Fire-sale channel of industry contagion: evidence from the pricing of industry recovery rate

Abstract

How does bankruptcy contagion propagate among industry peers? We study the fire-sale channel of industry contagion by examining whether the cost of debt of a company is affected by the observed recovery rates of its bankrupt industry peers. Our results show that lower industry recovery rates are associated with higher loan spreads but only when the contracts are originated during industry bankruptcy waves. Confirming the fire-sale channel of industry contagion, we find that the negative effect of industry recovery rate is significantly stronger under conditions where fire-sale discount is expected to be more salient. We also find that information asymmetry is an important determinant of the significance of the fire-sale effect, which manifests itself in both the pricing and non-pricing terms of newly negotiated bank loans. Valuation Insight: Valuation must consider the recovery rates of a firm's assets in the context of industry-wide fire sales. This paper finds an important value effect of observed recovery rates of bankrupt peer firms: costs of debt increase in times of industry bankruptcy waves.