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FOURTH QUIZ FNCE 238/738 March 14, 2012 WRITE ALL ANSWERS ON THE TEST. IF YOUR ANSWER CONTINUES ON THE BACK, MAKE A NOTE OF IT ON THE FRONT. 30 PTS / 25 MINUTES NAME:_____________________________________________ SECTION (10:30, 12, 1:30):__________________________________

1. (10 pts) From the Weekly Standard , November 7, 2011: The weight of the collapsed housing sector on the economy means that no amount of stimulus, whether a short-term Keynesian fix or a conventional pro-growth package, will fix this problem. Not only are nearly 25 percent of homeowners holding mortgages for more than their houses are worth, there are also nearly four million households that have stopped making mortgage payments at all. In the time it takes—usually one to two years, sometimes longer—for the legal system to put them into foreclosure and make them move out, these families (and the mortgage holders) find themselves in an uneasy limbo: The mortgage holders aren’t getting any money and the families aren’t spending all that much either, with the result being that consumption, lending, and the overall economy stagnate. We don’t need another stimulus to fix what ails the economy. We need to fix the housing market. And the way to do that is to allow a mortgage cramdown in the context of a personal bankruptcy . Consider the last sentence. What does this mean, and what are the relevant issues? Cramdown – principal amount of secured debt is reduced to actual (market) value of collateral What this deal essentially does is shift all of the upside to homeowners and give mortgage issuers all of the downside of future price increases Some positives of the deal include: (just list some) • Creates incentives for borrowers to pay • Should lower the number of foreclosures • More income available for consumers to spend (helps the economy) • Etc. Some negatives of the deal include: (just list some) • Creates a large incentive to file bankruptcy • Borrowers easily able to reduce mortgage values • Could increase interest rates in the future as lenders incorporate the risk of cramdown • Etc.

2. (5 pts) From the December 21, 2011 Wall Street Journal: The Quiznos sandwich chain plans to ask creditors to support a debt-restructuring deal hammered out with other big lenders or face the prospect of a Chapter 11 bankruptcy-protection filing, said people familiar with the matter. Quiznos, struggling amid slumping sales and a recent violation of debt terms, reached a deal to hand ownership to Avenue Capital Group, the hedge fund controlled by billionaire Marc Lasry, the people said. Avenue would convert debt to equity and invest cash in Quiznos as part of a tentative deal, they said, giving the hedge fund more than a 70% ownership stake in the chain. The plan would reduce Quiznos's roughly $875 million in debt by about $281 million. Quiznos plans before the end of the year to ask other creditors to support the deal or force them to go along with it in a prepackaged bankruptcy, the people said. Creditors will have about 30 days to decide whether to accept the deal. The deal requires creditors to forgive debts and push out due dates on obligations, depending on the circumstances. They could fare worse if Quiznos filed for bankruptcy protection. Senior lenders would likely get less of their debt paid back, and other creditors would end up owning less of Quiznos if the deal gets done in bankruptcy court, the people said. Spokespeople for Quiznos and Avenue declined to comment. What are the obstacles to completing a debt-restructuring deal like this, and how is Quiznos trying to overcome those obstacles? 1.) Obstacles As we need consent to alter principal, interest or maturity of the debt, the plan essentially calls for creditors to forgive some debts, push out dates on obligations and convert others to equity. Debt holders could thus believe that since others will accept the deal, they can free ride on the decision of others, get full value and be higher in the capital structure by not voting in favor of the deal (holdout problem). 2.) Solutions The firm is counting on the threat of bankruptcy, in which case debt holders would be worse off, to convince debt holders to vote in favor of the deal. In bankruptcy, the voting rules are more advantageous to the company as they only need 2/3 approval in a class to pass the deal. Alternatively, a judge could force debt holders to go along with a deal if it is deemed to be fair.

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3. (10 pts) In a year, a firm will be worth 100 or 40, each with probability ½. Also, the firm has bond with face value 100 maturing in one year, where this bond is held in equal parts by 100 different bondholders, dispersed around the world. The bond has a covenant that makes it senior to all other debt, and it takes a majority vote (i.e. >50%) to amend or remove this covenant. The firm proposes an exchange offer to its bondholders: if you tender your bond with face value 1 and vote to remove the covenant, and if the vote passes, then you get a new bond with face value 0.8, senior to the old bond. If the vote fails, the exchange will be called off. Would a rational bondholder participate in this exchange? What considerations are important? No deal → EV = .5(1) + .5(.4) = 0.7 If deal & tender → EV = .5(.8) + .5(.4) = 0.6 If deal & no tender → EV = .5(0) + .5(1) = 0.5 A rational bondholder would tender in the exchange. If not enough votes for exchange, bondholder would get EV = 0.7, so it doesn’t matter what they do. Considerations • What are other bondholders doing? Can I communicate with others? o If you can get everyone to collectivize and agree to not tender, you would get EV = 0.7, which is higher than 0.6 • If I am the deciding vote (I should still tender) o tender → EV = .5(.8) + .5(40/50) = 0.8 no tender → EV = .5(1) +.5(.4) = 0.7

4. (5 pts) A study of financially distressed firms found that bank debt, as a fraction of total firm debt, was 25% on average in the firms that ended up in bankruptcy, and 40% on average in the firms that restructured without bankruptcy. What could explain this difference? • Bank debt is typically more senior than other forms of debt • Bank debt holders want to maximize the amount they get, whether in bankruptcy or not • More bank debt means less junior debt • The fact that restructured firms have on average more bank debt than those in bankruptcy shows: o More bank debt means that banks realize that the firm is worth more to them outside of bankruptcy and want to save on bankruptcy costs. This would entice bank debt holders to allow a restructuring with potential distributions to bondholders in order to keep the firm out of bankruptcy (remaining value > bankruptcy value) o Less bank debt indicates that the firm is less likely to care about the remaining value of the firm, as it is possible that the remaining value is less than the bankruptcy value. Additionally, senior holders with smaller stakes are worried about distributing value to bondholders, which would make it less likely they get paid outside of bankruptcy. As bank debt is senior to junior debt, they are more likely to get paid in full in bankruptcy case with less junior debt.

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