Working Paper: CEPR ID: DP7122
Authors: Viral V. Acharya; Douglas M. Gale; Tanju Yorulmazer
Abstract: We consider the debt capacity of a risky asset when debt is being rolled over and there is a liquidation cost in case of default. We show that debt capacity depends on how information about the quality of the asset is revealed. When the information structure is based on ?optimistic? expectations, the arrival of no news about the asset is good news; under this structure, debt capacity does not depend upon rollovers and liquidation cost, and is simply equal to expected cash flows from the asset. In contrast, when the information structure is based on ?pessimistic? expectations, no news about the asset is bad news; under this structure, debt capacity of the asset is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.
Keywords: asset-backed commercial paper; credit risk; haircut; liquidation cost; repo; secured borrowing
JEL Codes: D8; G12; G21; G24; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimistic information structure (D84) | Debt capacity (G32) |
| Debt capacity (G32) | Expected cash flows (G19) |
| Pessimistic information structure (D80) | Debt capacity (G32) |
| Increasing liquidation costs (G33) | Debt capacity (G32) |
| Increasing rollover frequency (C41) | Debt capacity (G32) |
| Number of rollovers approaches infinity (C69) | Debt capacity approaches zero (G33) |
| Credit risk (G21) | Observed outcomes (C90) |
| Market sentiment (G10) | Observed outcomes (C90) |