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Debt: Deleveraging or Default

Author

Listed:
  • Motohiro Yogo

    (Federal Reserve Bank of Minneapolis)

  • David Perez-Reyna

    (University of Minnesota)

  • Guillermo Ordonez

    (University of Pennsylvania)

Abstract

We study the dynamics of how private information is resolved in credit markets and its dependence on systematic uncertainty in collateral value. We develop a model in which all borrowers have verifiable income that can be collateralized, but only good borrowers have additional income that is non-verifiable. Higher uncertainty reduces the precision of signaling through repayment from non-verifiable income, so that good borrowers must trade off the benefit of separation against the adverse selection cost of higher debt. For low volatility in collateral value, full separation is achieved through leveraging followed by deleveraging. For intermediate volatility, the benefit of separation outweighs the cost of higher debt, so that full separation is achieved through deleveraging if the collateral value rises, and default by bad borrowers if the collateral value falls. For high volatility, the cost of higher debt outweighs the benefit of separation, so that only partial separation is achieved in equilibrium.

Suggested Citation

  • Motohiro Yogo & David Perez-Reyna & Guillermo Ordonez, 2013. "Debt: Deleveraging or Default," 2013 Meeting Papers 139, Society for Economic Dynamics.
    • Handle: RePEc:red:sed013:139
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    Cited by:

    1. Bond, Philip & Zhong, Hongda, 2016. "Buying high and selling low: stock repurchases and persistent asymmetric information," LSE Research Online Documents on Economics 67011, London School of Economics and Political Science, LSE Library.

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