Introduction to Financial Crises

Lecture 8: Securitization and Liquidity Dry-Ups

University of Vienna – Masters in Banking and Finance

Winter Term 2022

 What is Securitization?

The years preceding the 2007/08 crisis witnessed a secular change in bank operations.

From originate and hold to originate and distribute.

Traditional Banking:
• Main financing source were (insured) deposits.
• Banks originated loans using deposits, and held these on their balance sheets.

Securitized Banking:
• Short-term wholesale lending partially replaced deposits, especially repos.
• Banks originated loans but then sold them to third-parites after securitization.

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Figure: Traditional Banking. Source: Gorton and Metrick (2012)

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Figure: Securitized Banking. Source: Gorton and Metrick (2012)

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 What is Securitization? (cont.)

An example of a typical “structured” product is a collateralized debt obligation (CDO).

What is the idea?:

1 Form diversified portfolios of mortgages, corporate loans, bonds, etc.
2 Transfer these loans to a Special Purpose Vehicle (SPV), who then...
3 “Slices” these portfolios into tranches, and sells these to investor groups based on
their preference for risk.

Tranches:
• The “senior tranche” offers investors a low rate of return, but it is first in line to
access cash flows generated by the portfolios.
• “Junior tranches” are only paid out after all other senior tranches have been paid,
and is usually held by issuing institution.
• “Mezzanine tranches” refer to the intermediate tranches of the security.

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Figure: Securitization. Source: Gorton and Metrick (2012)

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 Fragile Securitization

The liquidity of highly-rated (AAA) securities was based on the their safety.

This safety partly resulted from the securities’ perceived information insensitivity.

That is, the holders of the securities were not considered to possess better information
about the securities’ future cash flows compared to potential buyers.

The crisis showed that the market for these highly-rated securities can suddenly dry-up,
presumably because they were no longer considered to be information insensitive.

This phenomena of sudden market freezes can be the result of adverse selection.

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 Background on Adverse Selection

Static economy populated by a single buyer B and a single seller S.

Seller:
• The seller has a unit endowment of an asset that returns Ri ∈ {RH , RL }.
• The probability that the asset yields a low return is λ ≡ Pr(Ri = RL ).
• The seller’s valuation for the asset is: V S (Ri ) = βRi , where β < 1.

Buyer:
• The buyer has a large cash endowment but no asset.
• Buyers’ valuation for the asset is: V b (Ri ) = Ri .

The preference structure implies gains from trade ∆i ≡ (1 − β)Ri .

Assume that the seller has all the bargaining power.

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 Background on Adverse Selection
Sellers will choose P in order to maximize expected profits profits:

max P − βES [Ri ]
P

Buyers will accept the offers as long as they make non-negative profits:

EB [Ri ] − P ≥ 0

Complete Information:
• Assume both the buyer and the seller can observe asset returns.
• There will be two markets, depending on the return of the asset.
• As sellers have all the bargaining power, they will extract all the gains from trade.
• The market prices will be PH = RH and PL = RL .

Symmetric Information:
• Assume neither the buyer nor the seller can observe asset returns.
• There will be a unique pooling price at which assets will trade.
• The pooling price will be PP = λRL + (1 − λ)RH .

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 Background on Adverse Selection
Asymmetric Information:
• Now assume only the seller observe asset returns.
• There will still be a unique price P at which assets will trade.
• But now if the asset is good the seller will only trade if P > βRH .
• The buyer only accepts the pooling price PP if he believes good assets are traded.

The buyers’ beliefs about the fraction of bad assets supplied is:
(
λ if P ≥ βRH
λ̂ =
1 if P < βRH

The buyers’ expected valuation for the asset is therefore:

(
B λRL + (1 − λ)RH if P ≥ βRH
E [Ri ] =
RL if P < βRH

∆H
Hence, good assets will only trade if PP ≥ βRH ⇔ λ ≤ (RH −RL )
.

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 Adverse Selection and Liquidity Dry-Ups

How can markets suddenly switch from being liquid to freezing up?

That is: how can we think of liquidity dry-ups as an equilibrium phenomenon?

The following paper by Malherbe (2013) proposes an answer to this question.

His answer is based on traders’ endogenous portfolio choice decisions, and their
implications for secondary asset market prices.

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 Self-Fulfulling Liquidity Dry-Ups
Reference: Malherbe (2013)

Three period economy t ∈ {0, 1, 2} with a continuum of traders.

Traders are risk-averse and their preferences are represented by:

U (c1 , c2 ) = E[ln(c1 ) + ln(c2 )]

Traders have a unit endowment in t = 0 and can invest either in a short-term risk-free
asset (storage) or a long-term risky asset with binary return structure:
(
Rh with probability π
R̃ =
Rl with probability 1 − π

where E[R̃] > 1 > Rl .

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 Information and Trade

At date t = 1, traders privately learn their long-term assets’ quality i ∈ {h, l}.

Have option to sell asset shares to “deep-pocket” buyers in a secondary market.

The market price, p, depends on the average quality of traded assets:

p(q) = Rl + q(Rh − Rl )

where q ∈ [0, 1] denotes the fraction of good assets supplied to the market.

Definition
The secondary market is said to be illiquid whenever:

1 − Rl
p<1 ⇔ q<
Rh − Rl

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 Portfolio Choice

Traders choose in t = 0 how much of their endowment to invest in the long-term asset.

Formally, their portfolio choice solves:

maxE[ln(c1 ) + ln(c2 )]
s.t. c1,i = 1 − y + pxi − si ,
c2,i = (y − xi )Ri + si

Solve in two steps:

1 Optimal asset sale decision in t = 1 (xi ).
2 Optimal portfolio choice in t = 0 (y).

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 Optimal Asset Sale Decision

Traders’ optimal asset sale decision (xi ) depends on their asset’s type i ∈ {h, l}.

Low-type traders:
• Since p ≥ Rl , low-type traders always sell all of their assets.
• It follows that we must have that xl (p, y) = y.
• Traders then seek to equate their consumption in both periods.
• It follows that they will choose sl (p, y) such that:

1 − y + py
c1l (p, y) = c2l (p, y) =
2

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 Optimal Asset Sale Decision (cont.)

High-type traders:
• Since p < Rh , we cannot have both xh > 0 and sh > 0.
• If sh = 0, then utility optimization implies that we must have:

c2 Rh py − (1 − y)
= ⇔ xh (p, y) =
c1 p 2p
• Instead, if xh = 0, then c1h = c2h implies that we must have:

1 − y − yRh
sh (p, y) =
2

Lemma
The quantity of assets sold by high-type traders, xh (p, y), increases in y.

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 Optimal Portfolio Choice

Lemma
The optimal t = 0 portfolio choice, y(p), increases in the market price p.

Given traders’ optimal portfolio and asset sale decisions, we can derive the equilibrium
fraction of good assets supplied to the market in t = 1:

πxh (p, y(p))

q(p, y(p)) =
πxh (p, y(p)) + (1 − π)y(p)

The equilibrium market price therefore solves the following fixed-point problem:

p∗ = Rl + q(p∗ , y(p∗ ))[Rh − Rl ]

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 Self-Fulfilling Dry-Ups

Figure: Multiple equilibria for parameter values: Rl = 0.8, Rh = 2 and π = 0.5.

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 Liquidity Hoarding

Depending on the parameters, the economy can support multiple equilibria:

1 Low cash holdings: High secondary market trade, liquid market.
2 High cash holdings: Low secondary market trade, illiquid market.

The model therefore explains why cash hoarding can be a self-fulfilling phenomenon.

In particular, if traders fear that secondary asset markets are going to be illiquid, they
will have an incentive to hold a lot of cash in order to hedge their liquidity needs.

But the fact that traders hold a lot of cash implies that markets are more likely to be
illiquid since the only traders willing to sell will be those holding lemons.

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 Summary

Securitization has been a salient feature of financial innovation over the past decades.

It has to a large extent become a structural feature of contemporary financial markets.

While theory suggests that securitization has an important role to play in facilitating
liquidity, the 2007/08 Financial Crisis has also shown that it is fragile.

The fragility of securitization may be linked to financial market participants’ ability to

acquire information about nominally “informationally insensitive” assets.

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