Optimal incentives and securitization of defaultable assets

We study optimal securitization of defaultable assets in a continuous time setting. A financial intermediary can create a portfolio of defaultable assets and then sell it to outside investors. The default risk of the assets in the portfolio is determined by the unobservable costly effort exerted by the intermediary. We explicitly calculate the optimal contract for any given level of effort and show that the contract may have surprising properties - for example, payment by the investor for default cascades, whereby the investor makes the largest payments to the intermediary after a prescribed number of defaults occurs, one immediately after another. In stark contrast to the conventional wisdom, we show that, even when intermediaries have all the bargaining power, securitization improves the intermediary's screening incentives and increases the equilibrium effort level of the intermediary. Furthermore, the equilibrium effort level and the surplus converge to their first best levels when the number of securitized assets is sufficiently large. securitization, mortgage-backed securities, moral hazard, default risk