A debt contract promises a creditor a fixed repayment not contingent on a debtor’s performance. At the same time, it provides the creditor with a right to foreclose on the debtor’s assets in default and to enforce liquidation. However, in practice, even when the debtor misses (i.e., defaults on) the promised repayment, the creditor does not always enforce liquidation. Instead of enforcing it, she occasionally permits the defaulting debtor to restructure the contract terms to obtain relief (forgiveness) from the liability. The agents continue to keep the contractual relationship beyond the default.
Such debt restructuring is crucial in practice. Most actual defaulting firms first try to restructure their debt either in or out of court. In particular, most large companies restructure under Chapter 11 (court-supervised debt restructuring), rather than liquidate under Chapter 7 (termination of contract), when filing for bankruptcies in the United States. Also, in international finance, sovereign default is another typical example of debt restructuring. It is sometimes recurrent. A question is raised: why and under what conditions is debt restructuring, rather than liquidation, chosen strategically in equilibrium?
The purpose of this paper is to answer the question qualitatively by exploring a costly state verification (CSV, Townsend [19]) model in infinitehorizon discrete time. In previous literature, Wang [20] has studied a dynamic CSV problem with individually and independently distributed (i.i.d.) shocks. This paper extends his analysis to a dynamic CSV problem with (1) Markov shocks, assuming a two-point support for the shocks, and (2) two-sided limited commitment, in which a borrower commits to the contract, except for defaulting on a promised payment, whereas a lender can quit anytime. This paper shows that, if (1) income shocks are highly persistent, (2) the expected income is profitable enough, (3) the outside option of a lender is positively correlated with the income shocks, and (4) disclosure costs are a medium level, then equilibrium default in an optimal debt contract is debt restructuring that is followed by a period of bankruptcy protection, rather than liquidation.
Compared with the results of Wang [20], this paper has two new characterizations of an optimal contract. First, the borrower always has an opportunity to make a strategic decision either to keep, to repudiate, or to restructure his debt from a dynamic perspective in the environment of the two-sided limited commitment, whereas Wang’s model focuses on whether to keep or to restructure the debt. This paper makes clear the effects of structural economic factors on the two types of the equilibrium default behavior (i.e., liquidation and debt restructuring).
