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Subsidizing Price Discovery

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  • Kyungmin Kim

    (University of Iowa)

  • Benjamin Lester

    (Federal Reserve Bank of Philadelphia)

  • Braz Camargo

    (Fundação Getúlio Vargas)

Abstract

In the wake of the 2007-2008 financial crisis, a policy called the Public-Private Investment Program for Legacy Assets (PPIP) was introduced to promote price discovery and restore liquidity in the markets for a variety of asset-backed securities. Under this program, private investors who were interested in purchasing these securities from financially distressed banks were issued non-recourse loans from the FDIC in order to finance a fraction of the purchase price. This program effectively targets two frictions that are often cited as sources of market "freezes." First, given the put-option associated with non-recourse loans, this program helps mitigate the problem of adverse selection. Second, by allowing investors to leverage their investment up to a certain ratio, this program helps to relax liquidity constraints, thus easing the scope of cash-in-the-market pricing. In this paper, we construct an environment that incorporates both of these two frictions, and use it to formally analyze PPIP, paying particular attention to the optimal leverage ratio. We find that the relationship between information production and this leverage ratio is non-monotonic: few signals are produced when it is too small, while the information content of signals is diminished when it is too large. We characterize the optimal, interior leverage ratio.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 338.

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Date of creation: 2012
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Handle: RePEc:red:sed012:338

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  1. Christopher L. House & Yusufcan Masatlioglu, 2010. "Managing Markets for Toxic Assets," NBER Working Papers 16145, National Bureau of Economic Research, Inc.
  2. V.V. Chari & Ali Shourideh & Ariel Zetlin-Jones, 2010. "Adverse Selection, Reputation and Sudden Collapses in Secondary Loan Markets," NBER Working Papers 16080, National Bureau of Economic Research, Inc.
  3. Itay Goldstein & Ady Pauzner, 2005. "Demand-Deposit Contracts and the Probability of Bank Runs," Journal of Finance, American Finance Association, vol. 60(3), pages 1293-1327, 06.
  4. Nicola Persico, 2000. "Information Acquisition in Auctions," Econometrica, Econometric Society, vol. 68(1), pages 135-148, January.
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  7. Milgrom, Paul R, 1981. "Rational Expectations, Information Acquisition, and Competitive Bidding," Econometrica, Econometric Society, vol. 49(4), pages 921-43, June.
  8. Ben Lester & Braz Camargo, 2011. "Trading Dynamics in Decentralized Markets with Adverse Selection," 2011 Meeting Papers 1300, Society for Economic Dynamics.
  9. Foucault, Thierry & Gehrig, Thomas, 2006. "Stock Price Informativeness, Cross-Listings and Investment Decisions," CEPR Discussion Papers 5722, C.E.P.R. Discussion Papers.
  10. Athey, Susan & Haile, Philip A., 2007. "Nonparametric Approaches to Auctions," Handbook of Econometrics, in: J.J. Heckman & E.E. Leamer (ed.), Handbook of Econometrics, edition 1, volume 6, chapter 60 Elsevier.
  11. Bergemann, Dirk & Shi, Xianwen & Valimaki, Juuso, 2007. "Information Acquisition in Interdependent Value Auctions," Working Papers 25, Yale University, Department of Economics.
  12. Wolfgang Pesendorfer & Jeroen M. Swinkels, 1995. "The Loser's Curse and Information Aggregation in Common Value Auctions," Discussion Papers 1147, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  13. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  14. Farhi, Emmanuel & Tirole, Jean, 2009. "Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts," TSE Working Papers 09-052, Toulouse School of Economics (TSE), revised Oct 2010.
  15. Antonio Cabrales & Olivier Gossner & Roberto Serrano, 2013. "Entropy and the Value of Information for Investors," American Economic Review, American Economic Association, vol. 103(1), pages 360-77, February.
  16. Ilan Kremer, 2002. "Information Aggregation in Common Value Auctions," Econometrica, Econometric Society, vol. 70(4), pages 1675-1682, July.
  17. Asher Wolinsky & Stephan Lauermann, 2009. "Search with Adverse Selection," 2009 Meeting Papers 827, Society for Economic Dynamics.
  18. Robert Shimer & Veronica Guerrieri, 2011. "Competitive Equilibrium in Asset Markets with Adverse Selection," 2011 Meeting Papers 565, Society for Economic Dynamics.
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Cited by:
  1. Lester, Benjamin, 2013. "Breaking the ice: government interventions in frozen markets," Business Review, Federal Reserve Bank of Philadelphia, issue Q4, pages 19-25.
  2. Aleksander Berentsen & Michael McBride & Guillaume Rocheteau, 2013. "Limelight on dark markets: an experimental study of liquidity and information," ECON - Working Papers 126, Department of Economics - University of Zurich.

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