DeMarzo (2005)

Citation: DeMarzo, P.M. (2005). “The Pooling and Tranching of Securities: A Model of Informed Intermediation.” The Review of Financial Studies, 18(1), 1-35.

DeMarzo explains why financial intermediaries pool assets and issue tranched securities. The key insight: optimal securitization strategy depends on whether the issuer is informed or uninformed about asset values, with opposite implications for each.

The information destruction effect:

For an informed seller, pure pooling is costly. The issuer holds an option to sell each asset selectively based on private information. Pooling destroys this option.

Theorem 1: An informed issuer always prefers selling assets separately to a pure pass-through pool.

The risk diversification effect:

When the issuer can tranche the pool, the picture changes. If residual risks are diversifiable (uncorrelated), pooling creates a nearly risk-free senior tranche that is information-insensitive and therefore liquid.

flowchart TD
  subgraph Pooling + Tranching
    P[Pool many assets] --> DIV[Residual risks diversify]
    DIV --> SR[Senior tranche risk-free]
    SR --> LIQ[Information-insensitive = LIQUID]
  end

Theorem 2: If residual risk is diversifiable and the pool is large enough, pooling and tranching dominates both pure pooling and separate sales.

Uninformed sellers face the opposite incentive:

Seller Type	Pure Pooling	Pooling + Tranching
Informed	✗ Info destruction	✓ Optimal if diversifiable
Uninformed	✓ Reduces adverse selection	N/A

Pooling prevents informed buyers from cherry-picking the best assets.

Dynamic model of intermediation:

flowchart LR
  O[Uninformed originators] --> |Pool to reduce underpricing| IB[Informed intermediary]
  IB --> |Buys best pools| POOL[Further pools & tranches]
  POOL --> |Senior debt| CASH[Raises capital]
  CASH --> |Reinvest| IB

Intermediaries with securitization capability grow faster—pooling and tranching lets them leverage capital by issuing nearly risk-free debt rather than selling individual assets at lemons discounts.

Key conditions for beneficial pooling:

1. Private information general (correlated across assets)—reduces info destruction
2. Residual risks specific (uncorrelated)—maximizes diversification
3. Pool large enough for diversification to dominate

This explains why pools contain same-class assets (correlated info) but diversify geographically (uncorrelated idiosyncratic risk), and why classes aren’t mixed.

Key contribution:

The paper shows securitization is fundamentally about managing information asymmetry. Creating information-insensitive securities from information-sensitive assets lets informed intermediaries leverage capital and extract returns from private information—explaining both the structure of ABS markets and the role of sophisticated intermediaries.