1. Optimal Debt Financing and the Pricing of Illiquid Assets Antonio Bernardo and Ivo Welch Discussion

2. 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

3. Liquidity Constraints Cause Asset Prices 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

4. 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

5. 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)

6. 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

7. How Does this Relate to Events in 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

8. 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