The Technical Default Spread.

This article investigates the quantitative effects of lender control rights—specifically, the reallocation of investment control from borrowers to lenders upon breaching loan covenants (technical default)—on corporate investment, asset prices, and the aggregate economy. The authors develop a dynamic general equilibrium model incorporating endogenous loan covenants written on firms’ profits, where lenders, upon technical default, optimally choose low-risk investments, thereby mitigating borrowers’ risk-taking incentives and lowering the cost of equity. Calibrated to U.S. data, the model replicates key macroeconomic moments, including the countercyclicality of technical default probabilities and the mitigation of the financial accelerator effect, and predicts that firms closer to technical default exhibit lower investment risk and earn approximately 4.12% lower equity returns. Empirical analysis using DealScan loan covenant data confirms that higher covenant strictness is associated with reduced exposure to aggregate economic risk and lower expected stock returns, independent of financial distress measures, supporting the model’s mechanism that lender control rights significantly influence firm-level risk-taking and cost of capital as well as aggregate economic dynamics.