Effects of Security Design of Asset-Backed Securities on the Value of Asset-Backed Securities and the Value of Issuing Firm

Abstract

Security design of asset-backed securities (ABS) could affect the value of the ABS and that of the issuing firm as well when there exists an information asymmetry between insiders and outsiders of the firm, depending on the size of the assets sold. If the size is relatively small, the optimal security design will be such that the firm sells the risk-free, senior security (backed by the asset sold) to outsiders at a minimum size and retains the risky, subordinate security. If the size is large, the firm should sell outsiders both the risk-free security at a maximum size and the risky tranche at a minimum size. Meanwhile, if the firm has to sell an asset portfolio rather than an asset, the firm is better off by selling the portfolio through bundling the assets of the portfolio. It turns out that the bundling into senior and subordinate tranches is preferred to the bundling and selling to outsiders.