This paper studies the efficiency of financial intermediation through securitization in a model with heterogeneous lending opportunities and asymmetric information about the quality of securities. Issuers of securities can signal their quality by providing recourse to security buyers. I find that signaling increases the variation in the degree of asymmetric information over the business cycle, which creates the documented growth asymmetry in the cycle. In particular, in the boom stage of the business cycle, security quality remains private information and lower-quality securities accumulate on the balance sheets of lenders. This inefficient allocation of capital implies a deeper drop in output in a subsequent recession proportional to the length of the preceding boom.
Markets for securitized assets were characterized by high liquidity prior to the recent financial crisis and by a sudden market dry-up at the onset of the crisis. A general
equilibrium model with heterogeneous investment opportunities and information frictions predicts that, in boom periods or mild recessions, the degree of adverse selection in resale markets for securitized
assets is limited because of the reputation-based guarantees by asset originators. This supports investment and output. However, in a deep recession, characterized by high dispersion of asset qualities,
there is a sudden surge in adverse selection due to an economy-wide default on reputation-based guarantees, which persistently depresses the output in the economy. Government policy of asset purchases
limits the negative effects of adverse selection on the real economy, but may create a negative moral hazard problem.
We study loan default insurance when lenders can screen in primary markets at a heterogeneous cost and learn loan quality over time.
In equilibrium, low-cost lenders screen loans, while high-cost lenders may insure them. Insured loans are risk-free and always trade in
a secondary market, while uninsured loans are subject to adverse selection. Loan insurance reduces the amount of lemons traded in the
secondary market for uninsured loans and improves liquidity and welfare. This pecuniary externality implies insufficient loan insurance
in equilibrium. A Pigouvian subsidy on loan insurance restores constrained efficiency and dominates a policy of outright loan purchases.
Bail-in bonds have gained a lot of attention among bank regulators. These bonds supposedly raise the hurdle for a government
bailout by converting into loss-absorbing capital once the issuing bank runs into trouble. We argue that banks can short-circuit bail-in
requirements by offering investors off-balance-sheet insurance against conversion. The bond itself appears as a bail-in bond on the issuer's
balance sheet while the insurance is booked off balance sheet until the bond converts. The government can deter insurance provision by imposing
penalties when insurance is discovered, but these penalties may not be credible. We find conditions for an equilibrium in which insurance against
conversion is provided by banks and bailed out by the government rather than penalized upon discovery. We also present new empirical evidence in support of our model.