A number of commentators have noted that the secondary market for mortgage assets suffers from a “Market for Lemons” problem:
There are good used cars and defective used cars ("lemons"), but because of asymmetric information about the car (the seller knows much more about the problems of the car than the buyer), the buyer of a car does not know beforehand whether it is a good car or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. This is sometimes summarized as "the bad drive out the good" in the market.
Sandro Brusco applies this problem to the secondary mortgage market in “Mechanism Design and the Bailout”:
If the market starts to suspect that some of those Mortgage Backed Assets (MBAs) are more toxic than others and that the managers of the banks know the ones that are more dangerous, then the markets can easily collapse. This is the standard ''market for lemons'' problem, which is by now well understood: investors don't want to buy MBAs at a price equal to their average value, because they are afraid that what they get is not the average but the worse, i.e. they suspect that the banks will first try to unload the most toxic securities. Lowering the price in this case does not work, since it only convinces even more the investors that the securities are truly toxic. The market essentially freezes. Investors will only buy at very low prices, the ones corresponding to the most pessimistic expectations on the assets. But this must mean that on average the MBAs are worth more than the market prices and therefore the sellers will be unwilling to sell.
Leigh Caldwell in “Lemons and Toxic Assets” and Mark Thoma both outline the case for government intervention to get the market working again.
This view starts with the premise there is asymmetric information between sellers and buyers – that sellers know which assets are toxic, and buyers don’t. Is that true in this case? I don’t think so - to a large extent, banks don’t know which assets are toxic and how toxic they are. I’m not just talking about ignorance of their own portfolio (although there’s plenty of that). Real estate is relatively illiquid, highly leveraged, and values are driven by comparable sales that are mostly distressed these days. As I’ve outlined in a previous post, this creates a downward spiral effect as assets are liquidated, and what looks like a good asset now could easily be a bad asset a year from now.
William Buiter draws this distinction:
- Toxic assets are assets whose fair value cannot be determined with any degree of accuracy.
- Clean assets are assets whose fair value can easily be determined.
In this environment, there are not many real estate assets whose fair value can be easily determined. You can take a snapshot value using current income and comparable sales and decide if the mortgage secured by that asset is a good risk today. But, the snapshot only captures the present, and experienced real estate investors know we are in a nasty feedback loop which will drive down values further. The problem is not information asymmetry; the problem is no ones knows at what level the market which reach an equilibrium.
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