Securitization and Liquidity Creation in Markets with Adverse Selection

Abstract

This paper provides an information-based theory of tranching, a practice in which sellers slice a financial asset into debt securities with different seniority. I use the price posting framework to analyze asset-backed security markets with adverse selection and find that tranching is a robust equilibrium outcome. Tranching decomposes the asset into “information insensitive” and “information sensitive” components. The expected cash flow of the information insensitive component is independent of the seller's private signal, whereas the expected cash flow of the information sensitive component varies with the signal. When buyers are restricted to trade shares of assets, they have to purchase both components proportionally. Tranching, however, allows buyers to disproportionately purchase the information insensitive component. As a result, buyers are less concerned about adverse selection, and total trading volume in the market increases. My model also generates testable predictions on the liquidity of individual debt securities: the selling probability of a debt security increases in its seniority, which is observable to buyers, yet decreases with its performance, which is ex-ante unobservable to buyers; these predictions are supported by my empirical analysis of the non-agency MBS market.