Liquidity and Debt

The empirical evidence shows that throughout history, money (broadly defined to constitute assets that circulate widely as media of exchange) takes the form of debt. In the past we saw banknotes redeemable in coin with senior claim to bank assets. Today we have government-insured demandable bank liabilities redeemable in government fiat. More broadly, it is notable that the collateral objects that "circulated" in the repo market were debt instruments (e.g., US treasuries and AAA rated MBS).

Why do we pay for things using bank debt rather than bank equity? To put things another way, why is debt more "liquid" than equity? What is the link between liquidity and the optimality of debt?

There is, of course, a literature that explains the optimality of debt (e.g., Townsend, Hart and Moore). The focus of this literature, however, is on the primary market and not on the secondary market; that is, they do not link the optimality of debt to liquidity. There is also a literature that studies liquidity provision, but simply assumes the optimality of debt (e.g., Diamond and Dybvig).

Some good news: there is now a nice paper that makes some progress in linking liquidity and debt. The paper is by Tri Vi Dang, Gary Gorton, and Bengt Holmstrom: Opacity and the Optimality of Debt for Liquidity Provision.

I am not an expert in corporate finance, but the theory of debt laid out in this paper seems somewhat different from, say, Townsend's costly state verification model. In Townsend, the security issuer has private information over the realization of the project. The security purchaser has an ability to discover this information at some cost. Costly audits are a social waste, so it is desirable to minimize this expense. Equity finance is terrible in this regard because the purchaser must audit all the time. Debt, on the other hand, triggers an audit only when the security issuer reports terrible outcomes.

Dang, Gorton and Holmstrom (henceforth DGH) have a setup where project realizations are publicly verifiable ex post. The twist in their setup is that prior to exchange, agents have an opportunity to discover the true project realization at some fixed cost. Consider two extremes: the audit cost is zero or infinity. Question: which world would agents rather live in? Answer: ex ante welfare is maximized under ignorance. The intuition for this is similar to Hirchleifer's (AER 1971) classic result; although agents in DGH are risk-neutral.

So their first result is that symmetric ignorance dominates symmetric information (even if such information is costless). Imagine that the security issuer and purchaser both face the same cost (k) of discovery. Is it possible to design a security that gives both agents the incentive not to acquire private information?

Let x denote the project outcome, distributed according to cdf F(x). Let s(x) denote the security's promised payout in state x, and let p denote the price of the security. Since the purchaser is risk-neutral, he is willing to purchase the security (without scrutiny) if p = E[s(x)].

The problem here is that the purchaser will view himself as having "overpaid" for the security in bad states of the world; i.e., for all x such that p - s(x) > 0. The expected cost of overpaying in this manner is given by v = E[max{p-s(x),0}]. DGH show that v is the value of information to the purchaser (they also show that the corresponding value for the seller is always smaller, so we may, without loss focus on the buyer). If v < k, then no party has an incentive to acquire information (preserving symmetric ignorance).

Note to reader: this program does not seem to handle mathematical formulae well. After several attempts at editing without the desired result, I will try to explain as much as possible in words only.

DGH demonstrate that because debt is senior, it reduces the probability that one will overpay (ex post) for the asset, hence it reduces the incentive to acquire information to make sure that one is not overpaying.

If v(debt) < k < v(equity), then the existence of leverage will support trades that would not otherwise have occurred. Leverage lifts the economy higher. But of course, when something is created, one automatically creates the risk that it might collapse. DGH have in mind the arrival of bad news in the form of a public signal (e.g., declining real estate prices). The effect of such a shock may be to render k < v(debt); which is to say, it suddenly pays to acquire information on debt. Such information acquisition, while privately optimal, is socially suboptimal -- it has the effect of generating asymmetric information and adverse selection -- which further hampers the liquidity of debt beyond the effect of the fundamental shock (the bad news). It is in this sense that a fundamental shock can lead to a systemic event.

If you are motivated to read the paper, please let me know what you think about it. I think that the authors are on to something; but I'm not absolutely sure whether the details all hang together. I'd also appreciate references to related literature.