Seminar: Guillermo L. Ordoñez, University of Pennsylvania
Debt: Deleveraging or Default
Guillermo L. Ordonez
University of Pennsylvania
Date: February 21, 2014
Time: 10:00 am - 11:30 am
Location: Room 002
Private information in credit markets may be resolved through deleveraging or default, depending on the volatility and the evolution of collateral value. We develop a dynamic model in which all borrowers have collateral subject to systematic uncertainty, but only good borrowers have additional income that is unobservable. When the volatility of collateral is low, good borrowers are able to fully separate by deleveraging, that is, raising debt and subsequently paying it down with unobservable income. For higher volatility, the amount of debt that is necessary for full separation may force bad borrowers to default, so that good borrowers must trade off the benefit of separation against an adverse selection cost of higher debt. For sufficiently high volatility, only partial separation is achieved because the cost of higher debt outweighs the benefit of separation.
For more information, please contact Karen Robertson at: karen [dot] robertson [at] mcgill [dot] ca.