Denis Gromb - HEC Paris
2018-10-08 16:30 - 18:00 UTC
Conflicting Priorities: A Theory of Collateral and Covenants (joint with Jason Donaldson and Giorgia Piacentino )

Abstract:

Debt secured by collateral has absolute priority in the event of default - it is paid ahead of unsecured debt, even if unsecured debt is protected by negative pledge covenants prohibiting new secured debt. We develop a model of how this priority rule leads to conflicts among creditors. But we find that it can be optimal: borrowers? option to use collateral in violation of covenants allows for the dilution of existing debt, and hence prevents underinvestment, whereas creditors? option to accelerate debt following a covenant violation deters dilution, and hence prevents over-investment. The optimal outcome is implementable via a mix of different types of debt, including secured and unsecured debt with tight and loose covenants. The model explains some �stylized facts about debt structure, covenants, and their violations.

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