As the 2007–10 financial crisis unfolded, defaults in the subprime-mortgage market quickly dragged down the values of debts unrelated to mortgages, such as AAA-rated asset-backed securities with portfolios of student loans, credit-card loans, and auto receivables. In financial markets, this phenomenon is known as contagion.
While it’s tempting to view such negative credit events through the lens of defaulting companies and the quality of collateral behind their debts, there’s another issue: the presence of unskilled debt buyers, and the pivotal role they play in debt-market stability, according to research by Chicago Booth PhD candidate Hyunsoo Doh. If skilled debt buyers were to step in sooner than they typically do, they could limit contagion, Doh argues.
He draws his conclusions from an economic model in which debt-issuing companies are subject to idiosyncratic risks, so that the cause of one company’s default most likely differs wildly from the cause of another’s. Every company funds itself by issuing short-term debt to a group of creditors that may choose to extend or withdraw funding as issues mature. The debts’ maturities are staggered to avoid a concentrated liquidity crisis.
“If any single firm fails to repay its debt outstanding, it is forced to liquidate its assets and, by doing so, lowers the collateral values of other remaining firms,” Doh writes.
The speed and skill with which new investors refinance the market help to determine the depth and severity of price drops during default events. The potential buyers of liquidated assets have varying levels of skill as asset managers. But Doh argues that even in cases where there is money to be made by stepping in and buying a failing company’s assets, skilled investors may not be able to purchase failed assets immediately—they might have difficulty finding counterparties willing to sell their assets, or might not be paying attention to the market at every moment. In the meantime, prices for failed assets fall precipitously, which hurts market values, even for companies that have not defaulted.
The situation also leaves creditors with a conundrum that can cause runs in the credit markets. If they believe their recovery rates could drop, they have an incentive to permit companies to fail so that they can seize and sell the underlying assets before prices crater.
The overall effect is that the dynamics of debt buyers and creditors combine to increase default probabilities for all businesses in the model, even companies with sound fundamentals. But one group does benefit from contagion: distressed-debt investors who step in and scoop up assets at bargain prices.