The Dynamics of Default and Debt Reorganization

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Mella-Barral, Pierre, "The Dynamics of Default and Debt Reorganization", Review of Financial Studies, Vol. 12, No. 3, (Fall 1999), pp. 535–578.

Abstract: This article documents the fact that when debtors decide on their obligations too early, it is in the creditors' collective interact, as residual claimants, to make concessions prior to forcing a costly liquidation. Symmetrically, when debtors prefer to default at an inefficiently late stage, it is in the creditors' interest to propose a departure from the absolute priority rule. This article develops a continuous time pricing model of dynamic debt restructuring that reflects the crucial influence of the two counterparties' relative bargaining power. Simple and intuitive path-dependent pricing formulae are derived for equity and debt. The debt capacity as well as the evolution of the firm's capital structure throughout its existence is provided.

JEL Classification: G31, G32.

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