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Conflicting Priorities: A Theory of Covenants and Collateral

Jason Donaldson, Denis Gromb and Giorgia Piacentino
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Jason Donaldson: Washington University in St Louis
Giorgia Piacentino: Columbia University

No 157, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Debt secured by collateral has absolute priority in the event of default—it is paid ahead of unsecured debt, even if unsecured debt is protected by negative pledge covenants prohibiting new secured debt. We develop a model of how this priority rule leads to conflicts among creditors, but can be optimal nonetheless: borrowers’ option to use collateral in violation of covenants allows for the dilution of existing debt, and hence prevents under-investment, whereas creditors’ option to accelerate debt following a covenant violation deters dilution, and hence prevents over-investment. The optimal investment policy is implementable via a mix of different types of debt, including secured and unsecured debt with tight and loose covenants. The model is consistent with a number of stylized facts about debt structure, covenants, and their violations.

Date: 2019
New Economics Papers: this item is included in nep-ban
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