Stanford research finds bankruptcy laws drive corporate default rates

By Caroline Salls

Pittsburgh, June 6 - New research from the Stanford Graduate School of Business found that bankruptcy laws drive corporate default rates, according to a news release.

As reported in a recent issue of Stanford Knowledgebase, new research from Stanford shows that over the past 150 years, the U.S. corporate bond market has repeatedly suffered clustered default events.

"In a surprise finding, the study reveals that default episodes are only weakly related to bad business downturns. Rather, they seem to be a function of permissive bankruptcy laws," the release said.

"When it comes to corporate defaults, the current recession is, as of now, child's play in comparison not only to the Great Depression but another little-recalled period: the railroad crisis of 1873-1875."

Stanford Graduate School of Business associate professor of finance Ilya Strebulaev, Stanford assistant professor of management science and engineering Kay Gieseke, Stephen Schaefer of the London Business School and Francis Longstaff of UCLA's Anderson School of Management said they have developed the first set of data on bond defaults and debt prices reaching back to the 19th century.

Railroad crisis ties

Their information has allowed for the first analysis of the relationship between various macroeconomic conditions and financial cycles, including banking crises.

"Although our findings go back a century and a half, they allow us to reflect upon various theoretical models that are quite relevant for today's environment," Strebulaev said in the release.

According to the release, the study shows that the recent economic downturn in some senses is more similar to the railroad crisis of the 1870s than it is to the Great Depression.

"The 19th century debacle involved the collapse of the entire economy, whose engine was the transportation industry," Strebulaev said in the release.

"The railroad boom was akin to the telecom and internet booms.

19th century volatility

Yet, from the perspective of bond investors, the research showed that 19th century corporate bond default rate was much higher and more volatile than that of today, as default rates peaked at 17% annually in the 1870s.

In contrast, the highest bond default rate during the depression of the 1930s was 8%.

The release said the bond default rates have been only 3% annually in the recent recession.

The researchers said they found that between the 1930s and the 1980s there were almost no corporate defaults.

"Prior to the 1930s, there really was no bankruptcy code in the United States and instead courts concocted a procedure to deal with defaulted firms called equity receivership," Strebulaev said in the release.

"As a result, what happened in the case of defaults looked similar to what happens with Chapter 11 today - debtors were treated in a more friendly way, while creditors were treated in a less friendly way."

Bankruptcy reform role

After the Great Depression, however, bankruptcy codes were reformed to treat debtors more harshly and creditors more favorably, according to the release. Then, in 1978, a new bankruptcy code in the United States again reversed the trend, making it easier for corporations to default.

The study showed that the period from the 1930s to the 1980s was "a time in which it became extremely unpalatable for corporations to default."

"After the 1978 bankruptcy law change, numerous risky companies began issuing the famous junk bonds, and the stage was once again set for a wave of defaults," the release said.

Corporate bond history

In addition, the research showed that corporate bonds are not a recent phenomenon, contrary to popular assumptions.

The corporate bond market was very liquid in the 19th and 20th centuries, the release said, even more so than the equity market, and many corporations financed themselves primarily with bonds.

"The total number of bonds traded then is similar to the number issued as recently as 10 years ago," Strebulaev said in the release. "So, in fact, bonds were even more important then, than now."

The study also found that default cycles are only weakly related to business cycles, including recessions.

"We show that if you measure financial constraints as the incidence of corporate defaults, there is not much of a link to the economy as a whole," Strebulaev said in the release.

"Such defaults are more closely tied to the laws and institutional environment of the day."

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