‘Dynamic Asset-Backed Security Design’
by Kathy Yuan
London School of Economics
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Borrowers obtain liquidity by issuing securities backed by dividend and resale price of a long-lived collateral asset. They are privately informed about the dividend distribution. Asset price can be self-fulfilling: higher asset price lowers adverse selection allowing for borrowers to raise more funding which makes asset more valuable, leading to multiple equilibria. Optimal security design eliminates multiple equilibria, improves welfare through inter-temporal coordination, and can be implemented as repo debt. 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 stability of market-based financial systems..