Universal Savings & Loan has $1,000 to lend. They can offer one of two types of...

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Universal Savings & Loan has $1,000 to lend. They can offerone of two types of loans. If they offer a risk-free loan, theywill be paid back in full next year with 4% interest. If they offera risky loan, there is a 20% chance that the borrower will default(pay back nothing) and an 80% chance the borrower will pay back infull with 30% interest?
a. What are the expected profits for each type of loan? Whichtype of loan will they prefer to offer?
b.Now suppose that the lending institution knows that thegovernment will “bail out” Universal if there is a default. (Thegovernment will pay back the original $1,000.) What type of loanwill the lending institution choose to make? What is the expectedcost to the government?
c. What type of asymmetric information problem is the governmentcreating in this market?

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4.4 Ratings (607 Votes)

a Expected profits for each type of loan Risk free loan 10004 40 Risk Loan 10000830 1000020 240 USL would prefer to offer risk Loan As there is much more profit in it 240 B As Government will See Answer

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