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Prime vs. Subprime: Asymmetric Information and Equilibrium Securitization in a Business Cycle Model
We develop a general equilibrium model where loan securitization is an endogenous outcome in a credit market where information asymmetries lead to adverse selection across financial intermediaries. Securitization occurs when the resources saved by investors acquiring limited information about the risk-class of some borrowers outweigh the cost of being selected against by loan originators. This results in a time-varying market share of individually risk-priced loans held by banks, and of securitized loans held by the secondary market. We analyze the impact of conventional monetary policies and credit market policies in response to an increase in default risk, and discuss its welfare implications. Overall securitization allows more efficient funding of loans, at the expense of increased volatility in risky interest rates, consumption, and inflation over the business cycle.
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