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Security Design: Signaling Versus Speculative Markets

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  • Chemla, Gilles
  • Hennessy, Chris
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    Abstract

    We determine optimal security design and retention of asset-backed securities by a privately informed issuer with positive NPV uses for immediate cash. In canonical models, investors revert to prior beliefs if issuers pool at zero-retentions (originate-to-distribute), and separating equilibria are welfare-dominated since separation entails signaling via asset-retention and underinvestment. However, we show speculative markets arise if and only if issuers pool, creating previously overlooked costs. Pooling induces socially costly information acquisition by speculators. Further, in pooling equilibria, issuers never sell safe claims, leaving uninformed investors exposed to adverse selection and distorting risk sharing. In such equilibria, issuers retain zero interest in the asset, and speculator effort is maximized by splitting cash flow into a risky senior ("debt") tranche and residual junior ("equity") claim. Optimal leverage trades off per-unit speculator gains against endogenous declines in uninformed debt trading. Issuer incentives to implement the pooling equilibrium, with distorted risk sharing, are strong precisely when efficient risk sharing, achieved through separation, has high social value. In such cases, a tax on issuer proceeds can raise welfare by encouraging issuer retentions. Taxation dominates mandatory skin-in-the-game as a policy response, since the latter creates gratuitous underinvestment.

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    Bibliographic Info

    Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/6311.

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    Date of creation: Apr 2011
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    Publication status: Published in DISCUSSION PAPER SERIES, 2011
    Handle: RePEc:dau:papers:123456789/6311

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    Related research

    Keywords: issuer; pooling; security design; separating; speculator; type;

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    1. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
    2. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
    3. Nachman, David C & Noe, Thomas H, 1994. "Optimal Design of Securities under Asymmetric Information," Review of Financial Studies, Society for Financial Studies, vol. 7(1), pages 1-44.
    4. Ulf Axelson, 2007. "Security Design with Investor Private Information," Journal of Finance, American Finance Association, vol. 62(6), pages 2587-2632, December.
    5. Franklin Allen & Douglas Gale, . "Optimal Security Design," Rodney L. White Center for Financial Research Working Papers 26-87, Wharton School Rodney L. White Center for Financial Research.
    6. Dow, James, 1998. "Arbitrage, Hedging, and Financial Innovation," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 739-55.
    7. Arnoud W A Boot & Anjan V Thakor, 1992. "Security Design," CEPR Financial Markets Paper 0020, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
    8. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    9. Maskin, Eric & Tirole, Jean, 1992. "The Principal-Agent Relationship with an Informed Principal, II: Common Values," Econometrica, Econometric Society, vol. 60(1), pages 1-42, January.
    10. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
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