Asymmetric Information 591Consider the home lending market where some of the worst abuses
occurred.^10 Thirty years ago, most home loans were a matter between the indi-
vidual borrower and his or her bank lender. The lender’s task was to carefully
assess the borrower’s risk and set terms and conditions on the loan accord-
ingly. This done, both sides had a mutual objective in making the loan work and
having it successfully paid off. By contrast, today’s home lending market involves
many competing loan originators (not simply one’s local bank), and home
loans are “securitized”—packaged together to be sold as securities to investors.
Securitization is a means of risk sharing and lowering financial costs.
In the booming economic times of 2002 to 2006, abundant credit attracted
subprime (i.e., high-risk) borrowers who could fulfill their dream of owning a
home and, at the same time, acquire an ever appreciating asset. Borrowers and
lenders alike were seduced by the belief that housing prices could only go up.
Loan originators profited by signing up borrowers. Since other financial insti-
tutions and investors would assume the risks of the loans, originators paid lit-
tle heed to financial worthiness and whether the loans could be paid back. In
extreme cases, originators issued low or zero down payment loans or “stated-
income loans” in which borrowers simply stated their income without the
requirement of verification. Clearly, there was ample room for moral hazard on
the parts of borrowers and loan originators.
Asymmetric information became an increasing problem at other stages of
the financial process. The major ratings agencies such as Moody’s and Standard
and Poor’s gave these mortgage-backed securities optimistically high ratings—
partly because they failed to untangle and appreciate their true risks and undoubt-
edly because the agencies received their revenues from the very institutions whose
securities they were rating. The giant insurance company, American International
Group (AIG), issued default insurance on these mortgage-backed securities (in
return for hefty premiums). Brokers promoted the securities to investors as being
high return with tolerable risk. After all, the housing market was booming, the
securities were A-rated and backed by AIG insurance.
In 2007, the music stopped. Housing prices plateaued, then fell, the econ-
omy slowed, subprime borrowers began missing payments and then defaulting,
and the home lending market unraveled. The results were staggering losses in
the credit industry and a general tightening of credit. Subsequently, the Federal
Reserve and the U.S. Treasury stepped in to shore up or rescue a host of finan-
cial institutions, including the investment bank Bear Stearns. In 2008, Congress
established the $700 billion Troubled Assets Relief Program (TARP) to bail out
financial institutions through the purchase of nonperforming assets. In that
same year, Bank of America, Goldman Sachs, and other major financial institu-
tions received monetary infusions, and AIG was rescued by an $85 billion loan.(^10) For an analysis of the financial crisis paying special attention to the housing market, see R. Shiller,
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It,
(Princeton, NJ: Princeton University Press, 2008).
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