Information Acquisition vs. Liquidity in Financial Markets

This paper presents a model of securitization that highlights the link between information acquisition at the loan screening stage and liquidity in markets where securities backed by loan cashflows are sold. While information is beneficial ex-ante when used to screen loans, it becomes detrimental ex-post because it introduces a problem of adverse selection. The model matches key features of the securitization practice, such as the tranching of loan cashflows, and it predicts that when gains from securitization are 'sufficiently' large, loan screening is inefficiently low. There are two channels that drive this inefficiency. First, when gains from trade are large, a loan issuer is tempted ex-post to sell a large portion of its cashflows, and lower retention reduces incentives to screen loans. Second, the presence of adverse selection in secondary markets creates informational rents for issuers holding low quality loans, reducing the value of loan screening. This suggests that incentives for loan screening not only depend on the portion of loans retained by issuers, but also on how the market prices different securities. Turning to financial regulation, I characterize the optimal mechanism and show that it can be implemented with a simple tax scheme. This paper, therefore, contributes to the recent debate on how to regulate securitization.