Explain why the presence of adverse selection in credit markets explains the fact that collateral (or net worth) is important in debt contracts.
Collateral, property promised to the lender if the borrower defaults reduce the consequences of adverse selection because it reduces the lender’s losses in the event of a default. If a borrower defaults on a loan, the lender can sell the collateral and use the proceeds to make up for the losses on the loan. For example, if you fail to make your mortgage payments, the lender can take title to your house, auction it off, and use the receipts to pay off the loan. Lenders are thus more willing to make loans secured by collateral, and borrowers are willing to supply collateral because the reduced risk for the lender makes it more likely they will get the loan in the first place and perhaps at a better loan rate. The presence of adverse selection in credit markets thus provides an explanation for why collateral is an important feature of debt contracts (puzzle 7).
In addition, the more net worth a firm has in the first place, the less likely it is to default because the firm has a cushion of assets that it can use to pay off its loans. Hence when firms seeking credit have a high net worth, the consequences of adverse selection are less important and lenders are more willing to make loans.
