Portfolio Liquidation and Security Design with Private Information

Abstract

I consider the problem faced by an issuer holding a portfolio of securities that can be sold to raise cash. The issuer has private information that affects the value of all of the securities held, and so faces a lemons problem in the market for the securities. On the other hand, the issuer bears a retention cost if the securities are not sold. An equilibrium issuance strategy is characterized for the case in which the issuer’s information can be ordered in the sense that good news about one security is good news for all the securities held. The signaling equilibrium is shown to be unique subject to standard refinements. I also show that if the securities can be ordered in terms of their sensitivity to the issuer’s private information, then the issuance strategy is particularly simple: the issuer sells the least information-sensitive securities first. This result is then applied to standard debt and equity securities and is shown to confirm the Pecking-Order Hypothesis. Finally, the model also has implications for the optimal design of securities. In general, “splitting” a security into smaller tranches increases the issuer’s payoff. I also show that if the issuer can choose any monotone security design, then the optimal design is standard debt if the issuer’s information satisfies the hazard rate ordering.

Keywords: security design, signaling, securitization, pooling, tranching, ABS, asset-backed securities