From Tyler Cowen at Marginalrevolution.com:
“Gary Gorton has a new and excellent paper… called “Questions and Answers About the Financial Crisis.”…Gorton’s short paper is one of the best essays on the crisis so far.
For what it’s worth, I heartily agree with Tyler Cowen’s assessment of Gorton’s financial crisis FAQ…
During class on Tuesday, we discussed some of the problems that exist with Social Security. For what it’s worth, I just received my most current “statement” from the Social Security Administration, and here is what Michael J. Astrue, who is Commissioner of the Social Security Administration, has to say about “About Social Security’s future…” (you can download your own sample Social Security statement in PDF format here):
“Social Security is a compact between generations. Since 1935, America has kept the promise of security for its workers and their families. Now, however, the Social Security system is facing serious financial problems, and action is needed soon to make sure the system will be sound when today’s younger workers are ready for retirement. In 2016 we will begin paying more in benefits than we collect in taxes. Without changes, by 2037 the Social Security Trust Fund will be exhausted* and there will be enough money to pay only about 76 cents for each dollar of scheduled benefits. We need to resolve these issues soon to make sure Social Security continues to provide a foundation of protection for future generations.”
I hope everyone has a safe and enjoyable spring break. Please keep in mind that the reading assignment for the first class back (on Tuesday, March 16) consists of the following three readings:
1. Portfolio Theory and Risk Management (Doherty, Chapter 4)
2. Capital Market Theory (Doherty, Chapter 5)
3. Portfolio and Capital Market Theory, by James R. Garven
Also, Problem Set 6 will be due at the beginning of class that day.
A student observed in an email from earlier today that moral hazard and adverse selection seem closely related, and was curious whether there is a definitive test to say whether it is one or the other? For what it’s worth, here’s the response that I sent back to him/her:
Moral hazard and adverse selection are related, in the sense that both phenomena exist because it is costly to acquire information. Thus, information is asymmetric – the agent knows things that are important to her relationship with the principal that the principal is either not aware of or harbors suspicions about. Moral hazard is a problem of “hidden” action; action is hidden in the sense that the principal is not able to perfectly monitor the agent, so it’s in the interest of principal and agent alike to write incentive compatible contracts. Incentive compatible contracts motivate the agent to take actions (e.g., work hard and not shirk in labor markets, prevent or mitigate losses in insurance markets, etc.) that are consistent with maximizing the welfare of the principal.
What differentiates adverse selection from moral hazard is that the latter pertains to situations where a contractual relationship between principal and agent is already in place, whereas the former pertains to situations where a contractual relationship between principal and agent is in the process of being formed. Thus what you worry about as a principal is that you end up “getting stuck” with someone who or something that lacks the qualities that you are looking for. This is the “lemons” problem; e.g., you end up buying an inferior used car, hiring a lazy, incompetent and/or corrupt worker, etc. The strategies for mitigating adverse selection including screening on the part of the principal and signaling on the part of the agent. Examples of screening include requiring someone who is applying for health insurance, life insurance, or an annuity to have a medical exam, banks running credit scores on mortgage applicants prior to granting credit, etc. Also, the agent can credibly convey important information by signaling. Signaling typically takes the form of utilizing third party certification (this is what makes the signal credible). So students take time out of their busy schedules to earn degrees from Baylor University (here Baylor provides credible certification concerning quality of human capital!), used car sellers pay for vehicle inspections, etc. However, even after people have invested resources in screening and signaling, there still may exist some residual information asymmetry, and it’s here that one utilizes contract design as a strategy for incentivizing people to reveal their “true” types. The example I used in class involved insurance, where we know that some people are good risks whereas others are bad risks; the problem is that we can’t figure out who’s who. Therefore, we limit contract choices so that it will be in the agent’s self interest to effectively reveal truth by the contract choice. In the insurance example, risky drivers are attracted to expensive contracts that offer high levels of coverage, whereas safe drivers self-select into cheaper contracts that offer lower levels of coverage.
In summary, the definitive test for differentiating between moral hazard and adverse selection involves asking the following questions: 1) is there asymmetric information?, and 2) does a contractual relationship already exist? If the answer to 1 is yes and to 2 is no, then you need to be worried about adverse selection. If the answer to 1 is yes and the answer to 2 is yes, then you need to be worried about moral hazard.
During the second lecture on the topic of “Decision Making under Risk and Uncertainty” (given on February 2; see pp. 5–13), I referenced the so-called “behavioral finance” theory of Kahneman and Tversky for which Kahneman won the Nobel prize in economics in 2002. I would like to call your attention to a short video presentation by Professor Kahneman on the science of happiness which is well worth watching and thinking about. This video was filmed last month at the TED 2010 conference (held February 9–13 in Long Beach, CA; according to TED’s website, “TED is a small nonprofit devoted to Ideas Worth Spreading. It started out … as a conference bringing together people from three worlds: Technology, Entertainment, Design.”). Here’s is a synopsis of Professor Kahneman’s talk; you can view the presentation by clicking on Professor Kahneman’s image below:
“Using examples from vacations to colonoscopies, Nobel laureate and founder of behavioral economics Daniel Kahneman reveals how our “experiencing selves” and our “remembering selves” perceive happiness differently. This new insight has profound implications for economics, public policy — and our own self-awareness.”
Sometime between now and next class meeting, be sure to work through the moral hazard class problem. The problem appears on pp. 11–13 of the Moral Hazard and Adverse Selection lecture note, and I provide solutions for various questions in the following PDF file: http://fin4335.garven.com/spring2010/Moral%20Hazard%20Class%20Problem.pdf. The PDF file shows the logic behind the solutions and also references a spreadsheet template located at http://fin4335.garven.com/spring2010/execcomp.xls that you can use for finding these various answers. Anyway, I’ll begin class on Tuesday with this problem and then we’ll also hopefully complete our discussion of adverse selection. If time permits, try to also solve the adverse selection class problem that appears on p. 31 of the Moral Hazard and Adverse Selection lecture note!
Here are the course and midterm 1 exam grade descriptive statistics for FIN/RMI 4335:
| Course | Midterm 1 | |
| count | 19 | 19 |
| mean | 74.68 | 76.79 |
| mode | #N/A | 98.00 |
| standard deviation | 11.87 | 20.04 |
| minimum | 53.84 | 23 |
| 1st quartile | 67.98 | 66.50 |
| median | 74.10 | 75.00 |
| 3rd quartile | 80.63 | 93.00 |
| maximum | 95.86 | 100 |
| range | 42.02 | 77 |
Here are the course and midterm 1 exam grade descriptive statistics for FIN/RMI 5335:
| Course | Midterm 1 | |
| count | 5 | 5 |
| mean | 92.79 | 92.40 |
| mode | 97.67 | 97.00 |
| standard deviation | 11.66 | 12.58 |
| minimum | 71.97 | 70 |
| 1st quartile | 97.53 | 97.00 |
| median | 97.67 | 97.00 |
| 3rd quartile | 97.67 | 98.00 |
| maximum | 99.13 | 100 |
| range | 27.16 | 30 |
I recommend reading the WSJ Health Blog entry entitled “WellPoint’s Argument for 39% Rate Hike: Adverse Selection”, by Jacob Goldstein. This article explains how adverse selection is causing health insurance claims costs to increase substantially in the individual health insurance market in California. The adverse selection has come primarily in the form of healthy policyholders dropping coverage in the face of job losses due to the recession as the sickest individuals do all that they can do to hold onto their policies. Thus premiums on such policies are increasing (in line with increases in the underlying claims costs) by as much as 39%. This makes total sense because after all, the net effect of this “downard spiral” is that the morbidity risk of the average remaining policyholder in Wellpoint’s California health insurance risk pool has substantially worsened. In other words, there are real economic factors behind these so-called “skyrocketing” premiums, and it is not due (as some in the Obama administration and news media suggest) to some newfound avarice on the part of various and sundry sleazebag insurance CEO’s who are “putting profits ahead of people”.
Keep in mind that since insurance is state regulated, HHS Secretary Kathleen Sebelius has no legal authority to undertake a regulatory enforcement action against private insurers. This is why the White House is urging repeal of the health insurance industry’s exemption from the McCarran Ferguson Act of 1945 as part of its latest health care proposal (specifically, see page 3 of the proposal under the section entitled “Strengthen Oversight of Insurance Premium Increases”). Thus the administration’s current political strategy is to create a regulatory “carve-out” of the health insurance industry so that the feds can regulate health insurance premiums. Presumably the rest of the insurance industry would, for the time being, continue to be regulated primarily at the state level, as has been the case for the past 65 years.
As I noted in my earlier message concerning today’s (apparently prescient) class cancellation, I have had to make some minor changes in the course schedule which are now fully reflected on the course website. The biggest change pertains to the rescheduling of the 2nd midterm exam, which will now occur on Tuesday, April 13 instead of Thursday, April 8.
In view of the severe weather conditions, I have decided to cancel class for today. Furthermore, the National Weather Service’s forecast for Waco (as well as the entire I-35 corridor from Austin to DFW) is rather grim, so I urge all of you to exercise caution if you do any traveling today.
This class cancellation will necessitate some minor changes in the course schedule (which will soon be reflected on the course website) going forward. On Thursday, I will begin a two lecture series on the topics of moral hazard and adverse selection. The assigned reading for these topics include 1) Moral Hazard & Adverse Selection (Doherty, Chapter 3), 2) Moral Hazard & Adverse Selection Synopsis (by yours truly), and 3) Insurance and Gender: The Price of Equality, The Economist, November 13, 2003. I also hope to return your midterm exam 1 booklets to you on Thursday; the solutions for the exam are available online.