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Security Design: Signaling Versus Speculative Markets

  • Chemla, Gilles
  • Hennessy, Christopher A.
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    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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    File URL: http://basepub.dauphine.fr/xmlui/bitstream/123456789/6311/1/CEPR-DP8336.pdf
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    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
    Contact details of provider: Web page: http://www.dauphine.fr/en/welcome.html

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    1. 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.
    2. Dow, James, 1998. "Arbitrage, Hedging, and Financial Innovation," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 739-55.
    3. 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.
    4. Franklin Allen, Douglas Gale, 1988. "Optimal Security Design," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 229-263.
    5. Gorton, Gary & Pennacchi, George, 1990. " Financial Intermediaries and Liquidity Creation," Journal of Finance, American Finance Association, vol. 45(1), pages 49-71, March.
    6. Guillaume Plantin, 2011. "Good Securitization, Bad Securitization," Sciences Po publications 2011-E-4, Sciences Po.
    7. Boot, Arnoud W A & Thakor, Anjan V, 1993. " Security Design," Journal of Finance, American Finance Association, vol. 48(4), pages 1349-78, September.
    8. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
    9. Ulf Axelson, 2007. "Security Design with Investor Private Information," Journal of Finance, American Finance Association, vol. 62(6), pages 2587-2632, December.
    10. 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.
    11. 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.
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