Collateral, Renegotiation and the Value of Diffusely Held Debt

Debt with many creditors is analysed in a continuous-time pricing model of the levered firm. We specifically allow for debtor opportunism vis-à-vis a non-co-ordinated group of creditors, in form of repeated strategic renegotiation offers and default threats. We show that the creditors initial entitlement to non-collateralized assets will be expropriated through exchange offers. Exchange offers successively increase the level of collateral until all assets are fully collateralised. The ex ante optimal debt contract is neither fully collateralised nor without any collateral. Diffusely held debt allows for a larger debt capacity and bears lower credit risk premia than privately held debt. We derive simple closed-form solutions for the value of equity and defaultable bonds. Numerical estimates show that the bond valuation is very sensitive to the correct specification of the debt renegotiation model.