Adverse Selection Dynamics in Privately-Produced Safe Debt Markets

Foley-Fisher, Nathan; Gorton, Gary; Verani, Stéphane

doi:10.17016/FEDS.2020.088r1

Working Paper

Adverse Selection Dynamics in Privately-Produced Safe Debt Markets

Abstract: 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 investmentgrade firms.

Keywords: Safe debt; Adverse selection; Information sensitivity; Collateralized loan obligations;

JEL Classification: E44; G14; G23;

https://doi.org/10.17016/FEDS.2020.088r1