Reference no: EM13146077

In 2008, the Federal Deposit Insurance Corp. (FDIC) proposed a loss-sharing insurance plan to reduce home foreclosures. Under the plan, if a lender followed steps to reduce a borrower’s monthly mortgage payment (on the first mortgage) down to 31% of the borrower’s pre-tax income (via interest rate reductions, term extensions, or reduction of principal amounts), then, if the loan subsequently went into foreclosure, the federal government would pay to the lender half of the loss incurred by the lender. Without further restrictions or incentives, what possible adverse selection and moral hazard problems can you envision with this proposal? (Hint: Think about who are the two parties to the transaction (the loss-sharing insurance plan), and which party has better information on the credit quality of the underlying loans. Then, you can think about adverse selection and moral hazard.)