Intermediation and Value Creation in an Incomplete Market: Implications for Securitization

Abstract

This paper studies the impact of financial innovations on real investment decisions. We model an incomplete market economy comprised of firms, investors and an intermediary. The firms face unique investment opportunities that are not spanned by the securities traded in the financial market, and thus, cannot be priced uniquely using the no-arbitrage principle. The specific innovation we consider is securitization: the intermediary buys claims from the firms that are fully backed by cash flows from the new projects, pools these claims together, and then issues tranches of secondary securities to the investors. We first derive necessary and sufficient conditions under which pooling provides value enhancement from the new projects that are undertaken, and the prices paid to the firms are acceptable to them compared to the no-investment option or the option of forming alternative pools. We find that there is a unique pool that is sustainable, and which may or may not consist of all projects in the intermediary’s consideration set.