The Technical Default Spread

Abstract

We study the quantitative impact of lender control rights on firm investment, asset prices, and the aggregate economy. We build a general equilibrium model with endogenous loan covenants, in which the breaching of a covenant (technical default) entails a switch in investment control rights from borrowers to lenders. Lenders optimally choose low-risk projects, thus mitigating borrowers' risk-taking incentives and reducing a firm's cost of equity. Such a mechanism mitigates the financial accelerator effect (Bernanke et. al. 1999), and generates a technical default spread that firms closer to technical default earn 4% lower average returns than those further away from it.