The Pooling and Tranching of Securities: A Model of Informed Intermediation

Abstract

This paper considers the problem faced by a financial intermediary with n assets to sell in the presence of asymmetric information. I show that when the intermediary has superior information about the value of each asset, the intermediary is better off selling shares in the assets individually rather than as a pool. In particular, pooling has an information destruction effect that operates to the disadvantage of the intermediary by preventing the intermediary from fully exploiting its information regarding each individual asset. If, however, the intermediary can create a derivative security that is collateralized by the assets, pooling and "tranching" may be optimal. Tranching allows the intermediary to take advantage of the risk diversification effect of pooling to create a low risk and highly liquid security. I show that if the residual risk of each asset is not too highly correlated, then for large enough n, the risk diversification effect dominates and pooling and tranching is optimal for the informed intermediary. I then contrast this with the case of an uninformed originator, selling to both informed intermediaries and uninformed investors. I show that for an uninformed seller, pooling is is preferred to separate asset sales. Finally, I combine these results in a dynamic model of financial intermediation: uninformed originators sell pools of assets, some of which are purchased by informed intermediaries. These intermediaries then further pool the assets and sell senior tranches to investors in order to raise cash to buy new securities in the origination market. By doing so, the intermediaries leverage their capital more efficiently, enhancing the returns to their private information.

Keywords: pooling, tranching, financial intermediation, adverse selection, asymmetric information, mortgage backed securities, asset backed securities, security design

JEL Classification: G32, G21, G24, D82