Financial Innovation, Collateral and Investment

Financial innovations that change how promises are collateralized can affect investment, even in the absence of any change in fundamentals. In C-models, the ability to leverage an asset always generates over-investment compared to Arrow Debreu. The introduction of CDS always leads to under-investment with respect to Arrow Debreu, and in some cases even robustly destroys competitive equilibrium. The need for collateral would seem to cause under-investment. Our analysis illustrates a countervailing force: goods that serve as collateral yield additional services and are therefore over-valued and over-produced. In models without cash flow problems there is never marginal under-investment on collateral.