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Subsidizing Price Discovery

Author

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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.

Suggested Citation

  • Kyungmin Kim & Benjamin Lester & Braz Camargo, 2012. "Subsidizing Price Discovery," 2012 Meeting Papers 338, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:338
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    References listed on IDEAS

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    Cited by:

    1. Gaballo, Gaetano; Marimon, Ramon, 2016. "Breaking the spell with credit-easing : self-confirming credit crises in competitive search economies," Economics Working Papers ADE2016/01, European University Institute.
    2. Berentsen, Aleksander & McBride, Michael & Rocheteau, Guillaume, 2017. "Limelight on dark markets: Theory and experimental evidence on liquidity and information," Journal of Economic Dynamics and Control, Elsevier, vol. 75(C), pages 70-90.
    3. Farhi, Emmanuel & Tirole, Jean, 2015. "Liquid bundles," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 634-655.
    4. Braz Camargo & Kyungmin Kim & Benjamin Lester, 2016. "Information Spillovers, Gains from Trade, and Interventions in Frozen Markets," Review of Financial Studies, Society for Financial Studies, vol. 29(5), pages 1291-1329.
    5. Lester, Benjamin, 2013. "Breaking the ice: government interventions in frozen markets," Business Review, Federal Reserve Bank of Philadelphia, issue Q4, pages 19-25.

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