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In: Accounting

A bank wants to estimate the value of inventories or fixed assets pledged by a borrower...

A bank wants to estimate the value of inventories or fixed assets pledged by a borrower as collateral in the event of default on a loan. Discuss why the value of this collateral is affected by the likely reasons that a borrower might default on its loan.  In particular, compare the value of the collateral in the event of bankruptcy for a firm where the most likely reason for bankruptcy is due to risky investments in derivative securities to a more typical firm where the failure of the firm’s core business is the main source of bankruptcy risk.

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Expert Solution

A firm's bankruptcy reduces the collateral value of other industry participants, thereby increasing their cost of debt financing. We identify the collateral channel using novel data of secured debt tranches issued by U.S. airlines that include detailed descriptions of the underlying collateral pools. Our estimates suggest that industry bankruptcies have a sizeable impact on the cost of debt financing of other industry participants. We discuss how the collateral channel may lead to contagion effects that amplify the business cycle during industry downturns.
Theory predicts that the bankruptcy of industry participants lowers collateral values of other industry participants: the risk of fire-sales will place downward pressure on the value of similar assets in the industry, and firm bankruptcies will reduce overall demand for industry assets. However, identifying a causal effect of bankruptcies on solvent non-bankrupt competitors is difficult since bankruptcy fillings are potentially driven by the state of the industry, which masks the direction of causality. Using transaction prices in a novel dataset of secured debt tranches issued by U.S. airlines, we identify a causal link from bankrupt airlines to the cost of debt capital of non-bankrupt airlines. Our identification strategy relies on analyzing the differential impact of an airline’s bankruptcy on the price of tranches which are secured by aircraft of different model types. We hypothesize that bankruptcies create a ‘collateral channel’ effect in which expected liquidation value of collateral decline when some airlines file for bankruptcy thereby affecting solvent airlines with similar assets. Consistent with the ‘collateral channel’ hypothesis, we find that tranches whose underlying collateral are of model types which have a large amount of overlap with the fleet of the bankrupt airline exhibit larger price declines than tranches whose collateral has little overlap with the bankrupt airline’s fleet. We also find that, as predicted, the ‘collateral channel’ effect is stronger for less profitable airlines and more junior tranches. Our analysis suggests that bankruptcy filings by some firms in the industry impose externalities on other industry participants.

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