Dynamic Asset-Backed Security Design
63 Pages Posted: 14 Aug 2018 Last revised: 22 Apr 2021
Date Written: Feburary 14, 2021
Borrowers obtain liquidity by issuing securities backed by current period payoff and resale price of a long-lived collateral asset. They are privately informed about the payoff distribution. Asset price can be self-fulfilling: higher asset price lowers adverse selection, allows borrowers to raise more funding which makes the asset more valuable, leading to multiple equilibria. Optimal security design eliminates multiple equilibria, improves welfare, and can be implemented as a repo contract. Persistence in adverse selection lowers debt funding, generates volatility in asset price, and exacerbates credit crunch. The theory demonstrates the role of asset-backed securities on the stability of market-based financial systems.
Keywords: Liquidity; Dynamic Price Feedback; Tradable Assets; Security Design; Multiple Equilibria; Self-fulfilling Prices; Financial Fragility; Haircut; Repo; Repo Runs; Credit Crunch; Asset-Backed Security; Collateral; Limited Commitment; Adverse Selection; Market Based Financial Intermediation
JEL Classification: G10; G01
Suggested Citation: Suggested Citation