The market for lemons and the Garbage Pail Agency

A properly designed auction process can overcome the information asymmetry which accounts for some of today’s illiquidity. If so, the Garbage Pail Agency could pay more-than-market prices for MBS without overpaying in the sense of paying more than their present expected value, because the market prices are artificially deflated by the “lemons” effect. That’s on top of the possibility that once the system is stabilized the assets will actually be worth more than they are now.

If I had the ordinary common sense God promised a goose, I’d know better than to get in between Paul Krugman and Brad DeLong in an argument about the pricing of financial assets.

Krugman makes a straightforward argument: if the banks sold all their paper for what it would fetch on today’s market, they’d be broke. Therefore, the only way to rescue them is either to inject capital directly by buying equity or to overpay for some of their assets. DeLong responds that, in a market stabilized by an injection of $700 billion, the bad paper will actually be worth more than it is worth now: in effect, by creating (rational) confidence the Treasury can create a free lunch.

Kevin Drum tends to side with Krugman: after all, he says, there are vulture buyers out there right now, and the banks won’t sell to them at the prices they’re offering. So if the Garbage Pail Agency pays anything more than that, it must be overpaying.

But that’s where (I think) the argument breaks down, in two different ways.

1. If the only losses the banks now faced were on their shares of mortgages, then it’s hard, at first blush, to see how to make them more solvent (as opposed to more liquid) without giving them more than the expected present value of their shares of mortgages. But they also face losses on their holdings of one another’s paper, which is worth less than it would otherwise be because no one knows which of them will be the next Lehman. So making any financial institution\ more liquid will tend to make all the other financial institutions more solvent.

2. The very low prices offered by the vultures are what are called “lemons” prices, resulting from the information asymmetry in which the sellers know more about the value of the assets than the buyers do. The vultures have to make offers premised on tne notion that what they’re going to buy is the very worst sort of toxic sludge. At prices that low, any bank that holds paper any better than toxic sludge doesn’t want to sell, so the only transactions that actually occur are sales of rotten assets at rock-bottom prices.

If the Garbage Pail Agency can develop some sort of auction or precentage-proffer or clawback system that keeps the banks from selling only their lemons, it will be able to offer much-better-than-vulture prices without overpaying, because it will be buying assets better than the vultures can buy. Add to that the confidence boost, which will actually increase the value of all financial assets, and it’s quite possible that the Garbage Pail Agency could rescue a bunch of banks and turn a profit.

Now “quite possible” isn’t the same as “true,” and the auction-design problems look like hairy ones, especially if you have to solve them quickly. But unlike Kevin, I think that DeLong might well be right.

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: