Collateral Reallocation

Abstract: Assets pledged as collateral for secured debt cannot be sold unless the debt is paid or otherwise renegotiated. We develop a model of this role of collateralization. We find that debt market frictions (alone) can cause the asset market to fail. Asymmetric information about debt values frustrates efficient asset sales despite perfect information about asset values and freedom to renegotiate. Still, borrowers issue secured debt in equilibrium, but only as a last resort, when net worth is low, as in recessions. Our theory provides an explanation of why secured borrowing is countercyclical and asset reallocation procyclical.

Read the paper