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

A distressed firm has 200 dispersed bondholders and proposes an exchange offer that swaps existing bonds for new bonds with lower principal. Each bondholder would be better off if the others accepted while it held out and kept its original claim. Which problem does this describe, and which feature is often added to mitigate it?

This is the holdout problem: each bondholder gains by refusing to concede while others accept. Exit consents, which let tendering holders vote to remove covenants from the old bonds, reduce the attractiveness of holding out and increase participation in the exchange.

  1. ADebt overhang; adding new equity covenants
  2. BHoldout problem; exit consents that strip covenants from the old bondsCorrect
  3. CAsset substitution; adding collateral to the new bonds
  4. DAdverse selection; adding a put option to the new bonds

Explanation

Individual creditors have an incentive to free-ride on others' concessions, which is the holdout problem. Exit consents let participating holders vote to strip protective covenants from the old bonds, making holding out less attractive.

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