Sweetening the Lemon: House Prices and Adverse Selection in Secondary Loan Markets

Abstract

This paper builds a simple model to look at the effect of securitisation on the banking system. In this paper we build a model of asymmetric information in the secondary market for loans and a 'lemons' problem faced by uninformed agents who buy these loans. We show how certain conditions can sustain a secondary loan market even when banks have inside information about their borrowers, but only when other investment opportunities are good. Although the secondary loan market delivers welfare increases it is also unstable. We show how the emergence of secondary markets can lead not only to a fundamental increase in asset prices but also to a change in return correlations from negative to positive across asset classes.