Currently the US housing market experiences a substantial slow down and faces ma

Question

Currently the US housing market experiences a substantial slow down and faces many challenges. A major contributing factor is the crisis in mortgage market. Due to previous deregulations and lack of oversight, the mortgage lenders adopted highly risky practices. Financial institutions took inappropriate risks in their investments and at the same time wrote their loan contracts with many unfriendly clauses. The borrowers and investors, meanwhile, did not fully understand these contracts and practices and entered into these associations and agreements without proper information. Consequently, with a slowdown in the real estate market and the general economy, the mortgage market collapsed and caused further downfall in the real estate market. Many borrowers were not able to meet their mortgage payments and the wave of foreclosures emerged. Homeowners neglected and left the properties they could no longer pay for and the vacant and rundown foreclosed properties in various neighborhoods, not only became eye sores, but also turned into magnets for criminals and crime. Accordingly, the property values and quality of life in these areas took a severe hit.        

Obviously, the mortgage and real estate markets have not produced efficient outcomes here. Name and explain the two main categories of market failure that are evident in this situation?

Explanation / Answer

The two main categories of market failure that are evident in this situation are -

1. Adverse Selection - It has been stated that the financial institutions took inappropriate risks in their investment die to lack of regulation and wrote their loan contracts with many unfriendly clauses. This led to adverse selection as the high risk borrowers were the one purchasing the loan contracts. This led to default of the loan amount.

2. moral hazard - The borrowers did not understand these contracts and practices and entered into agreements without proper information. Thus, he did not take the required action after purchasing the contract. This led to moral hazard or hidden action problem.

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