Theory and evidence on the resolution of financial distress


Review of Financial Studies

2006, vol. 19, n°4, pp.1357-1397

Departments: Finance

Keywords: Real-estate, Bankruptcy, Valuation, Liquidation, Foreclosure, Crunch, Policy

We analyze a financially distressed owner-managed project. The main results of the model are: (1) borrower default is an endogenous response to the anticipated restructuring-foreclosure outcome; (2) the lender's restructuring-foreclosure decision depends critically 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. Empirical analysis of a large sample of defaulted commercial real estate loans supports many of the model predictions, including restructuring-foreclosure outcomes that are consistent with endogenous borrower default and firesale discounts that vary depending on industry market conditions at the time of foreclosure.