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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A distressed firm has 100 of bonds held by many dispersed bondholders and 60 of bank debt held by one bank. Management offers an out-of-court exchange: bondholders swap their bonds for new bonds with a lower face value. Many bondholders reason that if enough others accept, the firm will survive and their own untendered bonds will be paid in full. This behavior best illustrates which obstacle to out-of-court restructuring?

This is the holdout problem. Dispersed bondholders each prefer to free-ride on others' concessions and keep their full claim, so exchange offers struggle to reach required participation. It is a collective-action failure typical of widely held public debt, unlike a single bank lender.

  1. AAdverse selection by the bank lender
  2. BHoldout problem arising from collective action among dispersed creditorsCorrect
  3. CDebt overhang causing underinvestment
  4. DFraudulent conveyance risk

Explanation

Each dispersed bondholder has an incentive to free-ride on others' concessions by refusing to tender, hoping to be paid in full. This holdout or collective-action problem is why public debt is hard to restructure out of court. Debt overhang concerns investment incentives, not tendering behavior.

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