Financial markets exhibit asymmetric information in any transaction in which one of the two parties involved has more information than the other and therefore has the ability to make a more informed decision.

Economists say that asymmetric information leads to market failure. That is, the law of supply and demand that regulates the pricing of goods and services is skewed.

Key Takeaways

  • In any transaction, a state of asymmetric information exists if one party has information that the other lacks.
  • This is said to cause market failure. That is, the correct price cannot be set according to the law of supply and demand.
  • The subprime mortgage crisis of 2007-2008 has been seen as a case of asymmetric information.

The 2007-2008 subprime loan crisis was a classic example of the way asymmetric information can skew a market and cause market failure.

Understanding Asymmetric Information

Asymmetric information in the financial markets can occur whenever either the buyer or seller has more information on the past, present, or future performance of an investment. One party can make an informed decision but the other party cannot.

The buyer may know that the asset is underpriced. Or, the seller may know that it is underpriced. In either case, one party has the opportunity to profit from the transaction at the expense of the other.

The Subprime Meltdown and Asymmetric Information

The 2007-2008 subprime mortgage crisis could serve as a textbook illustration of the effects of asymmetric information. The products behind the crisis were mortgage-backed securities. Banks had extended the mortgages to consumers and then sold them to third parties. Those third parties packaged them together in batches and sold them on to investors. The securities were rated high-quality and were sold as such.

But many or most of the individual mortgages included in those products had been extended to borrowers buying bubble-priced homes that were beyond their means. When prices stalled the borrowers were stuck, as were the secondary buyers of their mortgages.

Unless nobody did their homework at any stage of this complicated process, the sellers had information that the end buyers did not. That is, they knew that risky mortgages were being passed off as high-quality debt. They were profiting from asymmetric information.

Other Examples of Asymmetric Information

Asymmetric information can occur in any situation involving a borrower and a lender when the borrower fails to disclose negative information about his or her real financial state. Or, the borrower may simply fail to anticipate a worst-case scenario such as a job loss or an unanticipated expense.

This is why unsecured loans can be so costly. The lender can review the borrower's credit history and salary level but cannot foresee bad luck. The lender will charge a risk premium to compensate for the disparity in information.

Ignoring Risks

Economists who study asymmetric information suggest that such situations can pose a moral hazard to one party in a transaction. Such a moral hazard can occur when the seller or buyer knows or reasonably suspects that a real but undisclosed risk is involved in the transaction.

As an example, consider again the sale of those mortgage-backed securities. The sellers may have done their homework and therefore have known they were selling low-quality mortgages packaged as top-rated investments. Or, they may have seen early warning signs of an imminent collapse in home prices.

Did the buyers have the same information? If they did, they presumably were engaged in the same game of pass-the-trash, and were counting on reselling the securities at a profit before the end came.