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)
"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