Securitization: A Low‐Cost Sweetener For Lemons

Since the launching of the mortgage backed market in the early 1970s, securitization has experienced extraordinary growth and spread to a remarkable variety of receivables. But financial economists in the tradition of Miller and Modigliani have been hard pressed to explain such growth. When viewed within the context of an M & M world of “perfect markets,” securitization appears to be simply another way—and a highly complex and costly one, at that—for a company to carve up its operating cash flows and repackage them for investors. This article seeks to explain the growth of securitization by identifying reductions in costs that M & M assume out of existence. For some types of companies, the largest sources of the cost savings are fairly obvious. Most mortgage securitizations are effectively subsidized by the U.S. government, which contributed greatly to the launching of the securitization movement. And commercial banks forced to meet regulatory capital requirements have found securitization of loans to be a low‐cost compliance strategy. But securitization appears to offer more than regulatory benefits. For example, higher rated companies with a variety of financing options appear to use securitization to diversify their funding sources and arbitrage small price differences in financial markets. But if such arbitrage profits can be significant, the non‐regulatory benefits appear to be largest for companies with few financing alternatives—those firms that face what economists refer to as a “lemons problem.” Available information about such companies is often limited (as in the case of smaller companies), unfavorable (companies in financial distress), or particularly difficult to appraise (companies in volatile industries, or facing unstable political environments or potentially large liabilities). Especially in the case of such “lemons” companies, securitization may reduce overall financing costs by carving up the evaluation of a company's securities into tasks amenable to greater specialization. In so doing, it may reduce aggregate information costs for all its securities and thus increase total value.