Government interventions in private debt negotiations could be more effective in preventing default waves if they accounted for the connections between lenders and borrowers across the “debt chain,” according to a new research paper by Wharton finance professor Vincent Glode and Christian Opp, associate professor of finance at the University of Rochester Simon Business School.

An efficient understanding of such connections would provide insights into debt default triggers and spot the right time for interventions, noted the paper titled “Private Renegotiations and Government Interventions in Debt Chains.” The paper’s model recognizes that economic shocks have varying effects on different entities across those debt chains, each of which has private information about its individual financial conditions.

The paper offered the example of a retail store that owes money to a supplier, which might have a loan from a local credit union, which again might have borrowed from a large national bank. This large national bank may be partly financed with bonds held by a pension fund that owes retirement benefits to workers. A debt chain could also begin with a household that owes money to its landlord, who in turn owes money to a credit union or a bank, Glode said.

“The prevalence of these debt chains implies that private debt renegotiations have important externalities that governments should recognize when designing and targeting their interventions,” the paper stated. “The effectiveness of private and public efforts [in preventing debt defaults] is crucially influenced by the fact that businesses tend to be sequentially interconnected through their liabilities.”

“You have to be careful how you intervene; your goal cannot be to solve the problems of just one credit relationship,” said Glode. He pointed to the Biden administration’s latest move on tenant protections that extends by one month a federal moratorium on evictions by landlords. “What you do with an eviction moratorium is decrease the liability of the tenant. But you’re then putting the landlord in a very tough spot; that landlord may owe money to its mortgage lender.” Government mandates on debt reductions protect borrowers but hurt lenders, he added.

“You have to be careful how you intervene; your goal cannot be to solve just one credit relationship.” –Vincent Glode

“If you want an intervention in the credit relationship between the individual and the landlord to produce positive externalities elsewhere through the debt chain, you’re better off boosting the assets of the renter than reducing the debt owed to the landlord,” Glode continued. That intervention could be in the form of a subsidy to the renter, which makes it more likely that the renter will not default. It also means the landlord has more money to pay its mortgage bank, and the benefits continue to flow across the debt chain, he explained. “You have to take the whole economy into consideration.”

Glode said his paper is timely against the backdrop of the government’s COVID relief programs and the need to design them to extend benefits across debt chains. “We are learning more with better data about these complex networks of debt obligations and how these relationships can affect other relationships elsewhere, and the whole economy sometimes.”

The effectiveness of interventions like subsidies depends also on how they allocate bargaining power between lenders and borrowers, the paper noted. The bargaining between a borrower and its lender is bilateral, and that could mean that one party’s bargaining power “impedes the efficiency of not only one credit relationship but that of the whole chain,” the authors wrote.

Glode and Opp traced the twists and turns in a typical debt renegotiation process. A lender faced with a potential default by its borrower might decide to reduce the payment that is due or take what is called “a haircut.” The motivation for that haircut is the possibility of a smaller chance that its borrower may default with a reduced payment obligation. But that also depends on how the lender expects a reduction in its own liabilities further up that debt chain. The more it expects its own liabilities to be reduced, the more likely is its willingness to be lenient with its borrower. The reverse is also true — a lender that doesn’t expect much respite for its own debt obligations may decide to talk tough with its borrowers.

But taking a tough stance could misfire on many fronts. “A tough renegotiation strategy may be privately optimal,” but it increases the potential for default, the paper pointed out. It could also hurt renegotiation efforts elsewhere in the chain, it added.

Key Findings

The paper’s authors analyzed how targeted government policies affect renegotiation outcomes throughout a chain to arrive at their findings.

First, they showed that providing subsidies to “downstream” borrowers like the retail store (whose debt payments are expected to flow up the chain) can be particularly effective in eliminating default waves. Such subsidies typically cover only a fraction of the potential shortfall the borrower faces because the lender has an incentive in reducing the debt to a default-free level. “Private renegotiation is an important factor determining the magnitudes of government subsidies needed to avoid default, and our analysis reveals under which economic conditions these subsidies can be particularly small while still being fully effective,” the paper explained.

Providing subsidies to a borrower like the retail store also increases the incentives for lenders further up the chain to renegotiate their borrowers’ debt to default-free levels. “By boosting the maximum debt payment the retail store can pay without defaulting on its inventory supplier, a subsidy to the retail store can first lead the inventory supplier, then the local credit union, and then the large national bank to more efficiently renegotiate with their respective borrowers,” the paper stated. The upshot of that approach is that “a subsidy to a downstream borrower can be highly effective in preventing default waves, compared to giving the same subsidy to an upstream borrower,” the authors wrote.

In their second finding, the authors showed how government interventions that influence the allocation of bargaining power in private renegotiations can help prevent default waves. For example, the government could prevent an upstream lender from being able to choose its renegotiation strategy and instead mandate a reduction of its borrower’s liabilities.

“We are learning more with better data about these complex networks of debt obligations and how these relationships can affect other relationships elsewhere, and the whole economy sometimes.” –Vincent Glode

“[Such mandates] can incentivize downstream agents to voluntarily renegotiate the debt owed to them to levels that also avoid default of their respective borrowers,” the paper stated. For instance, in the example cited earlier, reducing the local credit union’s debt to the large national bank may help the credit union, and later its borrower (the supplier), to renegotiate their debt with their respective borrowers more efficiently.

A caveat is that interventions like government mandates must be designed carefully. “If poorly designed, this type of intervention can backfire,” the paper noted; it could “significantly reduce” how much the bank’s bondholders could collect by renegotiating the bank’s debt. It could have repercussions further upstream, too, where the pension fund that holds the bank’s bonds may toughen its renegotiation strategy, thereby increasing default risk across the chain, the paper added.

Lenders that are privy to their borrowers’ financial condition would ask them to pay what they realistically can. Access to such information removes “a key friction impeding efficient renegotiation … and inefficiencies associated with default would be avoided throughout the chain,” the paper noted. “[But] with asymmetric information, each lender faces a generic tradeoff when renegotiating with its borrower.” The magnitude of that tradeoff depends on the degree of uncertainty a lender faces about its borrower’s financial condition as well as about the expected renegotiation outcomes elsewhere in the chain, it added.

The third takeaway from the paper has to do with timing the renegotiation process efficiently. The researchers argued that outcomes would be better across the chain if each entity begins its renegotiation process before it knows about how bad its situation could get. The less an entity knows about its worst-case scenario, the more likely others in the chain will be to assume higher asset values, the paper explained. Timing the process that way makes way for lenient renegotiation strategies since “[creditors] get increasingly aggressive as their asset values decline.” Drawing from that, “government policies that facilitate early renegotiation will lead to more desirable outcomes,” the paper noted.

The authors recognized that in practice, large-scale government interventions like subsidies and mandated debt reductions entail “significant costs and constraints” such as budgets, taxes, and moral hazards. They therefore analyzed the effectiveness of “minimal targeted interventions in eliminating inefficient default waves.” They found that “providing a subsidy to a struggling borrower does not only improve the recipient’s ability to make its payments, but also incentivizes upstream lenders to renegotiate the debt that is owed to them to default-free levels.”

With the pandemic continuing to take its toll on business activity, we must find ways to help firms survive, said Glode. “Businesses have to be able to hold their breath so that they can get out from under the water after the pandemic. With that as our starting point, what are the policies we would like to implement if one were to survive a period like what we are in right now? We need to choose our tools carefully.”