optimal debt financing and the pricing of illiquid assets antonio bernardo and ivo welch discussion
TRANSCRIPT
Optimal Debt Financing andthe Pricing of Illiquid Assets
Antonio Bernardo and Ivo WelchDiscussion
Model
• In tradition of Shleifer and Vishny, Geanakoplos, Stein, others
• Arbitrageurs make two period investments in period 0 using leverage.
• We focus on the case where bad news comes out in period 1, reducing arbitrageur wealth and ability to borrow
Liquidity Constraints Cause AssetPrices to Fall More than Fundamental
• Geanakoplos: “Optimists are wiped out; fundamental value down, volatility increases
• Stein: New investors have limited money; returns go up
• Concern by investors that arbitrageur model of expected returns is wrong (S-V)
• Without leverage: CRRA (constant elasticity/Cobb-Douglas) implies returns fluctuate with real growth
This Model
• After first period, a realization of whether in good or bad state
• Second period returns are normally distributed (not sure how negative are paid)
• Exogenously given debt ratio for arbitrageurs in second period
• Otherwise, split would be that arbitrageurs would take the upper tail of the distribution in second period
Equilibrium
• Arbitrageurs realize that in bad states they will be forced to sell some assets.
• The more that will be sold by risk-neutral arbitrageurs to risk averse investors the lower the price
• This leads to an equilibrium first period (and then, more simply, second period debt ratio)
Some Notes
• “Fire sales” in these models are very different from e.g. Diamond Dybvig --- it’s just that expected market returns fluctuate over time
• Exogenous debt constraint prevents us from having Arrow-Debreu securities and so complete markets
• Because of collateral constraints expected returns on assets may be correlated as in Geanakoplos-Fostel
How Does this Relate to Eventsin the Financial Crisis?
• For commercial banks, the regulatory capital system combined with government insurance encouraged firms to avoid asset sales and capital increases– FDIC top 7 years of equity/assets in 1941-2010– 300 bank failures in 2009-10 at an average shortfall
of 23% of assets– Bankia most recently in Europe– What could have been a smaller problem became a
much bigger one
My view
• Yes, limits to leverage do increase volatility in asset prices, create correlations
• However, no policy suggestions are made in the paper --- appropriately
• Government is a poor bearer of financial market risk (as opposed to some other risks)
• Losses will happen. Policy should be focused on a “Coasian” solution where “property rights” in financial losses are well defined --- and fully allocated to private investors