Adverse Selection By James Bleach Chris Moorhead Ji Hyun Lee and Timothy Becher What is Adverse Selection? o Adverse selection is the problem created by asymmetric information before the transaction occurs. o It occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome вЂ“ the bad credit risks вЂ“ are the ones who most actively seek out a loan and are thus most likely to be selected. The Lemons Problem o Nobel Prize winner George Akerlof вЂ“ вЂњThe Market for вЂ�LemonsвЂ™: Quality, Uncertainty and the Market MechanismвЂќ вЂў A buyer of a used car does not know whether a car will run well (peach) or if it will constantly give them trouble (lemon), therefore the price the buyer pays reflects the average quality of the cars in the market. вЂў The seller knows whether the car is a peach or a lemon, so the seller will be happy to sell the car if it is overpriced (lemon), but he may not sell the car at all if it is under valued (peach). вЂў Because the average quality of used cars available in the market will be low, there will be few sales, causing inefficiency in the used car market. If used cars were securitiesвЂ¦ вЂў Investors often do not have sufficient information to determine which firms have high or low risk. вЂў Investors will only be willing to pay a price for average quality firmsвЂ™ securities. вЂў Good firms know their securities are under valued and will not sell them. вЂў Bad firms know their securities are over priced and would love to sell. вЂў The only firms willing to sell will be the bad firms. вЂў Investors will not invest in firms. вЂў This scenario also goes for debt (bonds). What this means? 1) Marketable securities are not the primary source of financing for businesses in any country in the world. 2) Stocks are not the most important source of financing for American businesses. Tools to Help Solve Adverse Selection Problems 1) Private Production and Sales of Information 2) Government Regulation to Increase Information 3) Financial Intermediation 4) Collateral and Net Worth Private Production and Sale of Information вЂў Eliminates asymmetric information by supplying investors with the information to help determine whether a firm is good or bad. вЂў Major problem вЂ“ free riders. вЂў When investors pay for information and invest, people who donвЂ™t pay for information catch on and invest in the same things. This increases demand and therefore price of the undervalued securities. вЂў Investors who pay for information then have the burden of paying for information, and thus are worse off than the free riders. вЂў Private firms that sell information will lose business and will stop selling information. Government Regulation to Increase Information вЂў Because it is not efficient for private firms to produce information, the government can. вЂў SEC вЂ“ Securities and Exchange Commission вЂ“ requires firms selling their securities to have independent audits in which accounting firms certify that the firm is adhering to standard accounting principles and disclosing accurate information about sales, assets, and earnings. вЂў Problems : the government also would have to release negative information about certain firms, which can cause political backlash. - Bad firms may slant their information to make them look like good firms. - There is a lot more to knowing the quality of a firm than statistics can provide. Financial Intermediation вЂў Just as used car dealers help solve adverse selection problems in the car market, financial intermediaries play a similar role in financial markets вЂў Financial Intermediaries, like banks, become experts in producing information about firms, so it can sort out good credit risks from bad ones. вЂў Because the bank lends mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. The resulting profit that the bank earns gives it the incentive to engage in this information production activity. вЂў Financial Intermediaries, because they hold a large portion of nontraded loans, play a greater role in moving funds to corporations than security markets do. вЂў Indirect finances are more important than direct finance. Why Banks are so Important as Financial Intermediaries вЂў Banks avoid the free-rider problem by primarily making private loans rather than purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and bid up the loanвЂ™s price to the point that the bank receives no compensation for the information it has produced. вЂў For this reason, banks are the most important source of external funds for financing businesses. вЂў This is particularly important in developing nations, where information about the quality of firms is hard to gather. вЂў The smaller the role played by the securities market, the bigger the role of financial intermediaries. вЂў Conversely, well known corporations in industrialized nations rely less on banks because their securities are more fairly valued due to the availability of information on them. Collateral and Net Worth Collateral вЂ“ property promised to Net Worth (a.k.a. equity capital) вЂ“ the lender if the borrower the difference between a firmвЂ™s defaults assets and itвЂ™s liabilities вЂў Both Collateral and Net Worth offset the losses of the lender in the event of a default. вЂў Collateral leaves the lender compensation which can be sold to make up for the losses on the loan. вЂў If a firm has a high net worth, then even if it engages in investments that cause it to defaults on its debt payments, the lender can take title to the firmвЂ™s net worth, sell it off, and use the proceeds to recoup some of the losses from the loan. вЂў Creditors have compensatory priority over shareholders in the event that a company defaults. Adverse Selection In Credit Card Market вЂў вЂў пѓ� пѓ� пѓ� пѓ� In order to gain empirical evidence of adverse selection, data was taken on results of large-scale randomized trials in preapproved credit card solicitations. This is meaningful, as over 5 billion solicitations were sent out in 2001, a substantial portion of credit card marketing. From this test, four basic conclusions can be drawn: Adverse selection can be clearly seen from the start: respondents to mailed solicitations are those with characteristics of substantially worse credit risks than the average citizen. Offers with inferior terms, such as higher introductory interest rates, yielded smaller customer pools. Those who remained were always those with worse credit-risk characteristics. Predictably, customers who accept inferior offers also more likely to default. Finally, those who accepted the solicitation prioritized cards with low introductory rates with less regard to long-term rates, showing a tendency towards overly optimistic views about future borrowing. Adverse Selection in the Credit Card Market 1999 by Lawrence M. Ausubel. вЂњStickyвЂќ Interest Rates and Switching Costs вЂў More recent studies show a trend towards вЂњstickyвЂќ credit card interest rates; that is, ones that donвЂ™t adjust their interest rates with the flow of the market, increasing both initial cost and the cost of switching cards. вЂў This can be blamed largely on persisting informational barriers for companies. The cost to switch rises as card issuers cannot readily distinguish between applicants intending to switch and those intending to accumulate more debt, causing high-balance customers to have difficulty obtaining further credit. вЂў Adverse selection effects may compound these switching costs because, as the last test showed, those who respond to solicitations are higher-risk clients whoвЂ™re more likely to gather more debt. ItвЂ™s a legitimate possibility that high-balance customers may have been denied higher credit limits by their current issuer on the basis of private information. Stock Market Speculation вЂў Asymmetric information and adverse selection play a large role in the survival of public firms, their funding, and their current market value. вЂў Small firms ( Micro & Nano Cap firms < $300M value) heavily rely on funding through the issuance of debt and equity offerings. вЂў These firms are often considered вЂњgoing concernsвЂќ as investors and creditors have a difficult time valuing the firms and are unsure of the exact credit risk/likelihood of survival associated with each firm. вЂў This uncertainty creates significant volatility and doubt. Ticker Symbol AEN: 110% Increase In 2 Weeks CYCC: 2200% Fluctuation in 2 Years Market Speculation ContвЂ¦ вЂў High risks are associated with these firms because of an above average default risk. вЂў Along with increased risk comes investors seeking high returns. вЂў These investors in-turn create a market for low-quality, unsecured debt and debt instruments/insurance policies. вЂў One such debt/insurance instrument is called a Credit Default Swap (CDS). вЂў A CDS is a contract where the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a default or material change in a firmвЂ™s credit standing. вЂў Eg: Buyer pays $100/mth in exchange for a $10,000 payment if a company receives a downgrade from a Credit-rating agency or defaults on bonds or loans. Market Speculation ContвЂ¦ вЂў The speculative aspect of the whole situation is when neither party involved in trading the credit insurance actually owns the assets/liabilities in question. вЂў Imagine: one person being able to insure your house, but through someone else entirely not connected to your house; so that if your house is destroyed, that person get paid your houseвЂ™s value. вЂў ItвЂ™s making a bet on an outcome or event, which in the financial industry causes extreme instability when a certain series of events is triggered. The Housing & Credit Crises вЂў To an extent, the credit crisis and financial crisis can be directly attributed to by parties taking out вЂњinsuranceвЂќ policies related to assets they knew nothing about. вЂў Real-life examples of the disastrous outcomes of this speculation can be seen all throughout the government TARP and the bankruptcies/near failure of many prominent institutions that are vital to the function of the financial structure of the United States. вЂў To name a few: AIG, Fannie Mae, Bear Sterns, Lehman Brothers. Most troubles/failures are related to mortgagebacked securities. This is primarily because of the housing bubble where properties were artificially valued (knowingly or not). The above firms owned very large amounts of assets that were suddenly deemed worthless, or close to it. Real-Life Examples: #1-AIG вЂў As of June 2009, AIG had written $440 billion worth of swaps on corporate bonds and mortgage-backed securities. As the value of these insuredreferenced entities fell, AIG had massive write-downs and additionally had to post more collateral. And when its ratings were downgraded that month, the company had to post even more collateral, which it didnвЂ™t have. вЂў These instruments are causing many of the massive write-downs at banks, investment banks and insurance companies. This means that the value of the hedge funds, the credit markets and the stock market had to adjust downward, rapidly and drastically. вЂў The financial structure of the U.S. was severely damaged by a dominoeffect type forced liquidation by large firms and investors вЂ“ all as a result of billions of dollars being invested without sufficient information. AIG: Down from $900/sh to $25 = -97% Real-Life Examples: #2-Goldman Sachs вЂў Goldman Sachs is being charged with fraud by the SEC, relating to the sale of mortgage-backed securities. вЂў Goldman wrongly permitted a client (John Paulson) that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party. вЂў Basically, Goldman knew that the product being sold was poor, yet endorsed it as a good investment to innocent investors. вЂў This is illegal and can be defined as adverse selection in that Goldman hid essential information from investors as they pursued quality investment opportunities. Aftermath of AIG and GS Activities вЂў AIGвЂ™s poor choice to insure securities that were foreign to them caused a serious liquidity crisis for the company and for the financial industry. вЂў GoldmanвЂ™s wrongdoing has left investors outraged, the Government seeking strict regulation, and the stock market losing upward momentum. вЂў The future of the U.S. financial structure depends on past events, and the U.S. economy has been experiencing mostly negative events as of late. вЂў The massive amount of uncertainty over the economy can also be seen in politics/legislative battles every single day. Adverse Selection In Insurance вЂў The problem of adverse selection also applies to insurance markets. вЂў The customers that are most likely to want insurance are the people who face the highest risks. вЂў These are the people that insurance companies would least like to have as customers, as also seen respectively in the credit market and stock market. вЂў Insurance companies are aware that their customers will, on average, be worse insurance risks than a randomly-selected member of the population. вЂў So, instead of basing risk estimates on statistics for the population as a whole, they base them on statistics for insured people in previous years for more accuracy. Adverse Selection In Insurance ContвЂ¦ вЂў The healthy tend to avoid health insurance up until the point of requiring medical services to be paid. вЂў An example of a low-risk individual: a healthy 25 year old male with no family history of heart disease or cancer and no insurance claims made for 10 years. вЂў High-risk individual: a 55 year old investment banker whose parents died from cardiovascular disease, who also smokes, and is being treated for high blood pressure and diabetes. Role of Medical Underwriting вЂў Adverse selection is counteracted by medical underwriting. вЂў Medical underwriting involves the use of statistics and probability theory to predict the chance of paying benefits to the insured in the risk pool. вЂў Low-risk individuals have a very small chance of needing medical services, and so their premiums should be low enough when correctly underwritten so that buying insurance is an economically-wise decision вЂў High-risk individuals have a very high chance of needing medical services, so their premiums should be, on average, enough to cover all the medical expenses. Desire For Reform вЂў A small fraction of individuals account for a large share of total health expenditures. вЂў Avoiding high cost/high risk customers therefore overrides the incentive for insurers to instead effectively manage all clients. вЂў Excluding these individuals is seen as immoral to many and is politically controversial. вЂў The insurance industry needs competition to keep prices lower for consumers as a whole. вЂў Adverse selection limits the economics of health insurance, making health insurance prohibitively expensive for many individuals. Ways To Limit Adverse Selection In Health Insurance вЂў The government would have to remove its restrictions on medical underwriting. вЂў Insurers would need to have all information available to adjust premiums based on each individual's inherent risk. вЂў Examples of information needed: age, social behavior, family medical history, past medical history, claims history, genetic tests, work environment, level of education, BMI, blood pressure etc. вЂў The more that premiums are tailored to individuals, the more likely that individuals will buy insurance before the point of need. вЂў Low-risk individuals would pay low premiums, high-risk individuals would pay high premiums, similar to the auto insurance system.