Do bankrupt firms impose negative externalities on their non-bankrupt competitors?
We propose and analyze a collateral channel in which a firm’s bankruptcy reduces collateral values of other industry participants, thereby increasing the cost of external debt finance industry wide.
To identify this collateral channel,
we use a novel dataset of secured debt tranches issued by U.S. airlines which includes a detailed description of the underlying assets serving as collateral.
Our estimates suggest that industry bankruptcies have a sizeable impact on the cost of debt financing of other industry participants.
We discuss how the collateral channel may lead to contagion effects which amplify the business cycle during industry downturns.
For each of the debt tranches in our sample we can identify precisely its underlying collateral. We then identify the ‘collateral channel’ off of both the time-series variation of bankruptcy filings by airlines, and the cross-sectional variation in the overlap between the aircraft types in the collateral of a specific debt tranche and the aircraft types operated by bankrupt airlines.
For each tranche in our sample we construct two measures of bankruptcy induced collateral shocks.
The first measure tracks the evolution over time of the number of airlines in bankruptcy operating aircraft of the same model types as those serving as collateral for the tranche. Since airlines tend to acquire aircraft of the same model types which they already operate, an increase in the first measure is associated with a reduction in the number of potential buyers of the underlying tranche collateral.
The second measure of collateral shocks tracks the number of aircraft operated by bankrupt airlines of the same model type as those serving as tranche collateral. An increase in this second measure is associated with a greater supply of aircraft on the market similar to those serving as tranche collateral.
Increases in either of these two measures, therefore, tend to decrease the value of tranche collateral and hence increase credit spreads.
For example, our univariate tests show that the mean spread of tranches with no potential buyers in bankruptcy is 208 basis points, while the mean spread of tranches with at least one potential buyer in bankruptcy is 339 basis points.
We develop, and apply to data on U.S. corporations from 1987-2000, tests of the standard doubly-stochastic assumption under which firms’ default times are correlated only as implied by the correlation of factors determining their default intensities.
This assumption is violated in the presence of contagion or “frailty” (unobservable covariates for default that are correlated across firms).
Our tests do not depend on the time-series properties of default intensities.
The data do not support the joint hypothesis of well specified default intensities and the doubly-stochastic assumption, although we provide evidence that this may be due to mis-specification of the default intensities, which do not include macroeconomic default-prediction covariates.
We find strong evidence for the presence of common latent factors, even when controlling for observable factors that provide the most accurate available model of firm-by-firm default probabilities.
Standard credit risk models cannot explain the observed clustering of default, sometimes described as “credit contagion.” This paper provides the first empirical analysis of credit contagion via direct counterparty effects.
We find that bankruptcy announcements cause negative abnormal equity returns and increases in CDS spreads for creditors.
In addition, creditors with large exposures are more likely to suffer from financial distress later .
This suggests that counterparty risk is a potential additional channel of credit contagion. Indeed, the fear of counterparty defaults among financial institutions explains the sudden worsening of the credit crisis after the Lehman bankruptcy in September 2008.
A unique feature of this study is the use of a data source that identifies detailed credit exposures but has not been explored so far in the literature.
We collect a sample of bankruptcy filings listing the top unsecured creditors, credit amounts, and credit types for over 250 public bankruptcies over the period 1999 to 2005.
This allows us to investigate the effect of counterparty risk on different types of creditors, specifically industrial firms and financial firms.
This study examines the intra-industry information transfer effect of credit events, as captured in the credit default swaps (CDS) and stock markets. Positive correlations across CDS spreads imply that contagion effects dominate, whereas negative correlations indicate competition effects.
We find strong evidence of contagion effects for Chapter 11 bankruptcies and
competition effects for Chapter 7 bankruptcies.
Chapter 7 and Chapter 11 are two common forms of bankruptcy (11 before 7):
In a Chapter 11 bankruptcy, the company continues to operate and restructures under the supervision of a court-appointed trustee, with the goal of emerging from bankruptcy as a viable business.
In a Chapter 7 bankruptcy, the assets of a business are liquidated to pay its creditors, with secured debts taking precedence over unsecured ones.
We also introduce a purely unanticipated event, in the form of a large jump in a company’s CDS spread, and find that this leads to the strongest evidence of credit contagion across the industry.
Conflicts of interests between shareholders and creditors give rise to limits-to-arbitrage through higher short-sale constraints, but are mitigated by dual holders of equity and debt.
Using mergers of financial institutions to identify an exogenous variation in firms’ dual holder presence, we find that more dual holdings increase equity lending supply and reduce short-sale constraints. Dual holders make shareholders less likely to restrict lending supply before voting events’ record date to exercise control rights. Finally, dual holders increase short selling without rising shorting costs, lower arbitrage risk, and reduce stock overvaluation. These results suggest that shareholder-creditor conflicts have a real impact on market efficiency.