Strategic debt service and the limits to lending

This thesis develops a framework for studying the design and valuation of collateralized loan contracts in a dynamic setting under complete information and uncertainty. Contingent claims valuation techniques are integrated into a game theoretic setting in which borrowers and lenders behave noncooperatively to maximize the values of their claims as specified by the terms of the loan contract and applicable bankruptcy laws.;The analysis presumes that the market value of the loan collateral follows a diffusion process. The borrower attempts to deviate from the terms of the loan contract to enhance the value of his claim. This behaviour is tempered by contractual provisions which allow the lender to foreclose and seize the collateral in the face of such deviation. Hence the rational borrower engages in 'strategic default', deviating from the terms of the contract without provoking foreclosure. However, certain contractual indentures do yield foreclosure in some states along the equilibrium path of the game analyzed.;Consistent with empirical evidence, foreclosure is assumed to be costly. The incidence of these costs on the contracting parties is state dependent. Also, the level of the market value of the collateral at which foreclosure occurs is determined endogenously.;Results are obtained analytically and by numerical methods. Noteworthy results include: (1) The upper limit on credit extended by a rational lender is a modest fraction of the initial market value of the collateral when foreclosure costs and dividend flows are positive, regardless of the interest rate the borrower offers. (2) The credit supply curve facing a particular borrower may be 'backward bending', with more credit supplied at lower interest rates than higher interest rates. (3) Strategic default by the borrower has a significant negative effect on the quantity of credit supplied for any given contractual interest rate. (4) A contractual indenture which allows the lender to recover prior concessions made to the borrower, at a later date, mitigates this negative effect. (5) The quantity of credit extended is decreasing in the volatility of the market value of the collateral, the cash flows generated by the collateral and the term to maturity of the loan contract.;For the purposes of this study results (1) and (2) are referred to as 'credit rationing'. Such credit rationing prevails despite the lack of any informational asymmetries between the borrower and lender.