Illiquidity, Fire-Sales and Capital Structure

This paper investigates the industry dynamics and capital structure of firms that hold illiquid assets and face potential fire-sales. Firms enter the industry by paying a fixed cost financed by equity and debt. Once in operation, shareholders have the option to adjust their asset holdings at a cost but also retain the option to exit the industry by defaulting on their debt. While costly, asset sales allow the shareholders to boost dividends or to service debt payments rather than defaulting. However, as shareholders make their decisions once debt is in place, the resulting conflict with bondholders entails over-investment and early liquidation due to debt-overhang. A substantial number of firms also exit following an exogenous financial shock. In the stationary industry equilibrium, firms selling assets but are not defaulting find it more costly to reduce capacity due to the price effects of fire-sale liquidations. This price feedback effect results in lower industry leverage but a higher default rate. Capital regulation reduces leverage ex-ante but at the cost of inducing more default. Restricting asset sales mitigates fire-sales and also reduce leverage ex-ante.