Securitization under Asymmetric Information over the Business Cycle

This paper studies the effciency of financial intermediation through securitization with asymmetric information about the quality of securitized loans. In this theoretical model, I show that, in general, by providing reputation-based implicit recourse, the issuer of a loan can credibly signal its quality. However, in boom stages of the business cycle, information on loan quality remains private, and lower quality loans accumulate on balance sheets. This deepens a subsequent downturn. The longer the duration of a boom, the deeper will be the fall of output in a subsequent recession. In recessions, the model also produces amplification of adverse selection problems on re-sale markets for securitized loans. These are especially severe after a prolonged boom period and when securitized loans of high quality are no longer traded. Finally, the model suggests that excessive regulation that requires higher explicit risk-retention by the originators of loans can adversely affect both quantity and quality of investment in the economy.