Adverse Selection, Reputation, and Sudden Collapses in Secondary Loan Markets

Working Paper: NBER ID: w16080

Authors: VV Chari; Ali Shourideh; Ariel Zetlin-Jones

Abstract: Banks and financial intermediaries that originate loans often sell some of these loans or securitize them in secondary loan markets and hold on to others. New issuances in such secondary markets collapse abruptly on occasion, typically when collateral values used to secure the underlying loans fall. These collapses are viewed by policymakers as signs that the market is not functioning efficiently. In this paper, we develop a dynamic adverse selection model in which small reductions in collateral values can generate abrupt inefficient collapses in new issuances in the secondary loan market. In our model, reductions in collateral values worsen the adverse selection problem and induce some potential sellers to hold on to their loans. Reputational incentives induce a large fraction of potential sellers to hold on to their loans rather than sell them in the secondary market. We find that a variety of policies that have been proposed during the recent crisis to remedy market inefficiencies do not help resolve the adverse selection problem.

Keywords: Adverse Selection; Reputation; Secondary Loan Markets; Market Efficiency

JEL Codes: E44; E50; G01; G14; G18; G38

Causal Claims

Cause	Effect
reductions in collateral values (G33)	abrupt inefficiencies in secondary loan markets (E44)
reductions in collateral values (G33)	exacerbation of adverse selection problem (D82)
exacerbation of adverse selection problem (D82)	behavior of loan originators (G21)
behavior of loan originators (G21)	holding onto loans instead of selling them (G51)
reductions in collateral values (G33)	switch from positive to negative reputational equilibrium (D59)
switch from positive to negative reputational equilibrium (D59)	sudden collapse in new issuances (G33)
reductions in collateral values (G33)	significant shifts in market behavior (G41)