Strategic defaults and priority violations under costly state verification

Abstract

We reformulate the classic CSV model of financial contracting from Townsend (1979) and Gale & Hellwig (1985) to tackle criticisms raised against it, such as lack of subgame-perfectness at the repayment stage and its inability to encompass equity contracts. The implications drawn are shown to be consistent with empirical regularities, such as strategic defaults of debt obligations, firms being financed by a mix of debt and equity, violations of absolute priority rules, and a low debt ratio for high risk projects.