DP7122 Rollover Risk and Market Freezes
We consider the debt capacity of a risky asset when debt is being rolled over and there is a liquidation cost in case of default. We show that debt capacity depends on how information about the quality of the asset is revealed. When the information structure is based on ?optimistic? expectations, the arrival of no news about the asset is good news; under this structure, debt capacity does not depend upon rollovers and liquidation cost, and is simply equal to expected cash flows from the asset. In contrast, when the information structure is based on ?pessimistic? expectations, no news about the asset is bad news; under this structure, debt capacity of the asset is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.