Equilibrium Default Cycles

Abstract

This paper analyzes Markov equilibria in a model of strategic lending in which (i) agents cannot commit to long-term contracts, (ii) contracts are incomplete, and (iii) incumbent lenders can coordinate their actions. Default cycles occur endogenously over time along every equilibrium path. After a sequence of bad shocks, the borrower in a competitive market accumulates debt so large that the incumbent lenders exercise monopoly power. Even though the incumbents could maintain this power forever, they find it profitable to let the borrower regain access to the competitive market after a sequence of good shocks. Equilibria are computed numerically, and their attributes are qualitatively consistent with numerous known empirical facts on sovereign lending. In addition, the model predicts that a borrower who accumulates debt overhang will regain access to the competitive credit market only after good shocks. This prediction is shown to be consistent with data on emerging market economies.

Serial Default and Debt Renegotiation

“…However, none provides economic models describing how weak credit history or "original sin" features are associated with serial defaults. With stochastic dynamic model, Kovrijnykh and Szentes (2007) explain the equilibrium default cycles, but they do not derive any relation between default occurrences and outcomes of negotiations. This paper improves these papers by explaining how outcomes of current debt renegotiation, such as additional spread premia, lead to higher probability of next default in future.…”

Risk sharing with the monarch: contingent debt and excusable defaults in the age of Philip II, 1556–1598

“…On the other hand, Kovrijnykh and Szentes (2007) argue that repeated cycles of borrowing and default may be an efficient outcome, with lenders having an incentive to let borrowers escape from debt overhang. Bolton and Jeanne (2009) suggest that contracts that are ex post excessively difficult to restructure can be the result of efficient bargaining ex ante.…”

Credit Default Swaps and Sovereign Debt with Moral Hazard and Debt Renegotiation

“…Thus, until some repayment is made to the incumbent lender, the borrower cannot access the competitive loan market and the incumbent lender has some market power over the borrower. Kovrijnykh and Szentes (2007) show formally how this lender's switch from competitive in the pre-default stage to noncompetitive ex-post can arise endogenously when old debt is senior to new debt. Nevertheless, we have checked that the main intuition of our model that CDS can alleviate moral hazard would still hold if the lender have as much bargaining power ex-ante as ex-post.…”