Can the Cure Kill the Patient? Corporate Credit Interventions and Debt Overhang

Business credit programs (BCPs) are an important component of the public policy response to the recent recession. We develop and estimate a model to quantify the impact of BCPs on corporate leverage and investment. Our framework highlights the potential debt overhang effects of BCPs. Following a real shock, if private capital markets continue functioning normally, BCPs incentivize firms to take on too much leverage, leading to underinvestment in the recovery. However, if the shock is accompanied by a sudden stop in private capital markets, BCPs help limit the output losses caused by forced liquidations. Quantitatively, we show that this positive "level" effect outweighs the milder negative "growth" effects of debt overhang among surviving firms. Alternative designs (like equity injections) create only small gains over a simple loan program.