A Liquidity-based Model of Security Design

TLDR

Designing and selling a security backed by specified assets involves a tradeoff between retention costs and liquidity costs, with illiquidity driven by issuer private information about payoffs. The study seeks to characterize the optimal security design in several cases. The authors analyze the tradeoff between retention costs and liquidity costs to determine optimal designs. They find that standard debt is optimal in certain circumstances and that its riskiness rises with the issuer’s retention costs.

Abstract

We consider the problem of the design and sale of a security backed by specified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the time the security is issued, the issuer's or underwriter's private information regarding the payoff of the security may cause illiquidity, in the form of a downward-sloping demand curve for the security. The severity of this illiquidity depends upon the sensitivity of the value of the issued security to the issuer's private information. Thus, the security-design problem involves a tradeoff between the retention cost of holding cash flows not included in the security design, and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer's private information. We characterize the optimal security design in several cases. We also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer's retention costs for assets.