Subsidizing Lemons

Suppose that you are in the market for a car. You have no knowledge of the actual value of each individual car. The seller, however, knows exactly how well the car runs, whether it has been in accident, how many repairs it has undergone, etc. Thus, deciding how much you are willing to pay for each individual car on the market is quite difficult. Ultimately, you must rely on some metric such as the average quality of the available used cars to make your decision. The problem, of course, is that this price likely will not be high enough to entice the owners of above average quality vehicles in the market. It this process continues, it could ultimately result in a breakdown of the market itself resulting in a “no-trade” equilibrium.

This is George Akerlof’s market for lemons. It is also a good way to think about the market for the so-called toxic assets on banks’ balance sheets. So when thinking about the Treasury department’s new public-private investment plan (PPIP), it is important to keep this story in the back of one’s mind.

Readers will recall that I was not a fan of the Paulson Plan. The same can be said for the PPIP, or Geithner Plan.

The problem with these assets is that we simply do not know what they are worth given the great deal of uncertainty surrounding their underlying value. The Paulson Plan was designed to simply buy the assets at the depressed values and then sell them at a later date and hopefully earn a profit. Those who designed the Geithner Plan seem to have recognized the idiocy of this plan. Nonetheless, they have decided to partake in the madness by announcing a plan that would subsidize the purchase of these assets by the private sector with the FDIC ultimately bearing the losses. As Andrew Ross Sorkin wrote recently:

It’s [the FDIC] going to be insuring 85 percent of the debt, provided by the Treasury, that private investors will use to subsidize their acquisitions of toxic assets. The program, extraordinary in its size and scope, is the equivalent of TARP 2.0. Only this time, Congress didn’t get a chance to vote.

These loans, while controversial, were given a warm welcome by the market when they were first announced. And why not? The terms are hard to beat. They are, for example, “nonrecourse,” which means that if an investor loses money, he owes taxpayers nothing. It’s the closest thing to risk-free investing — with leverage! — around.

But, as we’ve learned the hard way these last couple of years, risk-free investing is an oxymoron.

So where did the risk go this time?

To the F.D.I.C., and ultimately, to us taxpayers.

Here is the real kicker:

So how much does the F.D.I.C. think it might lose?

“We project no losses,” Sheila Bair, the chairwoman, told me in an interview. Zero? Really? “Our accountants have signed off on no net losses,” she said. (Well, that’s one way to stay under the borrowing cap.)

By this logic, though, the F.D.I.C. appears to have determined it can lend an unlimited amount of money to anyone so long as it believes, at least at the moment, that it won’t lose any money.

Essentially, what all this means is that we are essentially subsidizing the lemons and expecting that this will fix the problem — at zero cost and without any oversight. I never thought that I would utter what follows, but this is perhaps worse than the Paulson Plan. Sure, it is great for private investors, who are essentially being given money to speculate on worthless assets with borrowed funds on which there is no recourse, but it is potentially terrible for the taxpayer.

Subsidizing the lemons on financial balances sheets will not lead to price discovery. Rather it will merely artificially inflate the prices of these assets without improving our knowledge about what they are truly worth. Further, it creates an incentive for financial firms to unload what they believe to be the worst of these so-called toxic assets with the taxpayer footing the bill for the losses.

2 responses to “Subsidizing Lemons

  1. “Ultimately, you must rely on some metric such as the average quality of the available used cars to make your decision. The problem, of course, is that this price likely will not be high enough to entice the owners of above average quality vehicles in the market. It this process continues, it could ultimately result in a breakdown of the market itself resulting in a “no-trade” equilibrium.”

    Ignoring the fact that even the present owner has only a limited ability to predict the future reliability of his vehicle, the logic of the situation is fundamenatally flawed.

    There seems to be no account taken of the fact that the ultimate source of economic value is subjective and that it is subject to the law of diminishing marginal utility.

    It seems highly likely that the majority of used cars not traded in and made available for sale by owners are, at the time of sale, secondary or tertiary vehicles to their owners. This means that they serve far less important ends for their owners than their primary vehicles. In fact, they are as likely to be costs to their owners as benefits.

    This is in contrast to the situation of the potential buyer, who is looking for a cheap means of primary transportation, likely necessary for employment.

    A free market exchange needs a reversal of valuation order for the good and the price for the two counterparties. It is almost certain that the difference in usefulness of the vehicle for the two parties will overwhelm any difference in their knowledge of vehicle quality.

    Regards, Don

  2. People just don’t understand that you can’t magically make bad assets disappear into thin air. The pain has to be felt…….if you prolong it, then you will just feel the pain worse later….sorta like a 5 year arm prolongs having to pay full mortgage premiums!

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s