Leverage dynamics and credit quality

Guillermo Ordoñez, David Perez-Reyna, Motohiro Yogo

Research output: Contribution to journalArticle

Abstract

We study a dynamic model of collateralized credit markets with asymmetric information, which allows for a rich set of signaling strategies based on the path of debt and repayment. Whether credit history reveals private information about credit quality depends on the degree of uncertainty in collateral value. When uncertainty is low, good borrowers fully and costlessly separate by deleveraging, that is borrowing a sufficiently high amount such that subsequent repayment reveals the presence of unobservable income. When uncertainty is higher, good borrowers pay an adverse selection cost through a higher interest rate because bad borrowers could default, and asymmetric information is not always resolved.

Original languageEnglish (US)
Pages (from-to)183-212
Number of pages30
JournalJournal of Economic Theory
Volume183
DOIs
StatePublished - Sep 2019

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics

Keywords

  • Adverse selection
  • Collateral
  • Credit score
  • Reputation
  • Signaling

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