Tuesday, September 18, 2007

Matryoshka Lemons

by Tom Bozzo

(Another coinage I wish I'd invented; credit goes to Dr. Hypercube, see here.)

One of the controversies regarding George Akerlof's famous paper on "lemons" and the markets for used cars is that nice used cars sell all the time and at some premium to nasty ones. While there are information problems (and accompanying horror stories), there are not-overly-costly means of assessing the quality of a car and so there's a big and reasonably liquid used car market.

The recent financial market disruptions, meanwhile, have been looking like a lemons market in action — or, at least, participants have reassessed the quality information in the market in such a way as to shift to a panicky lemons "equilibrium." There's been plenty of news about once-liquid securities failing to trade at any price, and the issue seems to be less that the securities are backed by some amount of low-quality loans than that nobody knows where exposure to the low-quality loans has been stuffed. The former should lead to price changes that may be unpleasant by some standards, but not a market failure as such.

To give Dr. Hypercube full credit for his concept, the information asymmetry can be aggravated by the layers of transactions between the original loan and the troublesome securities, so that quality assessment is extremely difficult or costly; as for the regulators and quasi-regulators, well, oops.

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Lehmann's earnings announcement today noted that they are valuing much of their MBS portfolio at a price of 92 or less.

I did some work with Fannie Mae's securitization people several years ago; the reason non-Agency securities are even more illiquid is two-fold: (1) "anything worth selling is worth selling to the Agencies" is more true than not and (2) the Agencies keep records in great detail of what securities are in their MBSes.

Btw, Johnny RootBeer is schooling The Maestro right now.
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