Page 649 - Microeconomics, Fourth Edition

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15.3 BEARING AND ELIMINATING RISK 623

early 2000s, investors could also purchase collections of that many home owners owed more on their mort-
mortgage-backed securities known as collateralized gage than the current market value of their home. At
debt obligations (CDOs), which were essentially the same time, interest rates on adjustable rate sub-
groupings of mortgage-backed securities, segmented prime mortgages began to “reset” from low “teaser
according to the riskiness of the underlying mortgages. rates” (designed to attract borrowers in the first
(In the language of Wall Street, these groupings were place) to much higher rates. These developments
known as tranches.) began to trigger a wave of mortgage defaults in
Even with the spreading of risks, some investors in 2006. As the rate of defaults rose dramatically in 2006
mortgage-backed securities or CDOs sought to purchase and 2007, not only did holders of mortgage-backed
insurance on their investments. This insurance was securities and CDOs experience significant losses, so
known as a credit-default swap. A credit default swap too did insurers of those securities such as AIG.
protects the owner of a bond or a CDO against the risk Indeed, AIG failed—and was bailed out by the U.S.
of default, that is, the possibility that the bond or CDO government—because it had inadequate capital re-
stops generating flows of repayments and lose value. In serves to pay off the claims of those to whom it had
effect, a credit default swap is an insurance policy on sold credit default swaps. These developments took
the bond or the CDO. An important issuer of credit many by surprise—including apparently the ratings
default swaps on CDOs was the insurance firm AIG. agencies such as Moody’s and Standard and Poor’s
Like any insurance supplier, suppliers of credit de- that had given AAA ratings to CDOs consisting of
fault swaps like AIG counted on the independence of mortgage bonds containing subprime mortgages.
the risks it was insuring. Unfortunately, in the late Many people (including policymakers such as Alan
2000s, such independence was an illusion. Between Greenspan and traders in Wall Street investment
1997 and 2005, the U.S. housing market experienced banks such as Bear Stearns, Lehman Brothers, and
a dramatic increase in prices. By the early 2000s, the Merrill Lynch) evidently had not anticipated that
market was in the midst of a speculative bubble in housing prices would decline and trigger massive
which many individuals decided to invest a large part subprime defaults. The unusual and dramatic decline
of their personal wealth in their homes. Banks also in housing prices meant that there was far less inde-
greatly increased the extent to which they were will- pendence in the default risks of individual mortgages
ing to issue “subprime” mortgages—which had much than many investors on Wall Street had believed.
higher risks of default. In 2006, the bubble began to Regrettably, the result was the massive financial crisis
deflate, and housing prices began to fall, to the point in 2008 and the Great Recession of 2008–2010.

ASYMMETRIC INFORMATION IN INSURANCE MARKETS:
MORAL HAZARD AND ADVERSE SELECTION

If you own a car, take a look at your automobile insurance policy. You will probably
see that you have what is known as a deductible. A deductible makes the car owner
responsible for a portion (e.g., the first $1,000 worth) of the damage from an accident,
while the insurance company insures the rest. A deductible transforms an insurance
policy from one of full insurance to one of partial insurance. 8
Why do insurance policies have deductibles? An important reason is the presence
of asymmetric information, which refers to situations in which one party knows asymmetric information
more about its own actions or personal characteristics than another party. In insurance A situation in which one
markets, there are two important forms of asymmetric information: moral hazard, party knows more about its
own actions or characteris-
which arises when the insured party can take hidden actions that affect the likelihood
tics than another party.
of an accident, and adverse selection, which arises when a party has hidden informa-
tion about its risk of an accident or loss.
8 Co-payments in health insurance policies do the same thing. A co-payment makes the insured party
responsible for a prespecified portion (e.g., 10 percent or $10) of his or her medical bills.