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.