Information Asymmetry, The Market For Lemons, and Pricing Toxic Mortgage Assets

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.

CRE Loans and the Death Spiral of Doom

When CRE markets start to decline, they can spiral downward dramatically over time. Let’s start out by looking at the underwriting for loans on two identical adjacent apartment projects in Los Angeles in 1989:

The two projects are identical, but the lenders underwrote differently – the Bad Lender used a 3% vacancy factor, but more importantly leveraged the deal to the breakeven point. This was very typical of the market then, and was usually accomplished either by underwriting on the pro forma appraisal income instead of the actual operations and/or by underwriting to a 1.25 DSC on a teaser start rate on a variable rate loan and a 1.00 DSC on the fully indexed rate. The theory was the borrower would refinance when the reset occurred (does this all sound familiar)? The consequence of this approach is the bad lender loan about 80% of the asset value, while the Good Lender loaned 64% LTV.

Let’s go forward to 1991. There have been huge employment losses in the market, and rents have decreased while vacancy has increased. Perceived risk has also increased so cap rates are up too. Here are the numbers (the 1989 Bad Lender underwriting is included for comparison purposes):

Rents are down 5% and the vacancy rate has increased to 15%, creating substantial negative cash flow for the Bad Lender borrower. He defaults, and the combination of lower net operating income and higher cap rate results in the Bad Lender takes a 24% loss. The cash flow for the Good Lender borrower has also taken a hit, but because her deal was not leveraged as highly to begin with, she does not default.

Things start to get interesting when the Bad Lender sells the REO property:

The REO buyer bases their purchase on a higher cap (it’s REO, after all) and suffers an additional loss bringing the overall loss to 33%. The Bad Lender finances the sale at 80% LTV. Note that since cap rates have risen relative to interest rates this level of leverage now has substantial debt service coverage.

By 1992 the REO buyer has dropped his rents 10% in order to capture the best quality tenants and reduce his vacancy factor – the result is his cash flow remains about the same and he has a better quality tenant base. The effect on the neighboring building is profound – this borrower already had negative cash flow and can’t match the rent decrease, so her vacancy goes up. The negative cash flow is too great, she defaults, and the Good Lender takes a 33% loss based on the market cap rate established by the first REO sale. When the Good Lender sells (at a higher cap rate, because it’s REO), their total loss is 40%.

REO Buyer 2 now has a much lower cost structure than REO Buyer 1, and can afford to drop rents below REO Buyer 1’s levels to recapture tenants. Do you see how this cycle reinforces itself? I foreclosed on some buildings 3 times over a five year period as the market spiraled down.

The market will eventually reach an equilibrium again – in LA this occurred when job growth finally returned and virtually all the highly leveraged buildings had been foreclosed upon. But, until an equilibrium is reached it’s impossible for anyone to predict the stabilization level. Those who talk about setting a new price level in CRE don’t seem to grasp that it’s a dynamic, multi-step process and not a one-time mark.

Also, note that the conservative lender actually took a larger loss in the example above, because their default occurred at a point further down the spiral. This is why many lenders consider their first loss to be their best loss, and are reluctant to modify loans.

A Snake Swallowing Its Own Tail: Mark to Market and Real Estate Values

I’ve previously posted on the illiquidity of the real estate markets and the difficulty and consequences of valuing real estate using distressed sales (see here, here, and here).

Via Newmark's Door, National Review Online has a good summary of the impact of mark to market rules on banks. An excerpt:

Mark-to-market rules damage banks in two ways. The first is that banks have to treat losses on paper as though they were real economic losses, accepting fire-sale valuations of securities that they may not intend to sell. The second is that, because mark-to-market rules are used in assessing banks’ capital requirements, those paper losses can quickly become real losses when banks are forced to sell assets, often at an enormous loss, to raise enough capital to keep the regulators satisfied. Those pressured sales, in addition to locking in losses, tend to drive down the prices of similar assets, creating a vicious cycle of wealth destruction. The market becomes a snake swallowing its own tail.

Marking CRE to Market

Marking assets to their current market value is an important aspect of the current crisis. Even if you agree CRE debt should be marked to market, it’s very difficult to do because the assets are not homogenous and because the market is thinly traded in the best of times and almost completely frozen now. CoStar has an excellent article describing these difficulties here.

For a good summary of the mark to market debate in general, see this Naked Capitalism post.