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Subsidizing Price Discovery

Kyungmin Kim, Benjamin Lester () and Braz Camargo ()
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Kyungmin Kim: University of Iowa

No 338, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: In the wake of the 2007-2008 financial crisis, a policy called the Public-Private Investment Program for Legacy Assets (PPIP) was introduced to promote price discovery and restore liquidity in the markets for a variety of asset-backed securities. Under this program, private investors who were interested in purchasing these securities from financially distressed banks were issued non-recourse loans from the FDIC in order to finance a fraction of the purchase price. This program effectively targets two frictions that are often cited as sources of market "freezes." First, given the put-option associated with non-recourse loans, this program helps mitigate the problem of adverse selection. Second, by allowing investors to leverage their investment up to a certain ratio, this program helps to relax liquidity constraints, thus easing the scope of cash-in-the-market pricing. In this paper, we construct an environment that incorporates both of these two frictions, and use it to formally analyze PPIP, paying particular attention to the optimal leverage ratio. We find that the relationship between information production and this leverage ratio is non-monotonic: few signals are produced when it is too small, while the information content of signals is diminished when it is too large. We characterize the optimal, interior leverage ratio.

Date: 2012
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More papers in 2012 Meeting Papers from Society for Economic Dynamics Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA. Contact information at EDIRC.
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