Efficient Recapitalization

We analyze public interventions to alleviate debt overhang among private firms when the government has limited information and limited resources. We first compare the efficiency of buying equity, buying risky assets, and providing debt guarantees. With compulsory participation, all the interventions are equivalent. With endogenous participation, buying equity dominates the two other interventions. We extend our results to deposit insurance, debt covenants, and heterogeneity across assets. Finally, we propose a constrained-efficient mechanism where the government makes a subordinated loan in exchange for call options on equity.

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