Dynamic Asset-Backed Security Design

Abstract

Borrowers obtain liquidity by issuing securities backed by dividend and endogenously-determined resale-price of a long-lived collateral asset. Security design alleviates adverse selection arising from borrowers’ private information about the asset quality. Higher asset price lowers adverse selection and generates more liquidity via a larger debt tranche and vice versa. When borrowers are constrained to issue equity only, dynamic feedback between asset price and adverse selection leads to multiple equilibria. Optimal security design eliminates multiple equilibria, improves welfare through intertemporal coordination, and can be implemented as repo. The theory demonstrates the role of asset-backed securities on stability of market-based financial systems.