Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?

51 Pages Posted: 14 Nov 2010  

Daniel O. Beltran

Federal Reserve Board

Charles P. Thomas

Federal Reserve Board

Date Written: November 1, 2010

Abstract

A key feature of the 2007-2008 financial crisis is that for some classes of securities trade has ceased. And where trade does occur, it appears that market prices are well below what one might believe to be the intrinsic value for that class of security. This seems to be especially true for those securities where the payoff streams are particularly complex (for example, CDOs). One explanation for this is that information about these securities' intrinsic values is asymmetric, with the current holders having better information than potential buyers. We show how the resulting adverse selection problem can help explain why more complex securities trade at significant discounts to their intrinsic values or do not trade at all. To examine whether asymmetric information alone would suffice to shut down portions of the asset-backed securities (ABS) market, we append a simple "workhorse" model for pricing securities under asymmetric information into a Monte Carlo simulation that generates hypothetical securities backed by residential mortgages. We conduct a type of "stress test" on the ABS by making the distribution of payoffs to the underlying loans worse, and find that the intrinsic values of the securities further down the securitization chain become dispersed in such a way that the market for them may shut down under asymmetric information. We then consider the role for government intervention, and compare the effectiveness of different policies that aim to unclog these markets.

Keywords: CDO, securitization, asymmetric, lemons

JEL Classification: C63, D82, D43

Suggested Citation

Beltran, Daniel O. and Thomas, Charles P., Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization? (November 1, 2010). FRB International Finance Discussion Paper No. 1010. Available at SSRN: https://ssrn.com/abstract=1708242 or http://dx.doi.org/10.2139/ssrn.1708242

Daniel O. Beltran

Federal Reserve Board ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Charles P. Thomas (Contact Author)

Federal Reserve Board ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
(202) 452-3698 (Phone)

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