, and scale effects. We examine empirically how the rise of distressed asset investment firms has altered the pricing dynamics in the corporate distressed market. We model the demand and supply of distressed debt over a thirty year period using historical data on loan issuances, corporate defaults and recovery rates. We find that the demand for distressed asset investment has become more responsive to supply over time with falling supply-demand ratios, implying lower investment returns. We conjecture that the emergence and growth of distressed asset investment firms has resulted in private sector workouts becoming more competitive and more efficient, especially in the United States.

Going for Broke: Optimizing Investments in Distressed Debt

How should governments and financial intermediaries restructure and optimize portfolios of distressed debt? What are the gains from doing so, and where do the gains come from? This paper shows that debt restructuring is Pareto improving and lucrative for borrowers, lenders, and investors in distressed debt. First, the methodological contribution of the paper is a parsimonious model for the pricing and optimal restructuring of distressed debt, i.e., loans that are under-collateralized and are at risk of borrower default, where willingness to pay and ability to pay are at issue. Distressed-debt investing is a unique portfolio problem in that (a) it requires optimization over all moments, not just mean and variance, and (b) with debt restructuring, the investor can endogenously alter the return distribution of the candidate securities before subjecting them to portfolio construction. Second, economically, we show that post-restructuring return distributions of distressed debt portfolios are attractive to fixed-income investors, with risk-adjusted certainty equivalent yield pick-ups in the hundreds of basis points, suggesting the need for more efficient markets for distressed debt, and shedding light on the current debate regarding the use of eminent domain in mitigating real estate failures.

The Constitutional Law of State Debt

State debt crises are an underappreciated driving force in American constitutional history. This article, which is being published as part of the Duke Journal of Constitutional Law & Public Policy’s symposium on “The Consequences and Constitutional Dilemmas of State Debt,” assesses the financial challenges facing the states, the different ways in which those challenges might be addressed, and constitutional issues that those responses might raise. We consider five different kinds of scenarios:1. Payment delays and IOUs: States may simply seek to delay repayment of their obligations without attempting to diminish their ultimate liability, or they may resort — as California and Illinois already have — to paying private businesses, local governments, and others with short-term IOUs rather than real money. To the extent that they alter the payment terms of state contracts, these short-term expedients may raise issues under the Contracts and Takings Clauses. But the short time frames involved make litigation unlikely. 2. Alterations to Long-Term Obligations: States in economic distress may decide to alter the terms of long-term agreements with current and former employees to provide pensions and healthcare benefits. Such alterations would raise more substantial Contracts Clause issues, although state sovereign immunity may severely constrain private parties’ remedial options.3. Bailout: The national government may seek to “bail out” a financially troubled state, much like the International Monetary Fund might bail out a sovereign debtor or a distressed debt lender might lend on an emergency basis to a cash-strapped business. If a bailout occurs, the interesting questions concern what concessions the national government might extract in order to minimize the prospect of recurrence, as well as what long-term effects a bailout might have on the financial independence of the states.4. Default: If states fail to pay principal or interest when due with no clear plan of when, if ever, it will be paid, that may well violate the Contracts Clause. The interesting issues will concern sovereign immunity and remedies, including the possibility that Congress may seek to abrogate the states’ immunity or induce immunity waivers.5. Bankruptcy: Though not currently an option for states, scholars and politicians have suggested a voluntary bankruptcy regime for states, and one of our fellow symposium contributors argues for a mandatory regime. We doubt that a mandatory regime would be constitutional, and we suggest some important reservations about a permissive regime as well.We do not purport to definitively resolve most of these issues. Our more modest purpose is to flag the constitutional considerations that may arise and suggest useful ways to think about them. Hopefully our roadmap will assist those scholars, lawyers, and policymakers who must pick their way through this maze.

Foundations of Forgiveness in Islamic Bankruptcy Law: Sources, Methodology, Diversity

This article provides a detailed examination of the structure, sources, and ultimate content of the Islamic law of distressed debt. With specific illustrations from the Qur'an, sunna, and fiqh (Islamic jurisprudence), it orients non-specialists on the path to understanding where Islamic law comes from, how it is structured, and what its most salient provisions say about the proper treatment of insolvent debtors. Tracing the various divisions within Islam on the proper identification of shari'a, this article reveals a rich tapestry of contrasting views among and within the shi'a and sunni doctrinal schools of thought. Both the original sources and the secondary juristic analyses of these sources struggle with a delicate balance between forcing debtors to pay their debts while enjoining creditors to be patient and forgiving with respect to distressed debtors. It is hoped that this detailed and sensitive discussion will enhance the increasingly frequent insolvency law reform conversations between Westerners and those in Muslim nations by encouraging the former to respectfully engage with classical Islamic sources and methods, as opposed to advancing arguments based merely on Western views of economic expediency, efficiency, and experience.

Recovery and Returns of Distressed Bonds in Bankruptcy

By linking the trading price of distressed debt after Chapter 11 filing to the ultimate recovery for a large sample of Chapter 11 cases in the past decade, this article finds that senior bonds realize large returns while junior bonds realize losses during bankruptcy reorganization. In addition, this study provides several explanations for the return anomaly observed in the distressed debt market. Liquidation, bankruptcy costs, and active involvement by hedge funds contribute to the understanding of the returns of the distressed bonds. The large negative returns of the junior bonds during bankruptcy reorganization are most likely the result of their initial overvaluation, which was due to their lottery-like features. <b>TOPICS:</b>Fixed-income portfolio management, statistical methods, exchanges/markets/clearinghouses

Editor’s Letter

The Great Recession has generated significant interest in distressed debt. In this issue of The Journal of Fixed Income , we begin with an article by Jacobs and Karagozoglu that provides empirical evidence on the loss given default experienced by major defaults from 1985–2008. They find that

Modeling Ultimate Loss Given Default on Corporate Debt

Loss given default (LGD) is a critical parameter in various facets of credit risk modeling. This study empirically investigates the determinants of LGD and builds alternative predictive econometric models for LGD on bonds and loans using an extensive sample of most major U.S. defaults in the 1985–2008 period. The authors build simultaneous equation models in the beta-link generalized linear model (BLGLM) class, identifying several that perform well in terms of the quality of estimated parameters as well as overall model performance metrics. This extends prior work by modeling LGD both at the firm and the instrument levels. In a departure from the extant literature, the authors find the economic and statistical significance of firm-specific debt and equity market variables. In particular, they find that information from either the equity or the debt markets at around the time of default (measures of either cumulative equity returns or distressed debt prices, respectively) have predictive power with respect to the ultimate LGD, which is in line with recent prior recovery and asset pricing research. They also document a new finding: Larger firms have significantly lower LGDs while larger loans have higher LGDs. <b>TOPICS:</b>VAR and use of alternative risk measures of trading risk, big data/machine learning, credit risk management

Modeling Ultimate Loss Given Default on Corporate Debt

Loss given default (LGD) is a critical parameter in various facets of credit risk modeling. This study empirically investigates the determinants of LGD and builds alternative predictive econometric models for LGD on bonds and loans using an extensive sample of most major U.S. defaults in the 1985–2008 period. The authors build simultaneous equation models in the beta-link generalized linear model (BLGLM) class, identifying several that perform well in terms of the quality of estimated parameters as well as overall model performance metrics. This extends prior work by modeling LGD both at the firm and the instrument levels. In a departure from the extant literature, the authors find the economic and statistical significance of firm-specific debt and equity market variables. In particular, they find that information from either the equity or the debt markets at around the time of default (measures of either cumulative equity returns or distressed debt prices, respectively) have predictive power with respect to the ultimate LGD, which is in line with recent prior recovery and asset pricing research. They also document a new finding: Larger firms have significantly lower LGDs while larger loans have higher LGDs.

In the Wake of the Crisis: Dealing with Distressed Debt Across the Transition Region

Summary This article reviews the origin and spread of the distressed debt problem in the transition region. We argue that while the crisis was triggered abroad, the current high level of distressed debt in various transition countries mainly reflects home-grown vulnerabilities. As in the West, the root causes of the debt problem were abundant and cheap funding and a gradual relaxation of banks’ lending standards – in particular an excessive reliance on rising real estate values. We document a strong positive relationship between pre-crisis house price increases, house price collapses during the crisis and subsequent increases in non-performing loans (NPLs). Policy options to deal with distressed debt range from decentralised approaches in which banks restructure NPLs on a caseby-case basis to more centralised options, such as a “London approach”, bad banks, or asset management companies. Centralised options may be called for if case-by-case debt restructuring is suboptimal from a system-wide perspective because of negative externalities or capacity constraints in either the banking or the judicial system.

Revisiting the Altman Definition of Distressed Debt and aNew Mechanism for Measuring the Liquidity Premium ofthe High-Yield Market

This article undertakes an empirical investigation of the efficacy of the Altman definition, which defines distressed debt as a security trading at a risk premium in excess of 1,000 bps over comparable U.S. Treasuries and whose long-term default rate is expected to be approximately 50%. The authors analyze the constituents of the Merrill Lynch High Yield Master II Index over the 1990–2009 period to test the Altman definition on an out-of-sample basis. They find distressed securities following the risk-premium-threshold component of the definition to experience a long-term average default rate between 48% and 51%, while exhibiting significant short-term variability and mean-reverting characteristics. Additionally, the authors introduce time-to-default characteristics to the Altman definition, finding the median time-to-default for distressed securities to be 14 months, with 90% of the cumulative defaults occurring within 46 months. Furthermore, evidence of convergence between the two Altman definitional components—risk premium threshold and default rate—provides strong support for the definition’s efficacy over long time periods. Finally, decomposition of the option-adjusted spread of the high-yield index finds the presence of liquidity and credit components, with the liquidity component exhibiting a high degree of variability; in contrast, the credit component remains relatively constant over time. Overall, the authors find liquidity risk to be more dominant than credit risk as measured by its contribution to the total variability of the option-adjusted spread of high-yield securities. <b>TOPICS:</b>Analysis of individual factors/risk premia, security analysis and valuation, fixed-income portfolio management, statistical methods

Introduction: Navigating the global private equity frontier: Tumultuous and opportunistic times

AbstractAt the Fifth Annual Global Private Equity Investing Conference on Thunderbird's campus in Glendale, Arizona, held in late March 2009, it was made clear the economic crisis not only has shown the world that economic globalization has come, but it also brings with it many new and surprising opportunities. For private equity in particular, globalization is imperative.This issue of the Thunderbird International Business Review offers an in‐depth look into several key topics for private equity in these tumultuous times, including how to structure a successful private equity portfolio, tools for reaching liquidity, and opportunities in the secondary and distressed debt markets. Katharina Lichtner of Capital Dynamics, Hans Swildens of Industry Ventures, Roger Wittlin of Silver Lake, and Sebastien Burdel of Coller Capital explore these timely topics in the following pages. © 2009 Wiley Periodicals, Inc.

Transfers of non-performing loan portfolios

In recent years, Argentina and other Latin American countries have faced some significant macro-economic and financial crises. These crises generated related losses, but also notable business opportunities. This article considers the acquisition of a large portfolio of distressed debt, particularly certain legal, tax and accounting issues. The recent worldwide financial crisis may generate similar opportunities, and the experience noted in this article may be useful for potential investors and sellers.

Recent Advances in Credit Risk Modeling

As is well known, most models of credit risk have failed to measure the credit risks in the context of the global financial crisis. In this context, financial industry representatives, regulators and academics worldwide have given new impetus to efforts to improve credit risk modeling for countries, corporations, financial institutions, and financial instruments. The paper summarizes some of the recent advances in this regard. It considers modifications of structural models, including of the classical Merton model, and efforts to reconcile the structural and the reduced-form models. It also discusses the reassessment of the default correlations using copulas, the pricing of credit index options, and the determination of the prices of distressed debt and estimation of recovery values.