Adverse Selection, Reputation and Sudden Collapses in Secondary Loan Markets

57 Pages Posted: 14 Jun 2010 Last revised: 10 Jun 2023

See all articles by Varadarajan V. Chari

Varadarajan V. Chari

University of Minnesota - Twin Cities - Department of Economics; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)

Ali Shourideh

Carnegie Mellon University - David A. Tepper School of Business

Ariel Zetlin-Jones

Carnegie Mellon University; Federal Reserve Bank of Minneapolis

Multiple version iconThere are 2 versions of this paper

Date Written: June 2010

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.

Suggested Citation

Chari, Varadarajan V. and Shourideh, Ali and Zetlin-Jones, Ariel, Adverse Selection, Reputation and Sudden Collapses in Secondary Loan Markets (June 2010). NBER Working Paper No. w16080, Available at SSRN: https://ssrn.com/abstract=1624121

Varadarajan V. Chari (Contact Author)

University of Minnesota - Twin Cities - Department of Economics ( email )

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Federal Reserve Bank of Minneapolis ( email )

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National Bureau of Economic Research (NBER)

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Ali Shourideh

Carnegie Mellon University - David A. Tepper School of Business ( email )

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Ariel Zetlin-Jones

Carnegie Mellon University ( email )

Pittsburgh, PA 15213-3890
United States

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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