Any economy implicitly has economic flaws in its package that cannot be gotten away with but can be reduced or controlled by the adoption of appropriate economic policies based on the economic indicators.

Asymmetry of Information is the prime flaw that results in Adverse Selection and/or Moral Hazard.

Asymmetric Information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power leading to undesired results termed as Adverse Selection.

2008 Subprime Crisis

The economic flaws are clearly depicted in the 2008 Subprime Lending Crisis that occurred after the Lehman Brothers collapsed and the whole global economy coupled with the US economy slowed down and subsequently led to recession in 2008.

Background of the crisis:

Dot.Com Bubble NASDAQ crash in 2000

Much before the 2008 recession occurred; there was a small bubble or collapse that occurred in the mid-late 1990s due to the euphoria of Software Co. stocks considering the exponential advancement of the Internet Business leading to the dot com bubble. However by early 2000 reality started to sink in. Investors realized that the dot-com dream had devolved into a classic speculative bubble and NASDAQ crashed.

Twin Tower & Enrol Scandal:

The Twin Tower attack in Sep 2001 resulted in approximately $40 billion in insurance losses, making it one of the largest insured events ever and led to global stock markets to drop sharply. Followed by it, the Enron scandal, revealed in Oct 2001, was attributed as the biggest audit failure.

Aftermath: The SOX Act

As a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, the SOX Act was passed in 2002. These scandals, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the US securities markets.

The Housing Bubble:

With an intention of improving the sentiments of the existing pessimism filled amongst the people, the then Governor Allen Greenspan, reduced interest rates to almost 1% which led to the sudden surge of buying homes.

Banks started lending loans at dramatically cheaper rates and also offered second mortgages. This was not limited only to the credit worthy but also to NINJAs (No Income No Jobs) that too at teaser rates. As a result, the mortgage market share declined and the private securities share grew, rising to more than half of mortgage securitizations. Subprime mortgages grew from 5% to 20% in 2006.

In the process of parceling loans as CDOs, the lenders started clubbing credit worthy loans with NINJA loans and Investment Banks started buying these. This helped the credit market to grow further as capital continued to flow due to CDOs.

Credit Rating Agencies, based on the bank reputation, started rating the CDOs without actually checking. This was a strong example of ADVERSE SELECTION.

Collapse of Lehman: Beginning of the End

The U.S. housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.

This had a ripple effect breaking the whole global economy resulting in recession worldwide.

Conclusion:

The mortgage crisis and the subsequent seizing up of world credit markets in late 2008, has commonly been attributed to severe adverse selection problems, when potential purchasers of credit instruments came to the abrupt realization that they had significantly less information about the prospect of repayment of such loans than did the issuers.