Financial innovations that change how promises are collateralized affect prices and investment, even in the absence of any change in fundamentals. In C-models, the ability to leverage an asset always generates overinvestment compared to Arrow-Debreu. Credit Default Swaps always leads to underinvestment with respect to Arrow-Debreu, and in some cases even robustly destroy competitive equilibrium. The need for collateral would seem to cause underinvestment. Our analysis illustrates a countervailing force: goods that serve as collateral yield additional services and can therefore be over-valued and over-produced. In models without cash flow problems there is never marginal underinvestment on collateral. (JEL D52, D86, D92, E44, G01, G12, R31)
Fostel, Ana, and John Geanakoplos.
"Financial Innovation, Collateral, and Investment."
American Economic Journal: Macroeconomics,
Economics of Contract: Theory
Intertemporal Firm Choice: Investment, Capacity, and Financing
Financial Markets and the Macroeconomy
Asset Pricing; Trading Volume; Bond Interest Rates
Housing Supply and Markets