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RFS Advance Access originally published online on February 22, 2006
Review of Financial Studies 2006 19(4):1357-1397; doi:10.1093/rfs/hhj031
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Theory and Evidence on the Resolution of Financial Distress

David T. Brown
University of Florida

Brian A. Ciochetti
Massachusetts Institute of Techology

Timothy J. Riddiough
University of Wisconsin-Madison

Address correspondence to David T. Brown Department of Finance, Insurance and Real Estate, Warrington College of Business, University of Florida, PO Box 117168, Gainesville, FL 32611-7168, or e-mail: david.brown{at}cba.ufl.edu.

We analyze a financially distressed owner-managed project. The main results of the model are: (1) borrower default is an endogenous response to the anticipated restructuring–foreclosure outcome; (2) the lender’s restructuring–foreclosure decision depends critically on the interaction between project value and industry liquidity; and (3) the lender waits for the industry to recapitalize before selling assets obtained through foreclosure. Empirical analysis of a large sample of defaulted commercial real estate loans supports many of the model predictions, including restructuring–foreclosure outcomes that are consistent with endogenous borrower default and firesale discounts that vary depending on industry market conditions at the time of foreclosure. (JEL G33)


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