Suppose bank A has two loans, each of which is due to be repaid one period hence and whose cash flows are independent and identically distributed random variables. Each loan will repay $250 to the bank with probability 0.8 and

$125 with probability 0.2. However, while bank A knows this, prospective investors cannot distinguish this bank’s loan portfolio from that of bank B that has the same number of loans, but each of its loans will repay $250 with probability 0.5 and $125 with probability 0.5. The prior belief of investors is that there is a 0.4 probability that bank A has the higher-valued portfolio and 0.6 probability that it has the lower-valued portfolio. Suppose that bank A wishes to securitize these loans, and it knows that if it does so without credit enhancement, the cost of communicating the true value of its loans to investors is 8% of the true value. Explore bank A’s securitization alternatives. Assuming that a credit enhancer is available and that the credit enhancer could (at negligible cost) determine the true value of the loan portfolio, what sort of credit enhancement should bank A purchase? Assume everybody is risk neutral and that the discount rate is zero.