How can fire sales for financial assets happen when the economy contains wellcapitalized but nonspecialist investors? Our explanation combines rational expectations equilibrium and "lemons" models. When specialist (informed) market participants are liquidity-constrained, prices become less informative. This creates an adverse selection problem, decreasing the supply of high-quality assets, and lowering valuations by nonspecialist (uninformed) investors, who become unwilling to supply capital to support the price. In normal times, arbitrage capital can "multiply" itself by making uninformed capital function as informed capital, but in a crisis, this stabilizing mechanism fails. IN A FIRE SALE, SELLERS ARE FORCED TO SELL assets at deep discounts because no one is willing to buy them at fair prices. Sellers can be forced to sell because of financial distress, credit market frictions, regulation, margin calls, etc. 1 Why do fire sales happen? What makes investors avoid buying assets that are apparently cheap? One explanation is offered by Shleifer and Vishny (1992): if industry experts with higher private valuations do not have enough liquidity, assets are bought at a discount by nonexperts who cannot use them efficiently. This argument applies naturally to real assets rather than financial securities. But since financial securities typically require that the holder only collects cash flows, not operates the assets, there should not be significant differences in private valuations. 2
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