Forums Economics Assignment Help Role of Asymmetric information in Subprime crisis

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    kingsly
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    In what sense did asymmetric information problems contribute to any of the recent financial crisis of the world (Subprime crisis/East Asian Crisis/Latin America Crisis)

    #15749

    kingsly
    Participant

    Asymmetric information was one of the fundamental reasons behind the financial crisis (subprime crisis) of 2008.

    The Federal Reserve controls the level of short term interest rates in the U.S economy. Back in 1990 the boom in investment because of the dot com bubble was followed by a burst in 2000’s. The U.S economy slowed down and the Federal Reserve lowered the interest to 1%. The biggest dream for every person living in the United States of America was to have his/her own house and when interests rate were as low as 1%, people could see their dream turning into a reality and started to borrow from banks and buy houses. This led to an increase House prices, 8% in 2001 and 14% in 2004-2005. Hence, people started to buy even bigger homes than they should have not only for consumption purpose (for living in it) but also for investment purposes with the aim of selling it off at a higher value.

    A significant portion of additional demand for loans came from segments of population with “low credit ratings”- the so called subprime segments, who had earlier been denied. On the supply side such low interest rate allowed bankers to take on more leverage in the sense that they can borrow significant amount of money from the FED at such low interest rates and make more risky bets than they would have if interest rates were higher. Hence there is an abundance of cheap credit that makes borrowing money easier for banks and for borrowers.

    Now property was considered by the bankers as the safest collateral and with rising prices they were willing to make mortgage deals they assumed the buyer may not be able to repay. And if the buyer defaulted the bank would get a property asset whose value is rising, these loans are called the subprime mortgages given to people with bad credit (no proof of income no down payments) or people with no credit history or may be to people with even history of defaults.

    These are called the subprime mortgages. This is where the problem of asymmetric information comes into the picture. THE BANKS ARE ADVERSELY SELECTING THE BORROWERS.

    Coming back to the demand side the rising house prices gave the subprime borrowers the ability to keep refinancing into low interest rate mortgages(thus oiding defaults)even as the withdrew the home equity they had build up to buy more cars etc. The invest bankers in lieu of constantly rising property prices want to buy the mortgage, the lender(banks) sells it to him for a fee. The investment banker then borrowers millions of dollars to buy more such mortgages and turns them into CDO’S ( collateral debt obligation)including both prime and subprime mortgages. Here Moral Hazard comes into the picture since banks didn’t care about the quality of deals they were making because they sold them away in bundles and therefore sold the responsibility.

    The investment banker divides the CDO’S into safe (AAA), OKAY, RISKY (UNRATED) and sells it to investors worldwide. The risky ones were sold to hedgers. Thus U.S financial sector thus bridged the gap between the over consuming and over stimulated U.S and the under consuming and under stimulated rest of the world but all this entire edifice rested on the housing market .New housing construction and existing housing sales provided new jobs in construction, real estate brokerage, and finance, while rising housing prices provided the home equity to refinance old loans and finance new consumption.

    However all thus came to a halt after the FED raised interest rates and halted the house price rise in fact they plummeted. The homeowners began to default or just refuse to their loan back as they see the price of their own houses falling. The seemingly smart banker turns out to have a substantial portion of high rated but low quality securities on their balance sheet, some of the banks failed and some went bankrupt. The investors have also bought these and because they are worth nothing now the investors, don’t want to buy more, also go bankrupt and the entire financial system is frozen. Economies around the world went into a deep slump from which they are recovering now.

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