There has been considerable interest in the illiquidity of some toxic assets, with many people arguing that adverse selection is at the heart of the problem. (a) [4 points] Explain what "adverse selection" means? And why it might mean illiquidity (equivalently, too little trade)? Give (and explain) one other examples of adverse selection. We know turn to a very stylized model. Suppose that you are confident that values will increase and are considering diversifying your portfolio by buying a mortgage-backed security (MBS), which you would particularly value. You believe that there are two kinds of MBS in the market: there are "good" ones which you value at $100 but for whom sellers (who are less confident about the market) would sell at $60 and there are "atrocious" ones which are worth 0 both to you and to sellers. You believe that half the MBSs on the market are atrocious, but you cannot tell which is which. (b) [6 points] You get to make an offer for an MBS. Draw a tree to represent this situation. What price do you offer? Why? The government is seeking to find ways to spend the stimulus funds that it has voted on, and has decided that it should subsidize the purchase of MBS to foster liquidity. It is considering two policies. (d) [4 points] It will subsidize a purchaser $15 to buy any MBS (to be entitled to this subsidy the price must be at least 15). How would this change any offer that you make? (e) [4 points] The government will guarantee the first $25 of the value of any purchase (at a price higher than 25) of a MBS-that is, it will pay $25 only to buyers of assets that turn out to be atrocious. What would you now offer for an MBS? (f) [2 points] Which scheme is more expensive for the government?