Debt Composition and the Determinants of Default: An Examination of the Optimal Waiver Policy upon a Covenant Violation

Abstract

I offer a model of the optimal creditor and firm owner decisions upon a covenant violation. The model implies that the share of private debt in a firm’s capital structure is more predictive of foreclosure than the share of total debt and that asset volatility is not predictive of foreclosure. I find the empirical evidence supports these hypotheses. These finding suggest novel conclusions about the determinants of creditor induced default and reemphasize the need to treat the default threshold as endogenous in credit risk and pricing applications.