The Great Recession experienced last decade was the most recent example of how detrimental a substandard loan can be. In this event, lenders were knowingly allowing substandard loans to be issued to receive short-term profits. This liability was shifted from business to business in the form of collateralized debt obligations. Once homeowners were no longer able to service these mortgages, the entire housing industry collapsed seemingly overnight. To minimize the issuance of substandard loans, lenders must understand moral hazard and adverse selection.
Understanding Adverse Selection
Adverse selection in the lending environment occurs when the lender and buyer do not have access to the same information. A buyer desperate to receive funds may potentially exaggerate income or assets to throw off the lender. Since the lender is going off of the available data, they are usually the victims of asymmetric information. At times, lenders still loan out money with this handicap in play to capitalize on future interest revenue. However, lenders are not always successful with this practice and become victims of substandard loans.
Understanding Moral Hazard
While Adverse selection occurs before an agreement, moral hazard appears after a buyer and lender close on a deal. An example of moral hazard could involve a buyer having a drastic change in income and the ability to service the loan. Once issued, both parties are expected to uphold the initial deal. However, unexpected circumstance can create a substandard loan which must be written off.
Another example of moral hazard involves a sense of comfortability. A buyer can receive a loan for any number of reasons. For instance, the loan could be for a small business looking to expand its operation. Obtaining a loan at this stage in the industry can provide a cushion and tendency to overspend since more funds are accessible. Moral hazard and adverse selection are just two ways of sniffing out substandard loans.