Academic journal article Real Estate Economics

Renegotiation of Troubled Debt: The Choice between Discounted Payoff and Maturity Extension

Academic journal article Real Estate Economics

Renegotiation of Troubled Debt: The Choice between Discounted Payoff and Maturity Extension

Article excerpt

Renegotiation of securitized debt contracts is generally a more efficient solution to default than foreclosure when there are significant deadweight costs associated with the enforcement of security rights. Recent literature shows that when renegotiation takes the form of discounted loan payoffs, it eliminates deadweight costs associated with the liquidation or transfer of assets. There is evidence, however, that, in practice, renegotiation of other contract terms such as maturity is a more common form of loan workout. This observation is puzzling because, in general, maturity renegotiation does not eliminate deadweight costs. We provide a partial answer to this puzzle by showing that maturity renegotiation better aligns the incentives of borrowers and lenders than does renegotiation of principal. Specifically, we find that borrowers who expect that lenders will renegotiate maturity in the event of default have less incentive to divert cash flow from the collateral during the term of the loan and less incenti ve to take on additional risk. If the lender's cost of managing these standard agency problems is positively related to the magnitude of the borrower's incentive, then maturity renegotiation will result in lower monitoring and enforcement costs.

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Renegotiation of debt contracts is a tool that borrowers and lenders have long used to improve the efficiency of financial contracts. Renegotiation is preferable to strict enforcement of the lender's right to the borrower's assets when value would be lost in the process of transferring and liquidating pledged assets. (1) For example, real estate lenders frequently renegotiate or "work out" problem loans because of the significant time and costs associated with the foreclosure process.

Deadweight foreclosure costs can result in inefficiency in debt contracts. The possibility of deadweight costs means that borrowers, a priori, place a higher value on the required loan payments than lenders place on the net payments they receive. Consequently, rational borrowers reject loans that generate zero profits for lenders, and profitable investment opportunities are lost. If borrower and lender expect that negotiation in the event of financial distress will eliminate these deadweight costs, then the inefficiency is eliminated. (2)

Recent literature (e.g., Riddiough and Wyatt 1994a, Anderson and Sundaresan 1996, Mella-Barral and Perraudin 1997) shows that when renegotiation takes the form of discounted loan payoffs (renegotiation of principal), it eliminates all deadweight costs associated with the liquidation of assets. For example, in the Mella-Barral and Perraudin model, defaulting borrowers make "take-it-or-leave-it" discounted payoff offers to lenders equal to the net proceeds lenders expect to receive after transfer. These offers are acceptable to lenders and beneficial to borrowers. In equilibrium, all occurrences of financial distress are resolved via discounted loan payoffs and the contracting inefficiency is eliminated.

There is substantial evidence, however, that renegotiation of other contract terms is more common in loan workouts than discounted payoffs (see Asquith, Gertner and Scharfstein 1994 and Mann 1997). These authors find that renegotiation of maturity is the most common form of loan modification. Asquith, Gertner and Scharfstein study companies in financial distress, and report that although the banks in their study almost never accepted discounted loan payoffs, they frequently modified other loan terms, including maturity. Mann reports that discounted payoffs occur in only a small fraction of the problem loan workouts he studied, while other forms of contract modification are common. (3) Maturity extension is especially prevalent in real estate lending. For example, many servicing agreements. associated with Commercial Mortgage-Backed Securities (CMBS) give the special servicer the right to extend maturity to resolve a default but not the right to forgive principal. …

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