Because of limited liability, insolvent banks have an incentive to continue lending to insolvent borrowers, in order to hide losses and gamble for resurrection, even though this is socially inefficient. We suggest a scheme that regulators could use to solve this problem. The scheme would induce banks to reveal their bad loans, which can then be dealt with. Bank participation in the scheme would be voluntary. Even though banks have private information on the quantity of bad loans on their balance sheets, the scheme avoids creating windfall gains for bank equity holders. In addition, some losses can be imposed on debt holders.

This paper derives closed-form solutions for values of debt and equity in a continuous-time structural model in which the demands of creditors to be repaid cause a firm to be put into bankruptcy. This allows discussion of the effect of creditor coordination in recovering money on the values of debt, equity, and the firm, as well as on optimal capital structure. The effects of features of bankruptcy codes that prevent coordination failures between creditors, such as automatic stays and preference law, are also considered. The model suggests that such features, while preventing coordination failures, can decrease welfare.

We model the debt maturity choice of firms in the presence of fixed issuance costs in the primary market and search frictions in the secondary market for debt. In the secondary market, short maturities improve the bargaining position of sellers, which reduces the required issuance yield. Long maturities reduce reissuance costs. The optimally chosen maturity trades off both considerations. Equilibrium exhibits inefficiently short maturity choices. An individual firm does not internalize that a longer maturity increases expected gains from trade in the secondary market, which attracts more buyers and, hence, facilitates the sale of debt issued by other firms.

In recessions, the number of defaulting firms rises. On top of this, the average amount recovered on the bonds of defaulting firms tends to decrease. This paper proposes an econometric model in which this joint time-variation in default rates and recovery rate distributions is driven by an unobserved Markov chain, which we interpret as the “credit cycle”. This model is shown to fit better than models in which this joint time-variation is driven by observed macroeconomic variables. We use the model to quantitatively assess the importance of allowing for systematic time-variation in recovery rates, which is often ignored in risk management and pricing models.

Because of limited liability, insolvent banks have an incentive to continue lending to insolvent borrowers, in order to hide losses and gamble for resurrection, even though this is socially inefficient. We suggest a scheme that regulators could use to solve this problem. The scheme would induce banks to reveal their bad loans, which can then be dealt with. Bank participation in the scheme would be voluntary. Even though banks have private information on the quantity of bad loans on their balance sheets, the scheme avoids creating windfall gains for bank equity holders. In addition, some losses can be imposed on debt holders.

What is the economic role played by arrangers of leveraged loans, and what are the risks they face? We provide evidence that arrangers solve a demand discovery problem. Investors have incentives to feign little interest in the loan to obtain better terms. To deter such behavior, arrangers underprice hot deals and ration investors on cold deals. The risk associated with demand discovery is often shared between borrowers and arrangers. One implication is that to ration investors on cold deals, arrangers retain larger loan shares. This motive for retention is different from the monitoring incentive motive previously considered in the literature.