Seminar

Self-Inflicted Debt Crises

Theodosios Dimopoulos (University of Lausanne)

March 8, 2021, 12:30–13:30

Online

Finance Seminar

Abstract

When present-biased borrowers have the option to default on their liabilities, we establish that they undervalue their default option by a U-shaped error. The biased beliefs gives rise to pseudo-wealth that explains why borrowers take excessive leverage, imperfectly smooth consumption, underinvest in good times, and risk shift in distress. Pseudo-wealth is an important consideration for the resolution of debt crises. When borrowers can extract concessions from lenders, the size and frequency of rescue packages depend on whether larger transfers exacerbate or alleviate the borrowers’ belief bias. This result highlights that optimal crisis resolution requires to account for borrowers’ time-inconsistency. We provide conditions for when borrowers procrastinate default and debt crises are protracted, and we show that distress can be cheaper to resolve when borrowers are more myopic. In turn, rational principals can benefit from myopic agents.