Endogenous Default Research Articles

Inequality, Leverage and Crises: The Case of Endogenous Default

The paper studies how high household leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of high-income households, a large increase in debt leverage of the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where higher leverage and crises arise endogenously in response to a growing income share of high-income households. The model matches the profiles of the income distribution, the debt-to-income ratio and crisis risk for the three decades prior to the Great Recession.

International Reserves and Rollover Risk

Two striking facts about international capital flows in emerging economies motivate this paper: (1) Governments hold large amounts of international reserves, for which they obtain a return lower than their borrowing cost. (2) Purchases of domestic assets by nonresidents and purchases of foreign assets by residents are both procyclical and collapse during crises. We propose a dynamic model of endogenous default that can account for these facts. The government faces a trade-off between the benefits of keeping reserves as a buffer against rollover risk and the cost of having larger gross debt positions. Long-duration bonds, the countercyclical default premium, and sudden stops are important for the quantitative success of the model.

Inequality, Leverage and Crises: The Case of Endogenous Default

The paper studies how high household leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of high-income households, a large increase in debtleverage of the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where higher leverage and crises arise endogenously in response to a growing income share of high-income households. The model matches the profiles of theincome distribution, the debt-to-income ratio and crisis risk for the three decades prior to the Great Recession.

Bilateral Exposures and Systemic Solvency Risk

By introducing a structure of the balance sheets of the banks, which takes into account their bilateral exposures in terms of stocks or lendings, we get a structural model for default analysis. This model allows distinguishing the exogenous and endogenous default dependence. We prove the existence and uniqueness of the liquidation equilibrium, we study the consequences of exogenous shocks on the banking system and we measure contagion phenomena. This approach is illustrated by an application to the French banking system

International Reserves and Rollover Risk

This paper provides a theoretical framework to quantitatively investigate the optimal accumulation of international reserves to hedge against rollover risk. We study a dynamic model of endogenous default in which the government faces a tradeoff between the insurance benefits of reserves with the cost of keeping larger gross debt positions. A calibrated version of our model is able to rationalize large holdings of international reserves, as well as the procyclicality of reserves and gross debt positions. Model simulations are also consistent with spread dynamics and other key macroeconomic variables in emerging economies. The benefits of insurance arrangements and the effects of restricting the use of reserves after default are also analyzed.

Bilateral exposures and systemic solvency risk

Abstract By introducing a structure of the balance sheets of the banks, which takes into account their bilateral exposures in terms of stocks or lendings, we get a structural model for default analysis. This model allows us to distinguish the exogenous and endogenous default dependence. We prove the existence and uniqueness of the liquidation equilibrium, we study the consequences of exogenous shocks on the banking system and we measure contagion phenomena. This approach is illustrated by an application to the French banking system.

Structural Credit Risk Models: Endogenous versus Exogenous Default

This article reviews structural credit risk models. Special emphasis is on the distinction between endogenous default versus exogenous default and the economic implications of the different assumptions. It is argued that models with endogenous default provide more insight into the default process. On the other hand, assuming exogenous default gives the flexibility to include certain features that are observed in actual credit markets.

Default risk and risk averse international investors

This paper develops an endogenous default risk model for small open economies that interact with risk averse international investors whose preferences exhibit decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with an emerging economy, the present model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets than the standard model with risk neutral investors. The paper shows that if investors have DARA preferences, then the emerging economy's default risk, capital flows, and bond prices are a function not only of the fundamentals of the economy but also of the level of financial wealth and risk aversion of international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy's default risk is lower, and its bond prices and capital inflows are higher. Additionally, with risk averse investors, the risk premium in the asset prices of the sovereign countries can be decomposed into two components: a base premium that compensates the investors for the probability of default and an “excess” premium that compensates them for taking the risk of default.

Endogenous Liquidity and Defaultable Bonds

This paper studies the interaction between fundamental and liquidity for defaultable corporate bonds that are traded in an over-the-counter secondary market with search frictions. Bargaining with dealers determines a bond’s endogenous liquidity, which depends on both the firm fundamental and the time-to-maturity of the bond. Corporate default decisions interact with the endogenous secondary market liquidity via the rollover channel. A default-liquidity loop arises: Earlier endogenous default worsens a bond’s secondary market liquidity, which amplifies equity holders’ rollover losses, which in turn leads to earlier endogenous default. Besides characterizing in closed form the full inter-dependence between liquidity premium and default premium for credit spreads, we also study the optimal maturity implied by the model based on the tradeoff between liquidity provision and inefficient default.

Double-exponential jump-diffusion processes: a structural model of an endogenous default barrier with a rollover debt structure

Double-exponential jump-diffusion processes: a structural model of an endogenous default barrier with a rollover debt structure

Competition and Strategic Control of a Central Counterparty: When Lower Risk Increases Profit

Central counterparties (CCPs) are becoming central to over-the-counter (OTC) markets. A CCP limits counterparty risk but raises entry barriers. We analyze the trade-off between dealers’ equilibrium default risk and competition in an OTC market with imperfect competition and endogenous default probability. We find that (i) CCP members favor entry restrictions and binding risk controls as a device to commit to less competition, (ii) restricting entry maximizes welfare when dealers’ transfer risk efficiently relative to their market power, and (iii) free entry reaches the first-best welfare if the CCP can limit risk-taking.

When Enough is Not Enough: Structural Credit Risk Based Estimation of Bank Capital

This paper proposes the use of a structural credit risk model to analyze the economic capital of banks. The particular model used in this paper is unique in that it has both endogenous default and a more robust depiction of the liability structure. As a result, it represents a reasonable model for identifying distress in the fi nancial sector. The model yields several useful metrics for evaluating the solvency and economic capital of financial institutions. Contrary to static measures of capital adequacy such as a fixed percentage of assets, which do not capture the true condition of a financial institution, the model is forward - looking in nature and can be used in a dynamic capacity to monitor and estimate the capital needs for banks. Empirical results show that, although the largest US Bank Holding Companies were well capitalized by regulatory standards, there was a dearth of economic capital as the Financial Crisis unfolded in 2008. The implication is that capital levels should be time-varying and conditional upon the health of the particular bank and the financial system as a whole.

Long Term Contracting with Private Information

This paper explores the possibility for efficient long term contracts among traders with changing and privately known incentives for exchange. We analyze a negotiation process that enables parties to adapt the default rules of exchange to changes in their preferences for trade. The selection of control rights and default options is delegated to the traders themselves, who collectively are best informed as to which investments and exchanges are efficient. The paper demonstrates how contracts with flexible and endogenous default options are tailored to maximize the gains from exchange. Applications of our findings for contract theory, the design of commercial contracts, and the need for legal support are discussed.

Mortgage Amortization and Amplification

Mortgages characterized by negative or low early amortization schedules amplify the macroeconomic effects of a housing risk shock. We analyze the role of mortgage amortization in a two-sector DSGE model with housing risk and endogenous default. Mortgage loan contracts extend to two periods and have adjustable rates. The fraction of principal to be repaid in the first period can vary. As the fraction of principal to be paid in the first period falls, steady-state mortgages and leverage increase and the impact of a housing risk shock on consumption and output is amplified. Borrowers prefer negative amortization. If free to choose the amortization schedule, borrowers would repay most of the principal in the last period of the contract. Low early repayments of principal allow borrowers to hold on to their housing stock and postpone default to the second period having incurred small sunk costs.

Macroeconomic Implications of Time-Varying Risk Premia

A large empirical literature suggests that risk premia on stocks or corporate bonds are large and countercyclical. This paper studies a simple real business cycle model with a small, exogenously time-varying risk of disaster, and shows that it can replicate several important facts documented in the literature. In the model, an increase in disaster risk leads to a decline of output, investment, stock prices, and interest rates, and an increase in the expected return on risky assets. The model matches well business cycle data and asset price data, and the countercyclicality of risk premia. I present an extension of the model with endogenous choice of leverage and endogenous default, and show that the model accounts well for the level and cyclicality of credit spreads, and in particular the relation between investment and credit spreads.

Calibrating structural models: a new methodology based on stock and credit default swap data

This paper presents a modified version of Leland and Toft's [J. Finance, 1996, 51, 987–1019] structural credit risk model, together with a novel calibration methodology based on stock and CDS data: the firm asset value and volatility are consistently derived from equity prices; the default barrier is calibrated from CDS premia. It empirically shows that as long as the appropriate default barrier is selected, the model generates time series of stock market implied credit spreads that fit the times series of CDS spreads. Moreover, CDS implied default barriers prove to be consistent with stockholders’ rationality, with predictions made by structural models with endogenous default, and with historical recovery rates.

Endogenous default risk in supply chain and non-linear pricing

Abstract Based on incomplete contract theories, we studied the strategic behaviors of up-stream and down-stream manufacturers by option game model and obtain some conclusions. First, the down-stream's pay-off function is a concave function of its investment in fixed assets, so there is an optimal investment, which ensures the down-stream's maximal pay-off and prevents it from being holdup. Second, in presence of endogenous default risks, the up-stream can improve its pay-off level through non-linear pricing. Last, increasing business risks of the down-stream may lead to an increased price fluctuation of the up-stream, while the down-stream's technological advancement can make such fluctuation less.

Sovereign default risk and volatility

In a model of sovereign debt with endogenous default, we find a non-monotonic relationship between default risk and volatility, reflecting a trade-off between prudence and the insurance value of default. We show that this feature also holds in the data.

A Perpetual American Model for Leveraged Firms

In this study, the structural reason of default is studied with fewer assumptions and external restrictions imposed. The liability structure is modeled as a perpetual and constant level. The equity value is solved in closed form and found to have embedded a perpetual American put option. The endogenous default level is found to rely on the liability level, firm’s volatility and risk-free interest rate. The implications on default probability and recovery rate are also discussed.

The Term Structure of Lease Rates with Endogenous Default Triggers and Tenant Capital Structure: Theory and Evidence

This paper focuses on the defaultable lease rate term structure with endogenous default. We combine the competitive lease market argument proposed by Grenadier (1996) and the endogenous default structural model proposed by Leland and Toft (1996) to examine the interaction between the lessee’s capital structure and the equilibrium lease rate. Under this framework, determining the lease rate is a simultaneous equation problem that captures the tradeofi between debt and lease flnancing. Using data on 2,482 real estate lease transactions, we empirically conflrm the predictions derived from the numerical analysis of the model.