The Dynamics of Adverse Selection in Privately-Produced Safe Debt Markets
Nathan Foley-Fisher, Gary Gorton, & Stéphane Verani
Privately-produced safe debt is designed so that there is no adverse selection in trade. This is because no agent finds it profitable to produce private information about the debt’s backing & all agents know this (i.e., it is information-insensitive). But in some macro states, it becomes profitable for some agents to produce private information, & then the debt faces adverse selection when traded (i.e., it becomes information-sensitive). We empirically study these adverse selection dynamics in a very important asset class, collateralized loan obligations, a large symbiotic appendage of the regulated banking system, which finances loans to below investmentgrade firms.
Keywords: Safe debt, adverse selection, information sensitivity, collateralized loan obligations
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October 21, 2020