Bankruptcy Code, Optimal Liability Structure and Secured Short-TermDebt
Coauthor(s): Jun Kyung Auh, Suresh Sundaresan
When the bankruptcy code protects the rights of lenders, as in Hart (1999), we show that there is no intrinsic reason to issue debt with safe harbor provisions. When the code violates absolute priority rule (APR) or results in significant deadweight losses, the optimal liability structure includes secured short-term debt, with safe harbor protection. The borrower is able to trade off between “run prone" safe harbored short-term debt and long-term debt depending on the inefficiencies in bankruptcy code, and the availability of eligible collateral to increase the overall value of the firm. The presence of a secured short-term debt will increase the spread of long term debt, and this reduces the long-term debt capacity of firms. Overall, the combined debt capacity increases for the firm. Using the onset of credit crisis in 2007 as an exogenous adverse shock to the collateral value of assets and to the riskiness of collateral, we find that the leverage and short-term debt of financial firms fell much more rapidly than non-financial firms due to the greater exposure of financial firms to “run risk". The provision of short-term credit by the Fed is shown to significantly buffer the reduction in short-term debt and leverage of financial firms, supporting the presence of a supply (of credit) effect in the data. While the Fed’s intervention resulted in credit spreads returning to the pre-crisis levels, there was still a net fall in the short-term debt and leverage of financial firms, suggesting a possible demand effect as well. These results are in broad conformity with the theory developed in our paper.
Jun Kyung Auh, Suresh Sundaresan "Bankruptcy Code, Optimal Liability Structure and Secured Short-TermDebt." , Columbia Business School, (2013).