Working Paper: NBER ID: w28016
Authors: Nathan Foley-Fisher; Gary B. Gorton; Stéphane Verani
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 investment-grade firms.
Keywords: Adverse Selection; Collateralized Loan Obligations; Safe Debt Markets
JEL Codes: E44; G14; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| AAA-rated CLO tranches transitioned from being information-insensitive to information-sensitive (G14) | increased adverse selection (D82) |
| one standard deviation increase in the volatility index (C46) | substantial decrease in the transaction price of CLOs (G33) |
| lowest transaction prices for AAA-rated CLOs became correlated with an index of stock price volatility in vulnerable industries (G19) | differentiation in investor behavior based on information production (D83) |
| highest prices remained uncorrelated with the index of stock price volatility (G19) | differentiation in investor behavior based on information production (D83) |