Information is a central element to efficient markets. When the costs of obtaining information are too high, some potentially beneficial transactions do not take place and markets tend to stall. Information costs sometimes make financial markets the worst functioning markets. In most all transactions, the issuer of a financial instruments,
borrowers, know some information which the buyer, saver, does not know. This is a situation know as asymmetric information. There are two information problems which form obstacles to smooth running financial markets. The first problem is called adverse s election . This problem arises before the transaction ever occurs. Simple fact
is that lenders need to know how to differentiate between good risks and bad risks. Unfortunately for them, that is information only the borrower has.
The second type of information problem is called moral hazard . This problem occurs after the transaction has taken place. Lenders need to find a way to tell whether borrowers will use the proceeds of a loan as they claim they will. We should look at some examples, their details and implications of these problems and their implications.
One of the best documented situations in study of asymmetric information is the Lemon’s Problem. This problem was revealed by 2001 Nobel Prize winner in Economics George Akerlof in his analysis of markets with asymmetric information.
His contribution came from a 1970 paper titled “The Market for Lemons” in which he explained why the market for used cars, some of which are “lemons”, does not function well. Suppose two cars are for sale, both of the same make and model. One is in good
shape and was owned by a previous owner who maintained a good maintance record and drove very little. The second car was owned by someone who sparingly changed the oil and loved to drive in the fast lane. The owners of the cars know whether their own car is in good repair, but the buyer does not. Let’s say the potential buyer is will to pay $15,000 for a well-maintained car and $7,500 for a lemon. The first car owner knows the car is in good shape and won’t sell it for less than( $12,500. The other owner knows that the car is in poor shape and would be willing to sell for as little as $6,000. Without knowing anything else about the car, the risk-neutral buyer would only be willing to pay the expected, average, price for these cars wh ich would be $11,250. That is less than the first owner is willing to sell for, thus the only car we can buy is the lemon. In this type of world no one with an above average car would ever put their car on the market. Thus, the market is full of lemons. Due to this asymmetric information, Several entities exist that help solve this problem. Consumer reports can be established about the sellers of used cars.
Many people now offer warranties on used cars and buyers can use mechanics to help verify the true state of the car. As a result we should find the prices for good and bad used vehicles closer to their true value.
When it comes to financial markets, this adverse selection problem exists just as it exists with used cars. Potential borrowers know more about the projects they wish to finance than potential lenders. In the same way that adverse selection can drive out the
good cars this situation can drive good stocks and bonds out of the financial market. For instance, two firms, one with good prospects and one with bad prospects, as a potential stock buyer, since you cannot tell which firm is which, you would only be willing to pay the average stock price as a risk neutral investor. The stock of the good company would be undervalued. Since managers of this company know that their stock would be undervalued, they would never bother issuing it in the first place. That leaves only the firm with bad prospects in the market. This would be known by investors and the market would have a hard time getting started.
The same thing can happen in the bond market. Risk requires compensation and if you cannot tell the high risk bonds from the low risk bonds, the lender will demand the average premium on all bonds. This drives companies with good credit out of the market unwilling to pay the inflated interest rate. Since lender are not interested in buying debt from bad companies, the market would not function.
Solving the Adverse Selection Problem
The adverse selection problem creates situations where good companies will pass on potentially valuable investments. Since these investments are lost, the best companies are not necessarily the ones that grow as rapidly as they should. At the same time, poorer companies may take on investments which they should not be doing. So, it is
important to identify the good companies from the bad companies. There are two basic methods for solving problems of adverse selection:
Create more information for the investors Disclosure of Information the most straightforward solution to adverse selection Since it creates more information. This can be done by government regulation or through other
market forces. Most publicly traded companies are required to release a lot of information through requirements set up by the Securities and exchange regulatory authorities. Public companies are also required to release information which can influence the wealth of the company and any information that is given to professional
stock analysts. The newly created accounting regulations are geared at closing these loop holes through which firms may be able to hide the true financial position of a firm.
Another way of solving this problem is providing guarantees in the form of contracts that can be written such that the owners of the firms face the same risks as the investors. The contract is written in such a way that lenders are compensated even if the borrower defaults on the loan. If the lender is guaranteed a payment, some bad credit risks no longer look so bad. There are two ways to ensure that a borrower is likely to repay a lender: collateral and net worth . Collateral is something of value pledged by a borrower to the lender in the event of default on a loan. This collateral is said to secure the loan. In many situations, the collateral for the loan is simply the good that is being
purchased by the borrower. For example: a house is collateral for a mortgage and the car is collateral for an auto loan. In this adverse selection is not much of a problem. In either case the lender gets paid and the borrower only gets a payoff if they meet their financial obligations. Loans without collateral (unsecured loans) generally have higher
interest rates. The lender is taking on more risk and must be compensated. Net worth is an owner’s stake in a firm. Under many cases, new worth serves like collateral. If a firm defaults on a loan, the lender can make a claim on the net worth of the firm. Of course if the firm has no or negative net worth, the lender would receive nothing, but in general the lender would still get some form of a payoff. In this case the lender still faces risk from changes in the value of the firm.