Debt: Deleveraging or Default

Motohiro Yogo, David Perez-Reyna and Guillermo Ordonez

No 139, 2013 Meeting Papers from Society for Economic Dynamics

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.

Date: 2013
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed013:139

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