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Adverse Selection, Reputation And Sudden Collapses In Secondary Loan Markets

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Executive Summary

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, the authors 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.

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