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Security Design: Signaling versus Speculative Markets

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  • Chemla, Gilles
  • Hennessy, Christopher

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.

Suggested Citation

  • Chemla, Gilles & Hennessy, Christopher, 2011. "Security Design: Signaling versus Speculative Markets," CEPR Discussion Papers 8336, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:8336
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    References listed on IDEAS

    as
    1. Boot, Arnoud W A & Thakor, Anjan V, 1993. " Security Design," Journal of Finance, American Finance Association, vol. 48(4), pages 1349-1378, September.
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    6. 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.
    7. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
    8. Guillaume Plantin, 2011. "Good Securitization, Bad Securitization," IMES Discussion Paper Series 11-E-04, Institute for Monetary and Economic Studies, Bank of Japan.
    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.
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    More about this item

    Keywords

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

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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