Thanks to a U.S. bankruptcy code that favors borrowers, United Airlines has gone nearly three years under Chapter 11 protection without a change of management. That situation is unthinkable in Germany or the United Kingdom, where bankruptcy laws are tougher. But a new U.S. law that goes into effect in October 2005 will make some important changes to the bankruptcy code, such as limiting restructuring to 18 months with no extensions. How will this law affect the U.S. market for corporate debt?
Suresh Sundaresan has studied how the institutional features of markets, particularly bankruptcy codes, influence the behavior of borrowers and lenders. He expects that the new law will change how U.S. companies borrow. They may use less debt, for example, or they may borrow in other currencies and then convert the debt into dollars through interest rate swaps. “For these reasons, it is not easy to predict a spread change,” says Sundaresan. “The situation is complicated by the fact that the Fed is increasing short-term interest rates to slow down the economy.”
Sundaresan and fellow researchers Ron Anderson of Université Catholique de Louvain, Hua Fan of Credit Suisse First Boston and Mark Broadie and Mikhail Chernov of Columbia have developed models that predict both the probability that a company will default on its debt and the payouts creditors can expect in the event of a default. This research method is of direct interest to credit rating firms such as Moody’s, Standard & Poor’s and Fitch, and it can also help buy-side asset management firms assess the pricing of particular loans and bonds.
One of the most important features of a debt market is, of course, its bankruptcy code. Because the U.S. code grants little protection to creditors, lenders should charge higher interest rates to U.S. companies than to German or British companies. The effect on pricing is difficult to document, however, because interest payments depend on a complex combination of factors, including market liquidity, tax codes and the contractual features of specific debt instruments.
In a country like the United States, where a company that gets into trouble can drag creditors into a prolonged and costly restructuring process, some borrowers are likely to engage in strategic default behavior. By threatening to declare bankruptcy, a company can essentially blackmail creditors into renegotiating debt contracts with terms that are more favorable to the borrower.
“Let’s say you owe me a million dollars of interest payments every year,” Sundaresan says. “You know that if I were to take you to court, I’m going to get only half a million, because half a million is going to be spent toward legal expenses. So you’re going to come to me and say, ‘Look, we could go to bankruptcy court, you’re going to get half a million. But you could renegotiate with me, and I could give you something better than that, but I’m not going to give you the whole amount.’”
Sundaresan and Ron Anderson found that this type of strategic debt service costs lenders anywhere from 25 to 100 basis points. So the interest rate a bank charges for a corporate loan should account for the risk that the company might ask to renegotiate the loan several times. “I didn’t think the numbers were going to be that big,” Sundaresan says. Naturally, the magnitude of the blackmail effect depends on who has greater bargaining power in a given scenario.
With sovereign debt, the potential for blackmail is even greater, as illustrated by Argentina’s December 2001 decision to halt payments on more than $100 billion in debt — the largest sovereign default in history. The workout agreement took three years, and most of the country’s creditors settled for 30 cents on the dollar. “In a corporate loan, the borrower and lender can go to bankruptcy court,” notes Sundaresan, “whereas you can’t take Argentina to court, nor can you access the assets of Argentina. If Argentina defaults, you can’t send an army and take Argentina’s natural resources. That’s a big difference. So with sovereign debt, lenders should charge a higher spread.”
Sundaresan and Hua Fan further explored the effects of bond covenants on payouts by developing models for two types of debt renegotiation: debt-equity swaps and strategic debt service. More recently, Sundaresan has examined bankruptcy codes in greater detail with Mark Broadie and Mikhail Chernov. They found that such features as automatic stay provisions, absolute priority rules and potential debt forgiveness, while increasing the likelihood of default, actually reduce the likelihood of wasteful liquidation.
“Our goal is to point out that if you’re a lender or a borrower, watch out for the code of the country in which you’re lending or borrowing,” Sundaresan says, “because it makes a difference to the interest you should be charging and to the kind of default behavior that you can expect.”
Suresh Sundaresan is the Chase Manhattan Bank Professor of Financial Institutions at Columbia Business School.
Read the Research
"Optimal Corporate Securities Values in the Presence of Chapter 7 and Chapter 11"
"Debt Valuation, Renegotiation, and Optimal Dividend Policy"
"Design and Valuation of Debt Contracts"