William Waller

While recent theoretical research has highlighted the importance of time-series variation in the cost of finan- cial distress in explaining well-document corporate debt puzzles, empirical research has found that estimates of firm recovery rates are unrelated to overall market conditions. This paper answers the question: do default costs vary across the business cycle or are aggregate measures of default costs simply picking up differences in asset quality? Specifically by jointly estimating a model of ex-ante recovery rates and default probabilities, I find that a one standard deviation increase in the level of interest rates is associated with a 0.3% increase in the cost of default (decrease in recovery rate) and with firms liquidated 13 months earlier than the case of no change in interest rates. Moreover, a one standard deviation increase in the slope of interest rates is associated with a 0.7% decrease in the cost of default (increase in recovery rate) and with firms delaying the default decision 45 months than in the case of no change in interest rates.