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Adverse Selection in Resale Markets for Securitized Assets
Adverse Selection in Resale Markets for SecuritizedAssets
Martin Kuncl
Bank of Canada
Banque de FranceOctober 23, 2015
Disclaimer: The views expressed in this paper are those of the author. Noresponsibility for them should be attributed to the Bank of Canada.
Adverse Selection in Resale Markets for Securitized AssetsMotivation
Motivation
Prior to the recent financial crisissecuritization became popular, and a lot of risk wasaccumulated in securitized assets (especially MBS),nevertheless markets for securitized assets worked well.
During the crisisa sudden and extreme market dry-up: increase in spreads anddrop in volumes Graphs
How to explain accumulation of low quality investment and thensudden dry-up of markets?
Underestimation of risks? Panic? Irrational expectations?(Shleifer and Vishny 2010, Gennaioli et al. 2013)
This behavior can be explained by a varying degree ofasymmetric information about quality of securitized assetsover the business cycle.
Adverse Selection in Resale Markets for Securitized AssetsMotivation
Motivation
Prior to the recent financial crisissecuritization became popular, and a lot of risk wasaccumulated in securitized assets (especially MBS),nevertheless markets for securitized assets worked well.
During the crisisa sudden and extreme market dry-up: increase in spreads anddrop in volumes Graphs
How to explain accumulation of low quality investment and thensudden dry-up of markets?
Underestimation of risks? Panic? Irrational expectations?(Shleifer and Vishny 2010, Gennaioli et al. 2013)
This behavior can be explained by a varying degree ofasymmetric information about quality of securitized assets overthe business cycle.
Adverse Selection in Resale Markets for Securitized AssetsOverview of results
Main results
DSGE model of financial intermediation through securitizationwith asymmetric information
Model predicts:In booms or mild recessions adverse selection on resalemarkets is limited → markets work well.In a deeper recession adverse selection becomessuddenly severe (in proportion to the length of the precedingboom) and may lead to partial market shutdowns.Financial crisis recessions are deeper and longer thannormal onesGovernment policy of asset purchases may limit thenegative effects of adverse selection on the real economy
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Outline
1. Motivation2. Overview of results3. Model mechanism4. Results of MS DSGE model
a. Methodologyb. Impulse responses
5. Conclusion
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Model mechanism
Continuum of financial firms face i.i.d. investment shockNeed for financial intermediationFocus on securitization (sale of cash flows from projects)
High projects
Low projects
(1‐ π) Fin. firms πµ Fin. firms π(1‐µ) Fin. firms
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
No frictions
Without frictions the solution is first-best
Primary market
High projects
Low projects loan sale
buy
buy
SELLERS BUYERS
(1‐ π) Fin. firms
πµ Fin. firms π(1‐µ) Fin. firms
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Introducing frictions
Primary market
High projects
Low projects loan sale
buy
buy
SELLERS BUYERS
(1‐ π) Fin. firms
πµ Fin. firms π(1‐µ) Fin. firms
Introduce frictions:“skin in the game”asymmetric information in primary and resale markets
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Introducing frictions
Primary market
Resale market
High projects
Low projects loan sale
buy
buy
buy
buy
loan sale
SELLERS BUYERS
(1‐ π) Fin. firms
πµ Fin. firms π(1‐µ) Fin. firms
Introduce frictions:“skin in the game”asymmetric information in primary and resale markets
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Asymmetric information on primary market
Introduce asymmetric information about allocation of newprojects to firms
Primary
marketbuyer seller
Quality?
loan sale buy
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Asymmetric information in primary market
Introduce asymmetric information about allocation of newprojects to firms
Primary
marketbuyer seller
Quality?
loan sale buy
+ implicit guarantees
Implicit guarantees enforced in a repeated game.Separating equilibrium : Sellers can signal the quality. Only high
quality projects are financed.Pooling equilibrium : Sellers cannot differentiate, both types of
projects are sold.
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Asymmetric information in the resale market
Assumption: Prohibitively costly to verify the quality ofsecuritized assets traded on resale markets.
Resale
marketbuyers
liquidity sellers (sell high and low
qual. assets)
loan sale
buy
Implicit guarantees increase the price on resale markets through:direct effect: lower the effective difference in project cashflows,indirect effect: prevent private information acquisition →“blissfull ignorance” equilibrium (Gorton and Ordonez 2014).
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Asymmetric information in the resale market
In a “deep recession” there is economy-wide default onimplicit guarantees → surge in adverse selection.
Resale
marketbuyers
liquidity sellers (sell high and low
qual. assets)
loan sale
buy
informed sellers (sell low qual. assets)
loan sale
Drop in the price & lower investment and output in theeconomy.
Adverse Selection in Resale Markets for Securitized AssetsModel mechanism
Introducing frictions
Asymmetric information in the resale market
May even cause partial market shutdowns.
Resale
marketbuyers
liquidity sellers (sell high and low
qual. assets)
loan sale
buy
informed sellers (sell low qual. assets)
loan sale
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Outline
1. Motivation2. Overview of results3. Model mechanism4. Results of MS DSGE model
a. Methodologyb. Impulse responses
5. Conclusion
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Methodology
Perturbation method for Markov-Switching DSGEAssumption: Counter-cyclical dispersion in TFP of projects(following Bloom (2009) and Bloom et al. (2012) )Three Markov states:
Regime 1 - Expansion: (high TFP, low dispersion →pooling equilibrium on primary market)
Regime 2 - Mild Recession: (low TFP, higher dispersion →separating equilibrium on primary market)
Regime 3 - Deep Recession: (low TFP, largest dispersion →separating equilibrium, default on outstanding implicitrecourse)
I use perturbation method for Markov-switching DSGE modelsusing methodology by Foerster et al. (2013)
Can capture differences in equilibrium across regimes.Can be used for more complex space of state variables.
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Methodology
Perturbation method for Markov-Switching DSGEAssumption: Counter-cyclical dispersion in TFP of projects(following Bloom (2009) and Bloom et al. (2012) )Three Markov states:
Regime 1 - Expansion: (high TFP, low dispersion →pooling equilibrium on primary market)
Regime 2 - Mild Recession: (low TFP, higher dispersion →separating equilibrium on primary market)
Regime 3 - Deep Recession: (low TFP, largest dispersion →separating equilibrium, default on outstanding implicitrecourse)
I use perturbation method for Markov-switching DSGE modelsusing methodology by Foerster et al. (2013)
Can capture differences in equilibrium across regimes.Can be used for more complex space of state variables.
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Methodology
Perturbation method for Markov-Switching DSGEAssumption: Counter-cyclical dispersion in TFP of projects(following Bloom (2009) and Bloom et al. (2012) )Three Markov states:
Regime 1 - Expansion: (high TFP, low dispersion →pooling equilibrium on primary market)
Regime 2 - Mild Recession: (low TFP, higher dispersion →separating equilibrium on primary market)
Regime 3 - Deep Recession: (low TFP, largest dispersion →separating equilibrium, default on outstanding implicitrecourse)
I use perturbation method for Markov-switching DSGE modelsusing methodology by Foerster et al. (2013)
Can capture differences in equilibrium across regimes.Can be used for more complex space of state variables.
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Impulse responses
Effects of defaults on implicit recourse on adverseselection
2 4 6 8 10 12 14time
200
400
600
fNIR
2 4 6 8 10 12 14time
-4
-3
-2
-1
1
qs
2 4 6 8 10 12 14time
-5
-4
-3
-2
-1
K
2 4 6 8 10 12 14time
10203040506070
Z
2 4 6 8 10 12 14time
-7-6-5-4-3-2-1
output
2 4 6 8 10 12 14time
1
2
3
4
Ω
Implicit guar. defaulted Implicit guar. honored
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Impulse responses
Introducing government policy of asset purchases
Motivated by the quantitative easing of the FED, I consider apolicy of asset purchases Graph
exchange of secur. assets in resale markets for governmentbonds at advantageous conditionscosts covered by lump sum taxes
Two effects:Cleans the market from low quality assets → eliminatesadverse selectionMoral hazard problem
Details
Adverse Selection in Resale Markets for Securitized AssetsResults of MS DSGE model
Impulse responses
Government policy eliminates the effects of assetrepurchases
2 4 6 8 10 12 14time
200
400
600
fNIR
2 4 6 8 10 12 14time
-4-3-2-1
123
qs
2 4 6 8 10 12 14time
-5
-4
-3
-2
-1
K
2 4 6 8 10 12 14time
10203040506070
Z
2 4 6 8 10 12 14time
-7-6-5-4-3-2-1
output
2 4 6 8 10 12 14time
1
2
3
4
Ω
Without Policy With Policy
Adverse Selection in Resale Markets for Securitized AssetsConclusion
Conclusion
The model proposes an explanation for:Accumulation of low quality securitized assets on financialsystem balance sheets prior to the crisisSmooth working of the market for securitized assets prior tothe crisisResale market collapse during the crisisFinancial turmoil on securitization markets cause deeper andlonger recessionBenefits and costs of the government policy of assetpurchases (similar to FED quantitative easing)
Adverse Selection in Resale Markets for Securitized AssetsReferences
Selected references
Brunnermeier, M. 2009. Deciphering the liquidity and credit crunch 2007-2008. Journal of Economic Perspectives23 (1): 77-100.Calomiris, C. and Mason, J. (2004). Credit card securitization and regulatory arbitrage. Journal of FinancialServices Research, Vol. 26, pp. 5-27.Cho, I.-K., and D. M. Kreps. (1987). Signaling Games and Stable Equilibria. The Quarterly Journal of Economics102 (2): 179-222.Foerster, A., Rubio-Ramırez, J., Waggoner, D. F. and Zha, T., 2013. Perturbation methods for Markov-switchingDSGE models. Federal Reserve Bank of Atlanta Working Paper Series (2013-1).Gertler, M. and Karadi, P., (2011). A model of unconventional monetary policy. Journal of Monetary Economics58 (1), 17-34.Gorton, G. and Pennacchi, G. (1995). Banks and loan sales: Marketing nonmarketable assets. Journal of MonetaryEconomics 35, pp. 389–411.Gorton, G. and Ordonez, P. (2012). Collateral crises. American Economic Review 104 (2), 343-378.Gennaioli, N., Shleifer, A. and Vishny, R. W., (2013). A model of shadow banking. The Journal of Finance 68 (4),1331-1363.Higgins, E. and Mason, J. (2004). What is the value of recourse to asset-backed securities? A clinical study ofcredit card banks. Journal of Banking and Finance, Vol. 28, pp. 875–899.Kiyotaki, N. and Moore, J. (2012). Liquidity, Business Cycles and Monetary Policy. NBER Working Papers, no.17934.Kuncl, M., (2014). Securitization under asymmetric information over the business cycle. CERGE-EI Working PaperSeries (506).Ordonez, G., (2014). Confidence banking and strategic default. Mimeo. University of Pennsylvania and NBER.Shleifer, A. and Vishny, R. (2010). Unstable banking. Journal of Financial Economics, Vol. 97, pp. 306–318.
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Separating equilibrium in recessions
Firms with Low projects find mimicking High too costlyInformation becomes public
Primary market
Resale market
High projects
Low projects
loan sale + implicit guar.
buy
buy
buy
buy
loan sale + implicit guar.
SELLERS BUYERS
(1‐ π) Fin. firms
πµ Fin. firms π(1‐µ) Fin. firms
Assumption: Counter-cyclical dispersion in TFP of projects(following Bloom (2009) and Bloom et al. (2012) ) Back Markov
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Pooling equilibrium in boom stage
Information remains privateBoth types of projects are financed
Primary market
Resale market
High projects
Low projects
loan sale + implicit guar.
buy
buy
loan sale + implicit guar.
SELLERS BUYERS
(1‐ π) Fin. firms
πµ Fin. firms
π(1‐µ) Fin. firms loan sale + implicit guar.
The longer the economy stays in the boom stage,the larger the share of low quality assets on balance sheets,and larger the stock of implicit guarantees. Back Markov
Adverse Selection in Resale Markets for Securitized AssetsAppendix
TFP ”shocks” are more dispersed in recessions- Bloomet al. (2011)
Back
Adverse Selection in Resale Markets for Securitized AssetsAppendix
CDS for subprime MBS increased dramatically in 2007
Figure reproduced from Brunnermeier(2009); Source of data: LehmanLive
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Drying-up of ABCP markets in 2007
200
400
600
800
1000
1200
2001‐01
2001‐07
2002‐01
2002‐07
2003‐01
2003‐07
2004‐01
2004‐07
2005‐01
2005‐07
2006‐01
2006‐07
2007‐01
2007‐07
2008‐01
2008‐07
2009‐01
2009‐07
2010‐01
2010‐07
2011‐01
2011‐07
2012‐01
2012‐07
2013‐01
2013‐07
2014‐01
2014‐07
Amount Outstanding (Billions USD
)
Commercial Paper
ABCP Other CP
Source: Board of Governors of the Federal Reserve System (US)
Back
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Quantitative easing by the FED
0.0
500.0
1000.0
1500.0
2000.0
2500.0
3000.0
Billions USD
Selected Federal Reserve Assets
Treasuries MBS
Source: Board of Governors of the Federal Reserve System (US)/FRED
Back to Motivation Back to Policy
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Introducing government policy of asset purchases
Motivated by the quantitative easing of the FED, I consider apolicy of asset purchases Graph
exchange of secur. assets in resale markets for governmentbonds at advantageous conditionscosts covered by lump sum taxes
Two effects:Cleans the market from low quality assets → eliminatesadverse selectionMoral hazard problem
Simplifying assumptions:Triggered in “Deep Recession”: r B
t+1 = Er ht+1 and following
periods target returns s.t. qBt+s+1 = qs
t+s+1Back to Policy
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Perturbation method for MS DSGE
Model equilibrium conditions can be written as
Et f (yt+1, yt , xt+1, xt , χt+1, χt) = 0nx+ny , (8.1)
in a discrete Markov chain process indexed by st and with astate-independent transition matrix P =
(ps,s′
).
For unique steady state Foerster et al. (2013) use mean ofparameters’ ergodic distribution
χ =∑
s
psχs .
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Perturbation method for MS DSGE
The solution of the recursive model (8.1) is
xt+1 = h (xt , ψ, st) ,
yt = g (xt , ψ, st) ,
yt+1 = g (xt+1, ψ, st+1) ,
The first order approximations hfirst and gfirst are
hfirst (xt , ψ, st)− xss = Dhss (st)St ,
gfirst (xt , ψ, st)− yss = Dgss (st)St ,
where St =[(xt − xss)
T ψ]T
. Back
Adverse Selection in Resale Markets for Securitized AssetsAppendix
Literature review
Securitization under asymmetric information (Gorton andPennachi 1995, Paligorova 2009 etc.)Implicit recourse - can be sustained in a reputationequilibrium (Gorton and Souleles 2006); may signal quality(Higgins and Mason 2004, Calomiris and Mason 2004)
”As the saying goes, the only securitization without recourse isthe last.” (Rosner and Mason 2007, p.38)
Confidence banking (Ordonez 2014), “Blissful ignorance”equilibrium (Gorton and Ordonez 2014)Kiyotaki and Moore (2012), Gertler and Karadi (2011),Gertler and Kiyotaki (2010), Kuncl (2014)
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