Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning

• Published date: 01 June 2019
• DOI: http://doi.org/10.1111/1475-679X.12252
• Date: 01 June 2019

DOI: 10.1111/1475-679X.12252

Journal of Accounting Research

Vol. 57 No. 3 June 2019

Printed in U.S.A.

Consequences of Debt Forgiveness:

Strategic Default Contagion and

Lender Learning

GERARDO P´

EREZ-CAVAZOS

∗

Received 6 March 2017; accepted 28 November 2018

ABSTRACT

I use a unique data set of loans to small business owners to examine

whether lenders face adverse consequences when they grant debt forgive-

ness to borrowers. I provide evidence consistent with borrowers commu-

nicating their debt forgiveness to other borrowers, who then more fre-

quently strategically default on their own obligations. This strategic de-

fault contagion is economically large. When the lender doubles debt for-

giveness, the default rate increases by 10.9% on average. Using an ex-

ogenous shock to the lender’s forgiveness policy, my findings suggest

that as the lender learns about the extent of borrower communication

∗Harvard Business School.

Accepted by Stephen Ryan. I am grateful to my dissertation committee: Douglas Skinner

(Chair), Phil Berger, Christian Leuz, and Haresh Sapra. I also thank two anonymous review-

ers, Ray Ball, Andreas Bodmeier, Alejandro Cavazos, Hans Christensen, Merle Erickson, John

Gallemore, Joseph Gerakos, Mark Maffett, Mike Minnis, Adair Morse, Valeri Nikolaev, An-

tonio Picca, Andreya Perez, Eugene Soltes, Suraj Srinivasan, Gwen Yu, Anastasia Zakolyuk-

ina, and seminar participants at Duke University, Harvard Business School, London Business

School, Massachusetts Institute of Technology, New York University, Stanford University, Uni-

versity of California at Los Angeles, University of Chicago, University of Illinois, University

of Pennsylvania, Washington University, and the 2014 AAA/Deloitte/J. Michael Cook Doc-

toral Consortium for helpful comments. Finally, I am extremely grateful to Financiera Ayu-

damos for providing their data. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

797

CUniversity of Chicago on behalf of the Accounting Research Center,2018

798 G.P´

EREZ-CAVAZOS

the lender tightens its debt forgiveness policy to mitigate default

contagion.

JEL codes: D10; D83; G21; M41

Keywords: debt forgiveness; contracting; strategic default contagion; learn-

ing

1. Introduction

In the debt forgiveness negotiation process, lenders attempt to minimize

losses from borrowers who default. Although this process can help both par-

ties achieve more efficient outcomes, loan forgiveness decisions may yield

adverse consequences for lenders. In this study, I examine whether infor-

mation about lenders’ debt forgiveness decisions is transmitted among the

lenders’ borrowers, leading to strategic default contagion. I present two key

findings. First, I document strategic default contagion when lenders grant

debt forgiveness to borrowers, consistent with borrowers communicating

the terms of their debt forgiveness to other borrowers, who are then more

likely to strategically default on their own obligations. Second, I provide evi-

dence that lenders over time learn about this default contagion and tighten

their forgiveness and origination policies to mitigate contagion.

I use a loan-level data set from Financiera Ayudamos (FA), a Mexican

credit institution that grants small business and consumer loans. FA selec-

tively grants debt forgiveness in cases of default in an effort to reduce loan

losses by incentivizing defaulters to repay their loans.1Iusethesedebtfor-

giveness events to analyze whether FA incurs costs due to communication

of its forgiveness decisions among borrowers. The idea is that a borrower

who is granted debt forgiveness can subsequently share the terms of the

forgiveness with other borrowers. Because of borrower-lender information

asymmetry, lenders may be unable to distinguish between borrowers who

can and cannot repay their loans and financially able borrowers can then

strategically default to try to obtain similar terms.

A distinct feature of this setting is that the lender privately grants debt

forgiveness to selected borrowers. Unlike a public event such as foreclosure,

a default and the subsequent renegotiation with the lender typically are not

publicly announced by either party or otherwise a matter of public record.

Therefore, the extent, if any, of information sharing among borrowers is

unclear ex ante. If borrowers communicate with each other, the resulting

strategic default may be substantial enough for the lender to reduce debt

forgiveness.

1For example, consider a borrower who is six weeks late on his payments and is only able

to pay half of his deficiency. This borrower may not make any payments because he knows he

will remain in default. If the lender offers to forgive three payments, the borrower can agree

to pay the remaining three installments and become current on his loan.

CONSEQUENCES OF DEBT FORGIVENESS 799

To identify costs due to strategic default contagion, it is necessary to dis-

entangle defaults attributable to borrower communication from defaults

that are the result of economic adversity. My empirical approach is based

on the premise that borrowers’ ability to pay is primarily determined by eco-

nomic shocks at work. Thus, I use the default rate in each borrower’s local

work area (zip code) to control for these shocks. Because FA’s borrowers

in my sample are business owners, an increased default rate in the work

area indicates that they have suffered shocks to income, whereas a stable

default rate indicates stable economic conditions. If an individual defaults,

but there is a low default rate in the work area, I attribute the default to

idiosyncratic shocks (e.g., accidents) or events within his home neighbor-

hood.

Widespread default in a home neighborhood can have two possible ex-

planations: (1) economic shocks to neighborhood cash flows or (2) strate-

gic default due to communication about the lender’s forgiveness decisions

among borrowers. I argue that the second explanation is an important

driver of my results because communication is high within Mexican neigh-

borhoods, which typically comprise tight-knit groups of families and friends

who have lived there most of their lives and interact through weekly com-

munity activities (Keefe [1984]).2To determine whether the default stems

from such communication, I examine the forgiveness rate within the home

neighborhood. A high forgiveness rate indicates more borrowers have ex-

perienced debt forgiveness. As these informed borrowers communicate the

terms of this forgiveness, neighborhoods with a higher forgiveness rate in a

month will have more strategic defaults in the subsequent month. To mit-

igate the possibility that defaults due to economic shocks drive my results,

I control for inflation, natural disasters, contagious diseases, and the con-

temporaneous default rate in the neighborhood.

My first set of results measures the rate of strategic default after the

lender increases debt forgiveness in a neighborhood. I find evidence consis-

tent with strategic default contagion resulting from communication among

borrowers regarding the terms of the lender’s forgiveness decisions. If FA

doubles its forgiveness rate in a neighborhood, the default rate increases by

1.7% in the following month, a sizeable 10.9% increase in FA’s monthly de-

fault rate. These results are robust across a wide range of tests. In addition

to controlling for economic shocks, I include home zip code fixed effects

to capture any unobservable time-invariant characteristics of home neigh-

borhoods and the interaction of work zip code and month fixed effects to

capture time-varying conditions in work areas.

My findings have the following implications that generalize beyond the

debt forgiveness setting I examine. First, my evidence raises questions about

2Keefe [1984] finds that Mexican-Americans families “have relatively large kin networks

with high rates of visiting and exchange. Even immigrant Mexicans, who have experienced

disruption of their kin group due to migration, surpass Anglos in the number of relatives

living nearby and their frequency of visiting kin.”