Credit Risk, Credit Crunch and Capital Structure

A firm partially financed by debt is considered. The firm is subject to two types of shocks: macro-shocks modeled as a finite state Markov chain, and idiosyncratic shocks. The dynamics of the latter may depend on the state of the macroeconomy; the state of the economy is determined not only by fundamentals but the market sentiment as well. The lenders are competitive and debt is rolled over until the macro-state changes. If conditions improve, the firm has an incentive to pay off debt and issue new debt on more favorable conditions. On the other hand, if conditions deteriorate, then debt covenants allow lenders to require debt renegotiation. It is also possible that in some states, the firm cannot roll over the debt at all (credit crunch). We compare the credit spreads which the model in the paper produces with the spreads in a less flexible model (Hackbarth, Miao, and Morellec (2006)), where the coupon is chosen at debt inception and remains fixed thereafter, and study the dependence of the spread on debt maturity, the market sentiment and probability of a credit crunch. Preliminary and incomplete