Theory and Evidence On the Resolution of Financial Distress
by David T. Brown of the University of Florida,
Abstract: This paper provides theory and evidence on the resolution of financial distress for an owner-managed project. The main insights of the model are: (1) borrower default is endogenous; i.e., the anticipated outcome of default determines whether or not default occurs in the first place, (2) the restructuring-foreclosure decision depends crucially on the interaction between project value and industry liquidity and (3) the lender waits for the industry to recapitalize before selling assets obtained through foreclosure. An empirical analysis of a large sample of defaulted commercial real estate loans supports many of the model predictions, including the existence of endogenous borrower default, significant underinvestment in distressed assets, liquidity provision vis-à-vis delayed asset sales in response to weak industry conditions, and firesale discounts that vary depending on market conditions at the time of foreclosure.
Published in: Review of Financial Studies, Vol. 19, No. 4, (Winter 2006), pp. 1357-1397.