Dynamic Asset-Backed Security Design
52 Pages Posted: 14 Aug 2018 Last revised: 25 Jan 2019
Date Written: January 18, 2019
We study a dynamic problem of the design and sale of securities backed by a long-lived collateral asset. Issuers are privately informed about the quality of the asset and raise capital by securitizing it. Issuers can pledge not only the current period payoff from the assets but also the future resale price. There is a dynamic feedback loop between the future asset price and today's collateral quality: An asset that is a good (lousy) collateral has high (low) resale price, but high (low) resale price makes an asset a good (lousy) collateral. Multiple dynamic - liquid and illiquid - equilibria might arise when only equity contracts can be issued. We characterize the optimal security design and demonstrate that it involves short-term liquid collateralized debt. It eliminates the multiple equilibria fragility and improves social welfare relative to the illiquid equity equilibrium. When the security contract is not flexible, runs might occur through the dynamic feedback loop. Comparative statics generate rich dynamic properties of haircuts and interest rates as well as runs in relation to adverse selection and default risk.
Keywords: Liquidity; Security Design; Financial Fragility; Repo
JEL Classification: G10; G01
Suggested Citation: Suggested Citation