The authors address the challenge of distress in debt portfolios, which has increased proportionately in recent years. Optimizing the restructuring and portfolio construction of pools of distressed debt can eliminate the deadweight costs of default and result in gains large enough to be shared by the original lender, borrower, and investor. The authors develop a model for the pricing and optimal restructuring of loans that are underwater and thus at risk of borrower default because of unwillingness or inability to pay.

Distressed holdings currently constitute a significant percentage of sovereign, corporate, and mortgage debt. Distressed debt suffers from concerns about liquidity default, in which the borrower is willing but unable to make payments on the loan, and strategic default, in which the borrower is solvent but chooses to walk away from the loan. The authors show that deleveraging by writing down debt is a key factor in the optimal restructuring of a distressed debt portfolio.

The gains from optimal restructuring are large enough to be attractive to institutional investors, such as hedge funds and private equity firms, which can buy and restructure distressed loans with the goal of earning favorable risk-adjusted returns. Furthermore, gains, albeit much smaller, in certainty-equivalent basis points can be achieved through diversification of distressed debt portfolios.

According to the authors’ model, the lender and the borrower also benefit from optimal restructuring. By having the principal of the debt written down, the borrower is more likely to be motivated to maintain the value of the underlying collateral, which means that the lender will gain as well. Because the gains from optimal restructuring are large and wide ranging, the authors posit that the general use of eminent domain to initiate restructuring may be a desirable means of clearing the securitization-induced logjam of distressed debt and bringing about market-wide change.

The authors use a tree-based model to price distressed debt, accommodating coupons and default risk. Default is accounted for by using a barrier function that considers incentive effects from shared appreciation and willingness to pay as well as other frictions. Restructuring approaches that are incorporated into the model include writing down the outstanding amount of the debt, reducing the interest rate on the loan, and swapping debt for an equity stake.

Given that an investor in distressed debt is aiming to enhance returns, the authors calculate the distribution of returns on unrestructured and restructured debt of a given maturity over the chosen horizon, usually shorter than the maturity of the original loan. They then examine the restructuring process for a single loan, determining the fair value of the loan before restructuring and computing the default probability and return distribution of the restructured loan. The authors compare those results with the unrestructured loan to filter out the benefits of the restructuring.

To compare the gains for an investor who is interested in higher-order moments and not just mean and variance, the authors examine the expected utility of an investor with constant relative risk aversion preferences for both minimally underwater and deeply underwater loans. They then convert the improvement in utility from loan restructuring into basis points by calculating the certainty equivalent between the return distributions of the base case loan and the restructured one.

The authors address a challenge that is pertinent in a variety of scenarios and make a strong case for the overall benefits of restructuring distressed debt along the lines that they describe. The main issue would seem to be how to put the ideas into practice. They consider the prospect of eminent domain as a possible solution to the current logjam—in which securitization cuts off investors from negotiating directly with borrowers—but acknowledge in the endnotes the arguments against that approach.