Optimal Incentives and Securitization of Defaultable Assets

73 Pages Posted: 21 Oct 2011 Last revised: 3 Jul 2012

See all articles by Semyon Malamud

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Huaxia Rui

University of Rochester - Simon Business School

Andrew B. Whinston

University of Texas at Austin - Department of Information, Risk and Operations Management

Date Written: May 27, 2012

Abstract

We study optimal securitization in the presence of an initial moral hazard. A financial intermediary creates and then sells to outside investors defaultable assets, whose default risk is determined by the unobservable costly effort exerted by the intermediary. We calculate the optimal contract for any given effort level and show the natural emergence of extreme punishment for defaults, under which investors stop paying the intermediary after the first default. With securitization contracts optimally designed, we find securitization improves the intermediary's screening incentives. Furthermore, the equilibrium effort level and the surplus converge to their first best levels with suciently many assets.

Keywords: securitization, mortgage-backed securities, asset-backed securities, moral hazard, default risk

JEL Classification: D8, G21, G24, G32

Suggested Citation

Malamud, Semyon and Rui, Huaxia and Whinston, Andrew B., Optimal Incentives and Securitization of Defaultable Assets (May 27, 2012). Swiss Finance Institute Research Paper No. 11-48, Available at SSRN: https://ssrn.com/abstract=1947202 or http://dx.doi.org/10.2139/ssrn.1947202

Semyon Malamud (Contact Author)

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Huaxia Rui

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Andrew B. Whinston

University of Texas at Austin - Department of Information, Risk and Operations Management ( email )

CBA 5.202
Austin, TX 78712
United States
512-471-8879 (Phone)

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