Pooling and Tranching under Belief Disagreement

We study optimal security design when issuer and market participants disagree about the characteristics of the underlying asset. We show that pooling and tranching assets can be preferable to selling optimal securities backed by individual assets: pooling mitigates belief disagreement between issuer and investors, and tranching allows the issuer to exploit belief disagreement among investors. Interestingly, differences in beliefs can make pooling and tranching complements. Pooling and tranching can be optimal even when the number of securities in the pool is small, and remain optimal even when the issuer sells all tranches, including the most junior ones