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Chapter 8: Q.6 (page 235)

Suppose you are applying for a mortgage loan. The loan officer tells you that if you get the loan, the bank will keep the house title until you pay back the loan. Which problem of asymmetric information is the bank trying to solve?

Short Answer

Expert verified

Adverse selection is the asymmetric information problem that the bank is attempting to address.

Step by step solution

01

Introduction

A mortgage loan is a loan secured by an asset.
Asymmetric information refers to information that is not identical, hence there will be inconsistency if the information presented to individuals differs from the genuine information.
02

Explanation

Asituationinwhichthebuyerhasmoreinformationthanthesellerorthesellerhasmoreinformationthanthebuyerisknownasadverseselection.
Adverseselectionistheasymmetricinformationproblemthatthebankisattemptingtoaddress.
It implies that the house is mortgaged against the loan amount; as a result, both the borrower and the lender are aware of the loan's repercussions and terms.
The bank solves the asymmetric information problem in this way.

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Most popular questions from this chapter

Would you be more willing to lend to a friend if she had put all of her life savings into her business than you would be if she had not done so? Why?

Go to the St. Louis Federal Reserve FRED database and find data on the percent of value of loans secured by collateral for all commercial and industrial loans (ESANQ) and the net percentage of domestic banks tightening standards for commercial and industrial loans to large and middle-market firms (DRTSCILM). Download the data into a spreadsheet.

a. Calculate the average, over the most recent four quarters and the four quarters prior to that, for the bank standards indicator and the “percent of loans secured by collateral” indicator. Do these averages behave as you would expect?

b. Use the Data Analysis tool in Excel to calculate the correlation coefficient for the two data series from 1997:Q3 to the most recent quarter of data available. What can you conclude about the relationship between collateral and bank C&I lending standards? Is this result consistent with efforts to reduce asymmetric information?

Suppose you have data about two groups of countries, one with efficient legal systems and the other with slow, costly, and inefficient legal systems. Which group of countries would you expect to exhibit higher living standards?

“The more collateral there is backing a loan, the less the lender has to worry about adverse selection.” Is this statement true, false, or uncertain? Explain your answer.

Gustavo is a young doctor who lives in a country with a relatively inefficient legal and financial system. When Gustavo applied for a mortgage, he found that banks usually required collateral for up to 300% of the amount of the loan. Explain why banks might require that much collateral in such a financial system. Comment on the consequences of such a system for economic growth.
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