Question

"one could argue that The dot com crash and bubble of the early 2000s was the result of overvaluated share prices which in turn was the result of information asymmetry and thus the market collapse was predictable to some extent"

use the "lemons" model to evaluate the above statement and be sure to focus on the IPOs that allowed owners to "cash out" to shareholders.

Answer 1

Majority of the financial institutions were financing the long-term investment with short-term debt. This mismatch of maturity made them vulnerable to economic shocks; and the mismatch of maturity in balance sheets of financial institutions was also a vital factor in the financial crisis of 2007-2009. Securitization lead to new information asymmetries to financial markets due to the lack of transparency and the complexity of the instruments the investors found to evaluate securitized assets. The collateralized debt obligations'(CDOs), were created from structured products in a diversified mortgages portfolios and other types of assets, such as credit cards, corporate bonds, and auto loans. The defaults on subprime mortgages in 2007 increased and huge fraction of CDO's were downgraded. Buyers were not aware due to the asymmetric information that whether the securities were being sold for the low quality or because sudden need for liquidity of the seller’s. The resulting adverse selection resulted to market free, reflecting the belief of buyers’ that majority of the securities in the market were of low quality. If economy is subject to a negative shock, such as a fall in housing prices, the securities value may become more sensitive to asymmetric information, and as a result the adverse selection can cause market illiquidity that occurred in 2008 crisis.