Valuation, Adverse Selection, and Market Collapses
Valuation has an externality: it creates information on which adverse selection can occur. We study a market in which investors (or lenders) buy uncertain future cash flows that are ex ante identical but ex post heterogeneous across assets from sellers (or borrowers) with reservation values. There exists a limited amount of a costly technology that can be purchased before the market opens that allows an investor to value an asset — to get a private signal of the future payoff of that asset. Because sellers of assets that are valued and are rejected can sell to other investors, there are strategic complementarities in the choice of the capacity to do valuation, the private benefits to valuation exceed its social benefits, the market can exhibit multiple equilibria, and the market can deliver a unique valuation equilibrium when it is more efficient to transact without valuation. In the region of multiplicity, the move from a pooling equilibrium to a valuation equilibrium is always socially inefficient and has many features of a financial crisis: interest rate spreads rise, trade declines, unsophisticated investors leave the market, and sophisticated investors make profits. The efficient equilibrium in the region of multiplicity can be ensured by a large investor with the ability to commit to a price. We characterize several policies that can improve on market outcomes.
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