Open AccessThe Dynamics of Adverse Selection in Privately-Produced Safe Debt Markets
Author(s) -
Nathan Foley-Fisher,
Gary Gorton,
Stéphane Verani
Publication year - 2020
Publication title -
finance and economics discussion series
Language(s) - English
Resource type - Journals
eISSN - 2767-3898
pISSN - 1936-2854
DOI - 10.17016/feds.2020.088
Subject(s) - adverse selection , debt , private information retrieval , business , asset (computer security) , collateralized debt obligation , loan , selection (genetic algorithm) , investment (military) , monetary economics , economics , finance , collateral , statistics , mathematics , computer security , artificial intelligence , politics , computer science , political science , law
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 and 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, and 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 investment-grade firms.