Abstract - Liquidity and Feasible Debt Relief

This paper analyzes the determinants of secondary debt market liquidity, identifying conditions under which trading in competitive markets results in sufficient ownership concentration to induce ex post efficient debt relief. The feasibility of debt relief is path-dependent, hinging upon interim economic conditions. Secondary debt markets are likely to freeze during recessions, precisely when trading has high social value. This is due to three factors: severe free-riding reduces profits of large bondholders; uninformed small bondholders are reluctant to sell due to high informational sensitivity of debt; and large investors are more likely to face wealth constraints. However, there are potentially countervailing effects facilitating trade in bad states. Specifically, recessions may cause a broader set of uninformed bondholders to face intense liquidity shocks. The intensity of such shocks encourages them to sell, while the breadth of the shock facilitates concentrated ownership. Both effects ultimately promote voluntary debt relief by a large investor.

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