Asset Securitization, Market Segmentation

and Monitoring
Paolo Colla
Universitá Bocconi
Filippo Ippolito
Universitá Bocconi and Oxford Financial Research Centre
July 15, 2008

Abstract
We develop a model to illustrate the incentive e¤ects on monitor-
ing of securitizing a risky asset when markets are segmented. Seg-
mentation means that …rst-market participants are unable to observe
secondary sales of the asset. Then, by selling the asset across the two
markets, the issuer can achieve complete insurance and cease to mon-
itor the asset. We draw policy implications with regards to market
transparency and integration in asset-backed markets.

JEL Classi…cation: G21, G28

Keywords: Securitization, Monitoring, Incentives, Asset-Backed
Securities, Transparency

Corresponding Author: Universitá Commerciale Luigi Bocconi, Via G. Röntgen n. 1

- 20136 - Milano, Second Floor - Room 2-D2-02, Tel. +39 02 58365918, Fax. +39 02
58365920 Email: …lippo.ippolito@unibocconi.it

1
1 Introduction
Recent turbulence in the …nancial sector suggests the need for stricter control
in the markets of asset-backed securities. As Keys et al. (2008) show in
a recent working paper on sub-prime mortgages, achieving full insurance
via securitization reduces the issuer’s incentives to monitor risky assets. To
examine this issue more formally, we consider the case of a risk-averse investor
that owns a risky asset, the future returns of which depend on the monitoring
e¤ort of the investor (moral hazard). A risk-neutral market exists for the
asset. The investor’s risk aversion leads to the sale of contractual rights over
the asset to the market, a process commonly referred to as securitization. A
trade-o¤ exists between insurance and incentives, as excessive securitization
generates ine¢ ciently low monitoring e¤ort (Gorton and Pennacchi (1995),
Morrison (2005)). In equilibrium, the market purchases a share of the asset
which is strictly smaller than one. The rationale of this outcome is that by
exposing the investor to some risk, incentives are preserved.
Suppose now that a second market for the asset exists and that this and
the …rst market are segmented, in the sense that the …rst market cannot
observe whether a secondary sale occurs and how much is being sold. Then,
due to risk aversion the investor obtains complete insurance by securitizing
the rest of the asset in the second market. The value of the asset drops in the
second market as a suboptimal level of monitoring is priced in. To the extent
that the …rst market does not anticipate the secondary sale, the …rst market
overpays for the asset. If instead the …rst market anticipates the secondary
sale, the asset trades in the …rst market below its optimal value.

2 The Model
Consider a setting in which an investor pays I to acquire cash-‡ow rights
R~ 2 f0; Rg over an asset. The investor’s monitoring e¤ort over the asset is
e 2 f0; 1g and the cost of e¤ort is (e) 2 f0; g. Monitoring a¤ects the
returns of the asset with probability e as follows:

1
~ = Rje = 1 =
= Pr R 0 + > 0
~ = Rje = 0 ;
= Pr R

where 1 ; 0 ; > 0 and 1 < 1. Once the investor has obtained her rights,
she may choose to sell (part of) them to other market participants (hereafter
referred to as ‘the market’). We refer to such sale as securitization of the

2
asset. Indicate with and A respectively the percentage of securitized rights
and the price at which they are sold to the market. The timing of contracting
is as follows: an investor acquires cash-‡ow rights (t0 ); she then securitizes
(possibly part) of them (t1 ); she chooses whether to monitor the asset (t2 );
…nally, returns are cashed in (t3 ).
We make the following assumptions:

A.1. (Investor): the investor’s preferences are quasi-linear in e¤ort, uI (x; e) =

u (x) (e), and the utility function u displays risk-aversion, i.e. u0 > 0
and u00 < 0. E¤ort e is unobservable (and therefore uncontractible) and
the reservation utility of the investor is nil, u (0) = 0.

A.2. (Market): the market is risk neutral and has all the bargaining power.

Following assumptions A.1 and A.2, the investor’s expected utility is

UI ( ; A; e) = e u (A + (1 )R I) + (1 e ) u (A I) (e) ; (1)

while that of the market is

UM ( ; A; e) = eR A: (2)

Moreover, we impose the following assumptions on the model parameters:

A.3. The asset has positive N P V :

1R I 0R I 0: (3)

A.4. Both the asset return and cost are su¢ ciently large with respect to the
cost of e¤ort:

1 (1 0) 1 0 ^
R>u u = R; (4)

1 0
I u ; (5)

1
where u denotes the inverse of the investor’s utility function.

3
2.1 Problem Setup and Equilibrium Characterization
The …nancial contract ( ; A) is chosen to maximize the market’s expected
utility. Since we are interested in contracts where the investor acquires the
asset and monitors it, we include the following conditions in the market’s
program:
UI ( ; A; 1) UI ( ; A; 0) (IC)
and
UI ( ; A; 1) 0; (P C)
which describe respectively the incentive compatibility (IC) and participa-
tion (P C) constraints of the investor. The optimal …nancial contract ( ; A )
is then obtained by solving the following program
( ; A ) 2 arg max 1R A
;A

s.t. [u (A + (1 ) R I) u (A I)] 0 (6)

1 u (A + (1 )R I) + (1 1 ) u (A I) 0
0 1, A 0
where we use (1) to explicitly write IC and P C, and the last two conditions
correspond to the feasibility constraints. The solution to program (6) is given
in the following:

Proposition 1 The optimal …nancial contract is given by:

^
R 0
1
=1 and A =I +u ; (7)
R
which implies that full securitization never occurs, i.e. < 1.

Proof. For notational convenience, we de…ne u = u (A + (1 ) R I)

and u = u (A I) as the levels of the investor’s ex-post utility in both states
of nature. Assuming interior solutions for ( ; A ), the Lagrangian of pro-
gram (6) is given by
L ( ; A; ; ) = 1R A+ [ (u u) ] + [ 1 u + (1 1) u ];
with associated FOCs
1 u0 1u
0
=0
0 ; (8)
1+ (u u ) + [ 1 u 0 + (1
0
1) u
0
]=0

4
where we set u 0 = u0 (A + (1 )R I) and u 0 = u0 (A I). Solving
the second eq. in (8) for the multiplier gives
0
1 (u u 0)
= 0 0
; (9)
1 u + (1 1) u

which is always positive due to risk aversion, so that P C binds. Replacing

from eq. (9) into the …rst equation in (8) and solving for the multiplier
gives
0
1 (1 1 ) (u u 0)
= : (10)
u 0u 0
According to eq. (10), is non-negative. In particular, = 0 if and only
if u 0 = u 0 , or equivalently = 1. Replacing = 1 into the IC gives
0 which cannot hold. Thus at the optimum it cannot be that = 1:
It then follows that > 0, so that IC binds. As both IC and P C bind at
the optimum, we can solve them as a system of two equations in u and u :
We get u = (1 0 ) and u = 0
, or equivalently the optimal contract
( ; A ) in (7). Condition (4) ensures > 0; while u (0) = 0 and u0 > 0 yield
^
R > 0 so that < 1. Finally, condition (5) corresponds to the feasibility
condition A > 0:

Proposition 1 shows that inducing e¤ort requires the investor to bear

some risk, i.e. < 1. This stems from the fact that the optimal contract
( ; A ) makes both the investor’s participation and incentive constraint
binding. Furthermore, observe that as P C binds at the optimum, the in-
vestor receives her reservation utility, while the market makes a pro…t equal
to
1 (1 0) 1 0
1R I 1u + (1 1 )u (11)
| {z }
NP V | {z }
Compensation to Investor

The allocation of bargaining power means that the market fully internalizes
the returns of the asset, as well as the cost of …nancing it, while providing a
compensation to the investor for exerting e¤ort.

2.2 Secondary Sale

Suppose now that after securitizing at t1 and before exerting e¤ort at t2 ,
the investor sells to a second market whole or part of the residual shares that

5
she still holds ( S ) against cash (AS ). We refer to the contract ( S ; AS ) as
the secondary sale.
From the previous section, we know that if the share held by the investor
falls below ; condition IC is violated. Therefore, a secondary sale neces-
sarily induces a drop in e¤ort. The second market then prices the sale with
e = 0 and solves the following program:

( S ; AS ) 2 arg max S 0R AS
S ;AS

s.t. 0 u (A + AS + (1 S) R I) + (1 0 ) u (A + AS I) 0
0 S 1 , AS 0

where the …rst condition describes the interim P C of the investor, while the
last two conditions correspond to the feasibility constraints. A solution to
this program requires that the interim P C binds at the optimum, so that the
investor is once again left at her reservation utility. Furthermore, given that:
1) the asset has positive N P V if e = 0; due to assumption A.3 and 2) the
investor is risk averse, due to assumption A.1; then complete securitization
is required at the optimum, i.e. S = 1 : Complete securitization implies
a violation of the investor’s IC; which instead requires the investor to bear
some risk. It then follows that a secondary sale induces a drop in e¤ort, i.e.
e = 0. We summarize these results in the following:

Proposition 2 The optimal secondary sale requires complete securitization:

S =1 and AS = I A: (12)

Proof. Similarly to the proof of Proposition 1, we de…ne

uS = u (A + AS + (1 S) R I)

and uS = u (A + AS I) as the levels of the investor’s ex-post utility in

both states of nature. Assuming interior solutions for , the Lagrangian
writes
L ( S ; AS ; ) = S 0 R AS + [ 0 uS + (1 0 ) uS ] ;

with associated FOCs

1 uS0 = 0
;
1 + [ 0 uS0 + (1 0
0 ) uS ] =0

6
where now
u 0 = u0 (A + AS + (1 S) R I)
1
and u 0 = u0 (A + AS I). From the …rst condition we have = (uS0 ) > 0;
so that the interim P C binds. Adding up the two FOCs gives
0
(1 0 ) (uS uS0 ) = 0;

which implies uS0 = uS0 since > 0. Condition uS0 = uS0 is equivalent to full
securitization so that the interim P C reduces to u (A + AS I) = 0; thus
yielding AS = I A.

2.3 Insurance and Ine¢ ciency

A secondary sale is pro…table for the investor: while the …rst market com-
pensates her for exerting e¤ort, in equilibrium e = 0 and the investor saves
: In this sense, the investor pro…ts from "fooling" the …rst market. More-
over, lower e¤ort means lower expected returns on the asset. The investor
is una¤ected, because the second sale o¤ers her perfect insurance. On the
contrary, the expected utility of the …rst market drops. More formally, when
e = 0, the return to the …rst market is

1 (1 0) 1 0
UM ( ; A ; 0) = 0R I 1u + (1 1 )u ;

and the loss in expected utility equals R (see also eq. (11)). As wealth
in the …rst market drops by more than what the investor gains, we conclude
that:

Corollary 3 Due to assumption A.3, R > 0, the reduction in e¤ort

associated with a secondary sale is strictly ine¢ cient.

2.4 Restoring e¢ ciency

The ine¢ ciency of a secondary sale rests on the premise that …rst-market
participants do not anticipate that a secondary sale will occur. However, in
equilibrium the …rst market does anticipate the e¤ects of a secondary sale

7
on e¤ort. This means that the …rst market disregards the IC of the investor
and (6) rewrites as
^ 2 arg max
(^ ; A) 0R A
;A

s.t. 0 u (A + (1 )R I) + (1 0 ) u (A I) 0
0 1, A 0

^ denotes the optimal contract when the …rst market correctly

where (^ ; A)
foresees that a secondary sale will occur. Solving the maximization we …nd
that ^ = 1 and A^ = I:1 This shows that complete securitization now occurs
during the …rst sale.

3 Discussion and Conclusions

We have shown that the existence of a second market leads to complete
securitization of the asset and to an ine¢ cient reduction of e¤ort. This in-
e¢ ciency arises because the investor is unable to commit that she will not
undertake a secondary sale. Can e¢ ciency be restored via some commit-
ment mechanism? This question has important practical scope and policy
implications. Consider the following two mechanisms:

Transparency (Internal Mechanism): If a second sale is observable,

…rst-market participants will require the investor to pay them a …ne
F R if he engages in a secondary sale.2 By doing so, the investor
will refrain from selling her residual shares to the second market, thus
restoring e¢ ciency. From a policy perspective, this suggests to foster
market transparency.

Regulation (External Mechanism): Suppose there is a regulator whose

aim is to maximize welfare so that he wishes to induce e¤ort in equi-
librium. To do so the regulator may forbid the investor from engaging
in a secondary sale. However, this may prove di¢ cult if the second
market is not under the control of the regulator, because for example
it is in a foreign country. This suggests that market integration or a
1
The proof of this result easily follows from the proof of Proposition 2, just replacing
the interim P C with the time t0 participation constraint.
2
Notice that F is not su¢ cient here to prevent renegotiation.

8
 "global" regulator may achieve e¢ ciency. An alternative strategy is for
the regulator to allow securitization up to a certain limit, i.e. in our
model. Clearly, this rule is di¢ cult to implement because such limit
varies across assets –the investment and return pro…le in our model, I
and R–as well as across investor types –the cost of e¤ort, . The con-
sequences of setting the wrong limit are twofold, depending on whether
the threshold is set too high or too low. Suppose the rule states that
the maximum level of securitization is equal to the level : If an asset
requires a < , then the investor securitizes in the …rst market
and in the second market, thus exceeding the incentive compat-
ible share . As a consequence, e¤ort drops to zero and incomplete
securitization occurs –a combination that is clearly undesirable. On
the other hand, if an asset has > ; the investor is asked to secu-
ritize less than she would like to. Both cases suggest that a policy of
one-size-…ts-all may generate ine¢ ciencies that are di¢ cult to quantify.

4 References
Gorton, G. B., and G. G. Pennacchi, 1995, Banks and Loan Sales:
Marketing Nonmarketable Assets, Journal of Monetary Economics 35,
389-411.

Keys, B., T. Mukherjee, A. Seru, and V. Vig, 2008, Did Securitiza-

tion Lead to Lax Screening? Evidence from Subprime Loans, Working
Paper

Morrison, A., 2005, Credit Derivatives, Disintermediation, and Invest-

ment Decisions, Journal of Business 78(2), 621-647.