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Abstract:
A key feature of the 2007-2008 financial crisis is that for some classes of securities trade has ceased. And where trade does occur, it appears that market prices are well below what one might believe to be the intrinsic value for that class of security. This seems to be especially true for those securities where the payoff streams are particularly complex (for example, CDOs). One explanation for this is that information about these securities' intrinsic values is asymmetric, with the current holders having better information than potential buyers. We show how the resulting adverse selection problem can help explain why more complex securities trade at significant discounts to their intrinsic values or do not trade at all. To examine whether asymmetric information alone would suffice to shut down portions of the asset-backed securities (ABS) market, we append a simple "workhorse" model for pricing securities under asymmetric information into a Monte Carlo simulation that generates hypothetical securities backed by residential mortgages. We conduct a type of "stress test" on the ABS by making the distribution of payoffs to the underlying loans worse, and find that the intrinsic values of the securities further down the securitization chain become dispersed in such a way that the market for them may shut down under asymmetric information. We then consider the role for government intervention, and compare the effectiveness of different policies that aim to unclog these markets.
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