A Model of Securitization When Bank Optimism and Liquidity Matter

We build a market equilibrium model of loan securitization as an alternative explanation of the cause of the recent Financial Crisis where there was initially deteriorating loan quality but coupled with aggressive securitization, and later investors “flight to quality” and market inefficiency and shut-down. Information asymmetry comes from level of optimism and information (in)accuracy. We show that securitization enhances banks' optimism in the loan market, and being optimistic is preferred to having perfect information in some circumstances. Dominance of optimistic banks blurs quality differences in securitization products, and competition among banks is welfare enhancing only when banks are optimistic. Our findings highlight the importance of awareness of over-optimism in creating contagion of financial fragility, and how capital requirement can alleviate possible financial crisis