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The authors examine how collateral affects the cost of debt capital. Theories based on borrower moral hazard and limited pledgeable income predict that collateral increases the availability of credit and reduces its price. Testing these theories is complicated by the very selection problem which they imply: creditors will demand collateral precisely from those borrowers who are riskier. This selection problem leads to a positive relation in the data between the presence of collateral and the loan yield. Analyzing the extensive margin of collateral use, therefore, masks the hypothesized negative impact that collateral exhibits on debt yields.
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