Econ 302 - Financial Engineering Always Leads to a More Efficient Financial System

ECON 302

Solutions to Problem Set 5

1. “Financial engineering always leads to a more efficient financial system”

Is this statement true or false? Why?

False, financial engineering may create financial products that are so complex, that it can be hard to value the cash flows of the underlying assets for a security, or to determine who actually owns these assets. The increased complexity of these structural products can destroy information and make asymmetric information problems worse. This can increase moral hazard and adverse selection problems.

Computer technology enabled the bundling together of smaller loans (like mortgages) into standard debt securities (securitization). Bankers could offer subprime mortgages to people with bad credit records.

Financial institutions bundled high risk mortgages in a standardized debt security called mortgage-backed securities. This provided a new source of funding for these mortgages. Financial engineering developed new financial instruments, structured credit products, to pay out income streams from a collection of underlying assets. These were designed to appeal to customers with different credit characteristics. Some of these were very risky. These new products, increased risk, and increased asymmetric information problems. They did not make the financial markets more efficient.

1. What is a major problem of the originate-to-distribute business model?

Explain.

There is an agency problem with the originate-to-distribute business model. The mortgage brokers that originated the loans did not make an effort to evaluate whether the borrower could pay off the loan, since they would quickly distribute the loans to investors in the form of mortgage-backed securities. Sometimes they extended loans to people they knew could not pay back. The mortgage brokers acted as agents to the investors (principals) but did not have the investors’ best interests at heart. Once the mortgage broker got his fee, he did not care if the borrowers could make the payments or not. The more volume the broker originated, the more money he made. Adverse selection became a major problem. Risk-loving investors took loans to buy houses, and “walked away” when things were bad. Mortgage brokers had incentives to give loans to people who could not pay back or who falsified information.

1. Do credit spreads increase or decrease during a financial crisis? Why?

They increase. Because banks get worried about the borrowers’ ability to pay back the interest and the loan. To insulate themselves against risk of default, banks ask for a higher interest rates during a financial crisis. Because the likelihood of default increases during a financial crisis, banks increase the credit spread to protect themselves from credit losses.

1. a)  What path triggered the financial crisis in South Korea in 1997-1998?

Mismanagement of financial liberalization and financial globalization

b)  What are “chaebols”?

Large family-owned conglomerates

c)   How did “chaebols” contribute to the South Korean financial crisis of 1997-1998?