David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Why Do Financial Intermediares Exist? The Lemons Problem: Akerlof (QJE – 1970) Suppose you want to buy a car. 10 cars are available for purchase in the marketplace. As an uninformed buyer, you are unable to distinguish between good cars and bad cars. Good cars have an open-market value of $4,500, while bad cars have an open-market value of $1,500. Based upon your unique knowledge and entrepreneurial ability, you can generate $6,000 in revenue (not profit) if you are able to obtain a good car, but only $2,000 in revenue if you obtain a bad car. Furthermore, it is common knowledge that 50% of all cars in the marketplace are good cars (and hence, the remaining 50% are bad cars). Assuming you are a risk-neutral, profit-maximizing investor:

David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Why Do Financial Intermediares Exist? Delegated Monitoring: Diamond (JB – 1984) Agency Cost Example:

David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Why Do Financial Intermediares Exist? Other Explanations Liquidity Argument – Gorton & Pencchi (JF – 1990)  Credit Availability – Peterson & Rajan (JF/QJE- ’94/’95)  Information Story – Berlin and Loeys (JF – 1988) 

David M. Harrison, Ph.D. Real Estate Finance Texas Tech University Are Bank Loans Unique? Eugene Fama – JME (1985) Empirical Evidence  Conclusions:

David M. Harrison, Ph.D. Real Estate Finance Texas Tech University MBA Extension: Local Bank Rates What is the average 30-year fixed mortgage interest rate in Lubbock? What are the average fees associated with originating these loans? What drives local mortgage rates?