Debt as an Option to Own in the Theory of Ownership Rights

In a seminal paper Grossman and Hart (1986) developed a theory of the optimal allocation of ownership rights based on incomplete contracts. In their model the only contracts feasible prior to investment decisions allocate ownership rights over physical assets. We investigate the role of a collateralized debt contract, which assigns ownership rights on an asset conditional on the repayment of the debt, in this setting. By allowing implicit conditioning on investments such a contract yields an efficiency improvement over the contracts considered by Grossman and Hart. In particular, if only one party has to invest an optimally designed debt contract implements the first best. Furthermore, the debt will be repayed in equilibrium.Our work departs from most analyses of debt contracts by emphasizing that debt contracts have an incentive effect on the creditor’s investment decision. The key effect is that the creditor’s relationship-specific investment affects the value of the debtor’s ownership right and thus whether or not he defaults on his debt.