China sends the U.S. toxic toys and foodstuffs; we send back toxic securitized loans and derivatives. Asymmetric information seems to be creating a gigantic “lemons problem.”

Apparently, in return for the toxic toys and foodstuffs the U.S. gets from the Chinese consumer-goods industries, our financial-services industry has been sending back toxic securitized loans and debt-derivative instruments. Now China is having its own credit crunch; the resulting pressure on Chinese banks may reveal that Chinese mortgage-lending practices have been no sounder than mortgage-lending practices in the U.S.

Since the U.S. economy is currently financed largely with Chinese money, a credit squeeze in China could lead to an extremely rough ride here at home.

A big part of the problem now is that the various flavors of Collateralized Debt Obligations are so complex and opaque that it’s hard for the owner, and even harder for a potential buyer, to figure out what they’re worth, because no one really knows which ones will go bad at different overall levels of default on different levels of mortgages, and the black-box risk-management software has proven so fallible in the face of unexpected market swings that no one trusts model-driven valuations anymore. As a result, the market faces a classic “lemons problem“: since the seller knows more than the buyer about the value of the asset, any offer to sell suggests that the asset is actually worth less than it seems to be worth. (It’s just like finding what seems to be an unreasonably good deal for a used car on E-Bay; maybe the seller is just plain desperate to sell and it really is a great deal, or maybe it’s a true P.O.S. and he’s trying to sell it on E-Bay because no one who saw it would touch it.)

This creates a huge headache for the seller as well as the buyer; if I have a good used car that I just have to get rid of because I’m going abroad, or a pile of CDOs that are really worth nearly their face value that I have to dump because I’m running out of cash, I have no way of convincing the buyer of the quality of the product, so he will pay only the bargain-basement price that would be appropriate to trashy car or toxic-waste-quality CDO.

That “lemons problem” is contributing to a liquidity crunch, in which even entities that have ample assets to cover their debts can’t sell enough or borrow enough to meet their current obligations, potentially triggering chain-reaction defaults. Underlying that is a solvency problem of unknown size. Certainly many homeowners owe more on their houses than the houses are worth, and won’t be able to cover the difference from other sources. Depending on how bad the default rates turn out to be it’s also possible that some fairly hefty financial institutions have debts that exceed their suddenly-depreciated assets. Central banks can add liquidity to the system by lending money to financial institutions. But adding liquidity is no solution to insolvency, and right now no one knows how much of the financial system is actually insolvent.

Of course, there’s lots of positive feedback here. Rising defaults have triggered tightening standards for housing lending, which in turn will tend to depress housing prices, which in turn will push even more homeowners into default. As those houses go on the foreclosure market, housing prices will fall even further. Since home construction has been a big source of employment and home refinancing has supported other kinds of consumer spending, a housing collapse could trigger a recession, which would push housing prices down yet more. If things get really bad, we could get a wave of abandonment as property-owners just stop doing maintenance and walk away from properties. When one unit in a development falls into disrepair, that further reduces the value of all the other units. And if people expect housing prices to keep falling, then they’re not going to buy, even at prices well below current prices.

In the long run, lower housing prices are no doubt A Good Thing. But in the long run we’re all dead, and the next year or five may not be any fun at all.

Fortunately, these are mostly unregulated transactions. Freed from the dead hand of government, they work perfectly, due to the magic of the marketplace. Laissez-faire!

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: