Securitization, Risk‐Taking and the Option to Change Strategy

20 Pages Posted: 20 May 2014

See all articles by Rose Neng Lai

Rose Neng Lai

University of Macau

Robert A. Van Order

George Washington University

Date Written: Summer 2014

Abstract

This article models the riskiness of structured securitization deals. The deals are put together by “banks,” which can exercise strategic options over the risk put into the deals. The banks face a trade‐off between the benefits of risk‐taking now and future franchise benefits if the deal pays off. The key insight is a convex relationship between the value of the bank's equity position and the risk in the deal. Although there is a continuum of possible risk, banks choose either the highest or lowest levels of risk open to them. Changes in strategy are discontinuous and unpredictable; a history of low risk‐taking may be a prelude to increased risk‐taking later. Competition, to the extent of reducing franchise value, can lead to more risk‐taking, as can more information in the market. The model provides insights into the risk‐taking that led up to the Great Recession and to institutions that are “Too Big to Fail.”

Suggested Citation

Lai, Rose Neng and Van Order, Robert A., Securitization, Risk‐Taking and the Option to Change Strategy (Summer 2014). Real Estate Economics, Vol. 42, Issue 2, pp. 343-362, 2014. Available at SSRN: https://ssrn.com/abstract=2439025 or http://dx.doi.org/10.1111/1540-6229.12040

Rose Neng Lai (Contact Author)

University of Macau ( email )

Av. Da Universidade, Taipa
Macau, Nil
Macau

Robert A. Van Order

George Washington University ( email )

2121 I Street NW
Washington, DC 20052
United States

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