Financial Innovation, Collateral, and Investment

We show that financial innovations that change the collateral capacity of assets in the economy can affect investment even in the absence of any shift in utilities, productivity, or asset payoffs. First we show that the ability to leverage an asset by selling non-contingent promises can generate over-investment compared to the Arrow-Debreu level. Second, we show that the introduction of naked CDS can generate under-investment with respect to the Arrow-Debreu level. Finally, we show that the introduction of naked CDS can robustly destroy competitive equilibrium.