Securitization: A Low-Cost Sweetener for Lemons

Abstract:     
Securitization is a technique firms use to raise financing. In securitization transactions, a firm issues securities payable from collections on its receivables. Securitization, in its present form, was created in the early 1970s. Transaction volume has grown rapidly; by the end of 1994, more than $1.9 trillion in securitization securities were outstanding.

I show how securitization can add value by identifying the real-world costs it reduces. I describe two different uses of securitization. One is for firms with many financing possibilities. Such firms often use securitization to exploit small, temporary price differences in different financial markets. The cost reduction is small, but real. The other is for firms with fewer financing possibilities. There, the cost reduction is larger. Indeed, securitization seems particularly effective in reducing information costs. Information about firms with fewer financing possibilities is often limited, unfavorable or particularly difficult to appraise. Investor fears about such firms are costly to dispel. Securitization reduces these costs by dividing the firm into slices which permit more specialized appraisal. The securitization 'slice' consists of non-firm-specific assets; securitization investors needn't appraise the particularly costly-to-appraise residual risks and prospects of such firms. Moreover, the securitization transaction structure inspired the development of more efficient appraisal techniques for the non-firm-specific assets at issue, receivables.

Keywords: lemons, securitization, capital structures, Modigliani, Miller, financing

JEL Classifications: G32, G34

Accepted Paper Series