Question

Subprime mortgage is a type of mortgage issued to borrowers with low credit scores. The widespread issuance of subprime mortgages was a contributing factor to the 2008 financial crisis.

1. The subprime mortgage is an example of a type of problem caused by asymmetric information. What is this problem called? Does this problem happen before or after the transaction occurs?

2. Explain why this problem may cause lenders to be reluctant to lend to anyone.

3. Bob proposed that the solution to this problem is for lenders to charge a high interest rate so that lenders are compensated for the risk. Indeed, the subprime mortgage has a higher interest rate than a prime mortgage (i.e. mortgage issued to borrowers with high credit scores). Do you think charging a higher interest rate will solve this problem? Explain.

4. Bel proposed a solution called “screening”. That is to collect information about borrowers and their projects to identify high-risk projects, and not lend to them. What might be a downside of “screening” to lenders?

Answer 1

The problem of asymmetric information in this case is called adverse selection. This means that a decision taken in good faith but based on incomplete information ends up harming the decision maker. This is different from moral hazard, wherein a decision is taken knowing the problems to satisfy some ulterior motives of teh decision maker.

Charging a higher rate of interest works for teh lender as they would get a normal average return after adjusting for defaults. It, however, discourages the genuine borrowers who may not be able to borrow at the high rates of interest.

Screening may result in screening out some of the genuine borrowers (type I problem) or not flagging high-risk borrowers (type II problem).