Does Bailout Anticipation Induce Adverse Selection?

We show the anticipation of a bailout of distressed firms worsens ex ante adverse selection, causing a market freeze and inviting government intervention - a "bailout trap." When firms of heterogenous qualities raise financing, high-quality firms are willing to bear adverse selection costs because they anticipate profitable opportunities to buy assets of lower-quality firms that have a higher future failure probability. But search frictions in private trading impede efficiency, inviting a bailout. This reduces ex post trading profits of buyers, dissuading ex ante participation by high-quality firms, possibly causing a freeze. This invites market-unfreezing interventions that are unnecessary absent bailout anticipation