A crucial impediment to the efficient functioning of the financial system is asymmetric information, a situation in which one party to a financial

contract has much less accurate information than the other party. For example, borrowers who take out loans usually have much better information about the potential returns and risk associated with the investment projects they plan to undertake than lenders do. Asymmetric information leads to two basic problems in the financial system: adverse selection (hidden information) and moral hazard (hidden action). Adverse selection is an asymmetric information problem that occurs before the transaction occurs when potential bad credit risks are the ones who most actively seek out a loan. Thus, the parties who are the most likely to produce an undesirable (adverse) outcome are most likely to be selected. For example, those who want to take on big risks are likely to be the most eager to take out a loan because they know that they are unlikely to pay it back. Since adverse selection makes it more likely that loans might be made to bad credit risks, lenders may decide not to make any loans even though there are good credit risks in the marketplace. This outcome is a feature of the classic lemons problem analysis first described by Akerlof (1970). Clearly, minimizing the adverse selection problem requires that lenders must screen out good from bad credit risks. A moral hazard is where one party is responsible for the interests another, but has an incentive to put his or her own interests first. Standard example is a worker with an incentive to shirk on the job. Financial examples include the following: I might sell other a financial product (e.g., a mortgage) knowing that it is not in others interests to buy it. I might pay myself excessive bonuses out of funds that I am managing on other behalf; or I might take risks that other people then have to bear. Financial crisis and moral hazard Economist Paul Krugman described moral hazard as: "...any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return] So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well, while being bailed out by the taxpayer if the investment turns out badly. Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards, because without such limits borrowers may spend borrowed funds recklessly, leading to default. The US subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backing said mortgages. Approximately 80% of U.S. mortgages issued to subprime borrowers were adjustable-rate mortgages. After U.S. house sales prices peaked in mid-2006 and began their steep decline forthwith, refinancing became more difficult. As adjustable-rate mortgages began to reset

at higher interest rates, mortgage delinquencies soared. Securities backed with mortgages, including subprime mortgages, widely held by financial firms, lost most of their value. Global investors also drastically reduced purchases of mortgage-backed debt and other securities as part of a decline in the capacity and willingness of the private financial system to support lending. Concerns about the soundness of U.S. credit and financial markets led to tightening credit around the world and slowing economic growth in the U.S. and Europe. In the years before the crisis, the behavior of lenders changed dramatically. Lenders offered more and more loans to higher-risk borrowers, including undocumented immigrants. Subprime mortgages amounted to $35 billion (5% of total originations) in 1994, 9% in 1996, $160 billion (13%) in 1999,and $600 billion (20%) in 2006. A study by the Federal Reserve found that the average difference between subprime and prime mortgage interest rates (the "subprime markup") declined significantly between 2001 and 2007. The combination of declining risk premia and credit standards is common to boom and bust credit cycles. In addition to considering higher-risk borrowers, lenders have offered increasingly risky loan options and borrowing incentives. In 2005, the median down payment for first-time home buyers was 2%, with 43% of those buyers making no down payment whatsoever. By comparison, China has down payment requirements that exceed 20%, with higher amounts for non-primary residences. The mortgage qualification guidelines began to change. At first, the stated income, verified assets (SIVA) loans came out. Proof of income was no longer needed. Borrowers just needed to "state" it and show that they had money in the bank. Then, the no income, verified assets (NIVA) loans came out. The lender no longer required proof of employment. Borrowers just needed to show proof of money in their bank accounts. The qualification guidelines kept getting looser in order to produce more mortgages and more securities. This led to the creation of NINA. NINA is an abbreviation of No Income No Assets (sometimes referred to as Ninja loans). Basically, NINA loans are official loan products and let people borrow money without having to prove or even state any owned assets. All that was required for a mortgage was a credit score. Another example is the interest-only adjustable-rate mortgage (ARM), which allows the homeowner to pay just the interest (not principal) during an initial period. Still another is a "payment option" loan, in which the homeowner can pay a variable amount, but any interest not paid is added to the principal. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out these option ARM loans, which meant they could choose to make payments so low that their mortgage balances rose every month. An estimated one-third of ARMs originated between 2004 and 2006 had "teaser" rates below 4%, which then increased significantly after some initial period, as much as doubling the monthly payment. The proportion of subprime ARM loans made to people with credit scores high enough to qualify for conventional mortgages with better terms increased from 41% in 2000 to 61% by 2006. However, there are many factors other than credit score that affect lending. In addition, mortgage brokers in some cases received incentives from lenders to offer subprime ARM's even to those with credit ratings that merited a conforming (i.e., nonsubprime) loan.

Mortgage underwriting standards declined precipitously during the boom period. The use of automated loan approvals allowed loans to be made without appropriate review and documentation. In 2007, 40% of all subprime loans resulted from automated underwriting. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay. Mortgage fraud by lenders and borrowers increased enormously. The Financial Crisis Inquiry Commission reported in January 2011 that many mortgage lenders took eager borrowers qualifications on faith, often with a "willful disregard" for a borrowers ability to pay. Nearly 25% of all mortgages made in the first half of 2005 were "interest-only" loans. During the same year, 68% of option ARM loans originated by Countrywide Financial and Washington Mutual had low- or no-documentation requirements. Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the 20072008 subprime crises, however, national credit authorities in the U.S., the Federal Reserve assumed the ultimate risk on behalf of the citizenry at large. Adverse selection and financial instability There are several channels, such as an increase in interest rates, deterioration of financial institutions balance sheets, and maturity mismatch that can aggravate problems caused by adverse selection and lead to financial instability.

Securitization brought new information asymmetries to financial markets because the complexity of the instruments and their lack of transparency made it difficult for investors to evaluate securitized assets. Structured products, such as collateralized debt obligations (CDOs), were created from diversified portfolios of mortgages and other types of assets, such as corporate bonds, credit cards, and auto loans. The pooled portfolios were sliced into different trenches that were prioritized based on how they would absorb losses from the underlying portfolio. The top trenches were constructed to receive a AAA rating. Before the crisis: Mortgage backed assets were rated as very safe As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS)

were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe. After the crisis 1: Adverse selection means no one could sell these assets When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information this makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

After the crisis 2: Even banks who are not exposed to MBS could not raise new capital The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital. In 2007, defaults on subprime mortgages increased, and a large fraction of Cdos were downgraded. The impact of declining house prices on the securities depended on the composition of assets and mortgages that backed them. The complexity of structured financial products and the heterogeneity of the underlying asset pool gave their issuers an informational advantage in evaluating them. Because of this asymmetric

information, buyers did not know whether securities were being sold because of their low quality or because of the sellers sudden need for liquidity. The resulting adverse selection led to market freezes, reflecting buyers belief that most securities in the market were of low quality. For example, during the crisis, the demand for asset-backed securities (AbS) in the United States collapsed from over US$500 billion in 2007 to US$20 billion in 2009 (Chart 1). The difficulty of evaluating these assets also resulted in a reduction in their ability to serve as collateral. Credit markets experienced considerable pressure: spreads widened significantly, and haircuts on collateral increased.13 In particular, the haircut on AbS, which was 3 per cent to 5 per cent in August 2007, increased to 40 per cent to 50 per cent in August 2008.

The bottom line Asymmetric information and adverse selection, moral hazard may prevent financial markets from functioning efficiently during a crisis. The possibility of such market disruptions provides a rationale for government intervention to alleviate financial crises and for ex-ante regulation to ensure the continuous functioning of financial markets. If someone takes a risk, someone has to bear it. If I take a risk, then it should be ensured that I be made to bear it. But if I take a risk at others expense, then thats moral hazard and thats bad. As the late, great Milton Friedman might have put it: there aint no such thing as a free risk.