What Is Asymmetric Information?

Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

Understanding Asymmetric Information

Asymmetric information exists in certain deals with a seller and a buyer whereby one party is able to take advantage of another. This is usually the case in the sale of an item. For example, if a homeowner wanted to sell their house, they would have more information about the house than the buyer. They might know some floorboards are creaky, the home gets too cold in winter, or that the neighbors are too loud; information that the buyer would not know until after they purchased the house. The buyer, then, might feel they paid too much for the house or would not have purchased it at all if they had this information beforehand.

Asymmetric information can also be viewed as the specialization and division of knowledge, as applied to any economic trade. For example, doctors typically know more about medical practices than their patients. After all, physicians have extensive medical school educational backgrounds that their patients generally don’t have. This principle equally applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other trained professionals. Asymmetric information, therefore, is most often beneficial to an economy and a society in increasing efficiency.

Advantages and Disadvantages of Asymmetric Information

Advantages

Asymmetric information isn’t necessarily a bad thing. In fact, growing asymmetrical information is the desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields.

For example, a stockbroker’s knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks to prepare for retirement. On the flip side, the stockbroker does not need to know how to grow crops or tend to livestock to feed themself, but rather can purchase the items from a grocery store that are provided by the farmer.

In each of their respective trades, both the farmer and the stockbroker hold superior knowledge over the other, but both benefit from the trade and the division of labor.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However, this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.

Disadvantages

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy’s sale.

For example, if the insured hides the fact that they’re a heavy smoker and frequently engage in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly disclosed risk profiles.

Special Considerations

To prevent abuse of customers or clients by finance specialists, financial markets often rely on reputation mechanisms. Financial advisors and fund companies that prove to be the most honest and effective stewards of their clients’ assets tend to gain clients, while dishonest or ineffective agents tend to lose clients, face legal damages, or both.

What Is an Automatic Stabilizer?

Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation’s economic activity through their normal operation without additional, timely authorization by the government or policymakers.

The best-known automatic stabilizers are progressively graduated corporate and personal income taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are called this because they act to stabilize economic cycles and are automatically triggered without additional government action.

Understanding Automatic Stabilizers

Automatic stabilizers are primarily designed to counter negative economic shocks or recessions, though they can also be intended to “cool off” an expanding economy or to combat inflation. By their normal operation, these policies take more money out of the economy as taxes during periods of rapid growth and higher incomes. They put more money back into the economy in the form of government spending or tax refunds when economic activity slows or incomes fall. This has the intended purpose of cushioning the economy from changes in the business cycle. 

Automatic stabilizers can include the use of a progressive taxation structure under which the share of income that is taken in taxes is higher when incomes are high. The amount then falls when incomes fall due to a recession, job losses, or failing investments. For example, as an individual taxpayer earns higher wages, their additional income may be subjected to higher tax rates based on the current tiered structure. If wages fall, the individual will remain in the lower tax tiers as dictated by their earned income.

Similarly, unemployment insurance transfer payments decline when the economy is in an expansionary phase since there are fewer unemployed people filing claims. Unemployment payments rise when the economy is mired in recession and unemployment is high. When a person becomes unemployed in a manner that makes them eligible for unemployment insurance, they need only file to claim the benefit. The amount of benefit offered is governed by various state and national regulations and standards, requiring no intervention by larger government entities beyond application processing.

Automatic Stabilizers and Fiscal Policy

When an economy is in a recession, automatic stabilizers may by design result in higher budget deficits. This aspect of fiscal policy is a tool of Keynesian economics that uses government spending and taxes to support aggregate demand in the economy during economic downturns.

By taking less money out of private businesses and households in taxes and giving them more in the form of payments and tax refunds, fiscal policy is supposed to encourage them to increase, or at least not decrease, their consumption and investment spending. In this case, the goal of fiscal policy is to help prevent an economic setback from deepening.

Real-World Examples of Automatic Stabilizers

Automatic stabilizers can also be used in conjunction with other forms of fiscal policy that may require specific legislative authorization. Examples of this include one-time tax cuts or refunds, government investment spending, or direct government subsidy payments to businesses or households.

Some examples of these in the United States were the 2008 one-time tax rebates under the Economic Stimulus Act and the $831 billion in federal direct subsidies, tax breaks, and infrastructure spending under the 2009 American Reinvestment and Recovery Act.

In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act became the largest stimulus package in U.S. history. It provided over $2 trillion in government relief in the form of expanded unemployment benefits, direct payments to families and adults, loans and grants to small businesses, loans to corporate America, and billions of dollars to state and local governments.

Special Considerations

Since they almost immediately respond to changes in income and unemployment, automatic stabilizers are intended to be the first line of defense to turn mild negative economic trends around. However, governments often turn to other types of larger fiscal policy programs to address more severe or lasting recessions or to target specific regions, industries, or politically favored groups in society for extra-economic relief.  

What Is an Adjustable-Rate Mortgage (ARM)?

The term adjustable-rate mortgage (ARM) refers to a home loan with a variable interest rate. With an ARM, the initial interest rate is fixed for a period of time. After that, the interest rate applied on the outstanding balance resets periodically, at yearly or even monthly intervals.

ARMs are also called variable-rate mortgages or floating mortgages. The interest rate for ARMs is reset based on a benchmark or index, plus an additional spread called an ARM margin. The typical index that is used in ARMs has been the London Interbank Offered Rate (LIBOR).

Understanding Adjustable-Rate Mortgages (ARMs)

Mortgages allow homeowners to finance the purchase of a home or other piece of property. When you get a mortgage, you’ll need to repay the borrowed sum over a set number of years as well as pay the lender something extra to compensate them for their troubles and the likelihood that inflation will erode the value of the balance by the time the funds are reimbursed.

In most cases, you can choose the type of mortgage loan that best suits your needs. A fixed-rate mortgage comes with a fixed interest rate for the entirety of the loan. As such, your payments remain the same. An ARM, where the rate fluctuates based on market conditions. This means that you benefit from falling rates and also run the risk if rates increase.

There are two different periods to an ARM. One is the fixed period and the other is the adjusted period. Here’s how the two differ:

• Fixed Period: The interest rate doesn’t change during this period. It can range anywhere between the first five, seven, or 10 years of the loan. This is commonly known as the intro or teaser rate.
• Adjusted Period: This is the point at which the rate changes. Changes are made during this period based on the underlying benchmark, which fluctuates based on market conditions.

Another key characteristic of ARMs is whether they are conforming or nonconforming loans. Conforming loans are those that meet the standards of government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. They are packaged and sold off on the secondary market to investors. Nonconforming loans, on the other hand, aren’t up to the standards of these entities and aren’t sold as investments.

Rates are capped on ARMs. This means that there are limits on the highest possible rate a borrower must pay. Keep in mind, though, that your credit score plays an important role in determining how much you’ll pay. So, the better your score, the lower your rate.

Types of ARMs

ARMs generally come in three forms: Hybrid, interest-only (IO), and payment option. Here’s a quick breakdown of each.

Hybrid ARM

Hybrid ARMs offer a mix of a fixed- and adjustable-rate period. With this type of loan, the interest rate will be fixed at the beginning and then begin to float at a predetermined time.

This information is typically expressed in two numbers. In most cases, the first number indicates the length of time that the fixed rate is applied to the loan, while the second refers to the duration or adjustment frequency of the variable rate.

For example, a 2/28 ARM features a fixed rate for two years followed by a floating rate for the remaining 28 years. In comparison, a 5/1 ARM has a fixed rate for the first five years, followed by a variable rate that adjusts every year (as indicated by the number one after the slash). Likewise, a 5/5 ARM would start with a fixed rate for five years and then adjust every five years.

Interest-Only (I-O) ARM

It’s also possible to secure an interest-only (I-O) ARM, which essentially would mean only paying interest on the mortgage for a specific time frame—typically three to 10 years. Once this period expires, you are then required to pay both interest and the principal on the loan.

These types of plans appeal to those keen to spend less on their mortgage in the first few years so that they can free up funds for something else, such as purchasing furniture for their new home. Of course, this advantage comes at a cost: The longer the I-O period, the higher your payments will be when it ends.

Payment-Option ARM

A payment-option ARM is, as the name implies, an ARM with several payment options. These options typically include payments covering principal and interest, paying down just the interest, or paying a minimum amount that does not even cover the interest.

Opting to pay the minimum amount or just the interest might sound appealing. However, it’s worth remembering that you will have to pay the lender back everything by the date specified in the contract and that interest charges are higher when the principal isn’t getting paid off. If you persist with paying off little, then you’ll find your debt keeps growing—perhaps to unmanageable levels.

Advantages and Disadvantages of ARMs

Adjustable-rate mortgages come with many benefits and drawbacks. We’ve listed some of the most common ones below.

Advantages

The most obvious advantage is that a low rate, especially the intro or teaser rate, will save you money. Not only will your monthly payment be lower than most traditional fixed-rate mortgages, you may also be able to put more down toward your principal balance. Just ensure your lender doesn’t charge you a prepayment fee if you do.

ARMs are great for people who want to finance a short-term purchase, such as a starter home. Or you may want to borrow using an ARM to finance the purchase of a home that you intend to flip. This allows you to pay lower monthly payments until you decide to sell again.

More money in your pocket with an ARM also means you have more in your pocket to put toward savings or other goals, such as a vacation or a new car.

Unlike fixed-rate borrowers, you won’t have to make a trip to the bank or your lender to refinance when interest rates drop. That’s because you’re probably already getting the best deal available.

Disadvantages

One of the major cons of ARMs is that the interest rate will change. This means that if market conditions lead to a rate hike, you’ll end up spending more on your monthly mortgage payment. And that can put a dent in your monthly budget.

ARMs may offer you flexibility but they don’t provide you with any predictability as fixed-rate loans do. Borrowers with fixed-rate loans know what their payments will be throughout the life of the loan because the interest rate never changes. But because the rate changes with ARMs, you’ll have to keep juggling your budget with every rate change.

These mortgages can often be very complicated to understand, even for the most seasoned borrower. There are various features that come with these loans that you should be aware of before you sign your mortgage contracts, such as caps, indexes, and margins.

How the Variable Rate on ARMs Is Determined

At the end of the initial fixed-rate period, ARM interest rates will become variable (adjustable) and will fluctuate based on some reference interest rate (the ARM index) plus a set amount of interest above that index rate (the ARM margin). The ARM index is often a benchmark rate such as the prime rate, the LIBOR, the Secured Overnight Financing Rate (SOFR), or the rate on short-term U.S. Treasuries.

Although the index rate can change, the margin stays the same. For example, if the index is 5% and the margin is 2%, the interest rate on the mortgage adjusts to 7%. However, if the index is at only 2% the next time that the interest rate adjusts, the rate falls to 4% based on the loan’s 2% margin.

Adjustable-Rate Mortgage vs. Fixed Interest Mortgage

Unlike ARMs, traditional or fixed-rate mortgages carry the same interest rate for the life of the loan, which might be 10, 20, 30, or more years. They generally have higher interest rates at the outset than ARMs, which can make ARMs more attractive and affordable, at least in the short term. However, fixed-rate loans provide the assurance that the borrower’s rate will never shoot up to a point where loan payments may become unmanageable.

With a fixed-rate mortgage, monthly payments remain the same, although the amounts that go to pay interest or principal will change over time, according to the loan’s amortization schedule.

If interest rates in general fall, then homeowners with fixed-rate mortgages can refinance, paying off their old loan with one at a new, lower rate.

Is an ARM Right for You?

An ARM can be a smart financial choice if you are planning to keep the loan for a limited period of time and will be able to handle any rate increases in the meantime. Put simply, an adjustable-rate mortgage is well suited for the following types of borrowers:

• People who intend to hold the loan for a short period of time
• Individuals who expect to see a positive change in their income
• Anyone who can and will pay off the mortgage within a short time frame

In many cases, ARMs come with rate caps that limit how much the rate can rise at any given time or in total. Periodic rate caps limit how much the interest rate can change from one year to the next, while lifetime rate caps set limits on how much the interest rate can increase over the life of the loan.

Notably, some ARMs have payment caps that limit how much the monthly mortgage payment can increase, in dollar terms. That can lead to a problem called negative amortization if your monthly payments aren’t sufficient to cover the interest rate that your lender is changing. With negative amortization, the amount that you owe can continue to increase, even as you make the required monthly payments.

The Bottom Line

Borrowers have many options available to them when they want to finance the purchase of their home or another type of property. You can choose between a fixed-rate or adjustable-rate mortgage. While the former provides you with some predictability, ARMs offer lower interest rates for a certain period of time before they begin to fluctuate with market conditions. There are different types of ARMs to choose from and they have pros and cons. But keep in mind that these kinds of loans are better suited for certain kinds of borrowers, including those who intend to hold onto a property for the short term or if they intend to pay off the loan before the adjusted period begins. If you’re unsure, talk to a financial expert about your options.

What Is an Asset-Backed Security (ABS)?

An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables. It takes the form of a bond or note, paying income at a fixed rate for a set amount of time, until maturity. For income-oriented investors, asset-backed securities can be an alternative to other debt instruments, like corporate bonds or bond funds.

Understanding Asset-Backed Securities (ABSs)

Asset-backed securities allow their issuers to raise cash, which can be used for lending or other investment purposes. The underlying assets of an ABS are often illiquid and can’t be sold on their own. So, pooling assets together and creating a financial instrument out of them—a process called securitization—allows the issuer to make illiquid assets marketable to investors. It also allows them to get shakier assets off their books, thus alleviating their credit risk.

The underlying assets of these pools may be home equity loans, automobile loans, credit card receivables, student loans, or other expected cash flows. Issuers of ABSs can be as creative as they desire. For example, asset-backed securities have been built based on cash flows from movie revenues, royalty payments, aircraft landing slots, toll roads, and solar photovoltaics. Just about any cash-producing vehicle or situation can be securitized into an ABS.

For investors, buying an ABS affords the opportunity of a revenue stream. The ABS allows them to participate in a wide variety of income-generating assets, sometimes (as noted above) exotic ones that aren’t available in any other investment.

How an Asset-Backed Security Works

Assume that Company X is in the business of making automobile loans. If a person wants to borrow money to buy a car, Company X gives that person the cash, and the person is obligated to repay the loan with a certain amount of interest. Perhaps Company X makes so many loans that it starts to run out of cash. Company X can then package its current loans and sell them to Investment Firm X, thus receiving the cash, which it can then use to make more loans.

Investment Firm X will then sort the purchased loans into different groups called tranches. These tranches contain loans with similar characteristics, such as maturity, interest rate, and expected delinquency rate. Next, Investment Firm X will issue securities based on each tranche it creates. Similar to bonds, each ABS has a rating indicating its degree of riskiness—that is, the likelihood the underlying loans will go into default.

Individual investors then purchase these securities and receive the cash flows from the underlying pool of auto loans, minus an administrative fee that Investment Firm X keeps for itself.

Special Considerations

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

Types of Asset-Backed Securities

Theoretically, an asset-based security (ABS) can be created out of almost anything that generates an income stream, from mobile home loans to utility bills. But certain types are more common. Among the most typical ABS are:

Collateralized Debt Obligation (CDO)

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that ABS. There are a variety of subsets of CDOs, including:

• Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
• Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
• Structured finance-backed CDOs have underlying assets of ABS, residential or commercial mortgages, or real estate investment trust (REIT) debt. 
• Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.
• Collateralized mortgage obligations (CMOs) are composed of mortgages—or, more precisely, mortgage-backed securities, which hold portfolios of mortgages (see below).

Though a CDO is essentially structured the same as an ABS, some consider it a separate type of investment vehicle. In general, CDOs own a wider and more diverse range of assets—including other asset-based securities or CDOs.

Home Equity ABS

Home equity loans are one of the largest categories of ABSs. Though similar to mortgages, home equity loans are often taken out by borrowers who have less-than-stellar credit scores or few assets—the reason they didn’t qualify for a mortgage. These are amortizing loans—that is, payment goes towards satisfying a specific sum and consists of three categories: interest, principal, and prepayments.

Auto Loan ABS

Car financing is another large category of ABS. The cash flows of an auto loan ABS include monthly interest payments, principal payments, and prepayments (though the latter is rarer for an auto loan ABS is much lower when compared to a home equity loan ABS). This is another amortizing loan.

Credit Card Receivables ABS

Credit card receivables—the amount due on credit card balances—are a type of non-amortizing asset ABS: They go to a revolving line of credit, rather than towards the same set sum. So they don’t have fixed payment amounts, while new loans and changes can be added to the composition of the pool. The cash flows of credit card receivables include interest, principal payments, and annual fees.

There is usually a lock-up period for credit card receivables where no principal will be paid. If the principal is paid within the lock-up period, new loans will be added to the ABS with the principal payment that makes the pool of credit card receivables staying unchanged. After the lock-up period, the principal payment is passed on to ABS investors.

Student Loan ABS

ABSs can be collateralized by either government student loans, guaranteed by the U.S. Dept. of Education, or private student loans. The former have had a better repayment record, and a lower risk of default.

An ABS will usually have three tranches: class A, B, and C. The senior tranche, A, is almost always the largest tranche and is structured to have an investment-grade rating to make it attractive to investors.

The B tranche has lower credit quality and, thus, has a higher yield than the senior tranche. The C tranche has a lower credit rating than the B tranche and might have such poor credit quality that it can’t be sold to investors. In this case, the issuer would keep the C tranche and absorb the losses.

The Bottom Line

Asset Backed Securities (ABS) are pools of loans that are packaged together into an investable security, which can in turn be bought by investors, predominantly large institutions, like hedge funds, insurance companies, and pension funds. ABS provide a method of diversification from typical bond mutual funds or individual bonds themselves. Most importantly, they are income generating assets, typically with a higher return than a normal corporate bond, all depending on the credit rating assigned to the ABS.

The underlying assets of an ABS could consist of auto loans, credit card receivables, and even more exotic investments, such as utility bills and toll roads. Such categories of ABS are referred to by different names such as CDO’s (Collateralized Debt Obligations), which are broken down into further sub-categories, such as CLO’s (Collateralized Loan Obligations). However, by far, the most popular and therefore liquid ABS are MBS (Mortgage Backed Securities), which provide an income stream from mortgage payments.

For the investor, ABS provide an income stream in line with the credit rating of the security, and offer an alternative to standard bond mutual funds.