Controlling Information Premia by Repackaging Asset-Backed Securities
David, Alexander, Journal of Risk and Insurance
Credit securitization began with the development of the residential mortgage-backed securities business in the 1960s and now includes products backed by a range of receivables, including commercial mortgages, auto loans and leases, home equity loans, student loans, credit card receivables, ticket sales, insurance premium loans, and an expanding list of other assets. Receivables are packaged, underwritten, and sold in the form of asset-backed securities, for many of which market-makers keep open markets. Buyers of these securities use them for hedging various risks. By the end of 1994, the value of outstanding securitized instruments exceeded $1.9 trillion, and more than $500 billion of securitization transactions were done in 1994 alone. Of the many benefits of securitization, perhaps the most important is its ability to increase the value of the receivables by selling them in higher quality and more liquid financial markets (Schwarcz, 1993; Hill, 1996). This article studies the optimal creation of securities from a pool of receivables when the goal of the issuer is to enhance the liquidity of these securities.
How many securities should be created from a given pool of receivables and what is the ideal statistical distribution between the receivables underlying the securities issued? The answer partly depends on how insiders with superior information about the receivables underlying the security might affect the liquidity of one asset versus multiple securities markets.(1) I follow Bagehot's (1971) intuition that market-makers compensate themselves for bad trades due to the adverse selection of insiders by making markets less liquid. This could shrink the base of customers trading in the markets and lower the profits from the sale. How illiquid these markets must be depends on the information content of the different securities issued, the composition of uninformed traders (individuals vs. institutions), and their understanding of linkages among the markets created.
In secondary markets securities backed by seemingly identical pools of receivables trade at different prices, reflecting the information content of receivables underlying the pools. Becketti and Morris (1991) and Stanton (1994) point out that much of the market commentary on mortgage-backed securities focuses on identifying so-called fast pay and slow pay pools - that is, pools that consistently pay out faster or slower, respectively, than apparently comparable pools. Stanton's study of the prepayment behavior of five 12 percent GNMA pools between January 1983 and December 1989 finds that the proportion of principal remaining relative to the original principal varies between 10 and 35 percent for the five pools. When the market lacks information on the prepayment characteristics of homeowners, pools are priced "generically," that is, all comparable GNMAs have roughly the same price at any point in time. In this situation, an investor who can identify fast and slow pay pools can profit from the market's inefficiency.
For most receivables securitized, it is possible to vary the correlation of different securities issued by the separation of microcharacteristics of these receivables. In the case of home mortgages, the prepayment behavior of homebuyers is to a large extent determined by the path of interest rates and other macroeconomic factors; but it also depends on other buyer characteristics, such as the number of children in the household and duration of marriage and job. Advances in computer and communications technologies have made possible the collection and dissemination of credit information on buyers. This role is often played by mortgage bankers, who often are also involved in the underwriting and repackaging of pass-throughs. An agency with detailed information on buyer characteristics can create multiple securities by dividing the pool of buyers into different classes. The correlation between the securities created would depend on how the classes of buyers are chosen. …