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Professional blogger and full time investor in real estate, stocks and bonds. Focus is on cross over investing, multi asset and long-short. Started a small private hedge fund.
  • Market For Lemons 0 comments
    Sep 1, 2014 4:45 PM

    Whenever market participants need to best guess what the price of the quality is of the products/assets they own, their incentive to sell may fall. The overall quality of the market deteriorates because owners of 'good' assets withdraw from the buying/selling process. Prospective buyers revise their expectations down for any given asset, and that motivates owners of assets of moderate quality to not sell either. What's left is a market where low quality assets are traded and provided by lower tier issuers. This is what the "lemon theory" describes. Lack of information-asymmetric info--leads to a market where people buy an asset under the impression it is relatively good, while in reality it is not. The bad drives out the good, as Gresham's law would say, and the bad gets worse.

    During the '07 subprime debacle, the lemon theory was often mentioned. Cumulative loss curve methodology and collateral stratification was not transparent, that caused perceptions of dubious quality, which over time saw investor participation slowly decline. There were others that put the subprime problem in the context of 'Ponzi units'. Subprime bonds appreciated in value on the belief such would be sufficient to refinance the underlying subprime mortgages. Yet the poor borrowers were simply unable to make principal and interest payments, regardless of lower interest rates. There is overlap between Lemons and Ponzi units. Both theories say prices do not properly reflect the true quality of the vendors that are able to offer lower quality goods to a less informed market. Such can continue for a while because of the presence of "public guarantees" or regulation that provides a comfort to the consumers the goods are of seemingly higher quality.

    In today's market, an aspect of the lemon theory is that more and more investors are clinging on 'safe' assets because they are getting scarcer. Unwilling to sell those, it has made their risk premiums thin over 'safe' Treasuries. It's partly a function of supply and demand because the universe of AAA rated-"safe"-assets is shrinking due to sovereign downgrades, causing AAAs to be a "dying breed". The demand for such AAA assets is so high, their prices are perhaps inelastic. This in part caused by a trend of lower net issuance that has created a supply-demand imbalance for safe assets. Investors are less willing to sell safe assets because they are scarce, and so the remaining available assets may see quality deterioration by having less reliable, less reputable and lower tier issuers meet the soaring demand. In terms of marginal cost-benefit analysis, it suggests returns diminish when consumption reaches a point of satisfaction. That also greatly depend on economic scenarios, inflation expectations, and reversal in default rates. With current default rates low, and assumed to stay low, leverage is making a careful comeback. That may prove to be the real lemon when default rates do rise when true safe assets are no longer available.

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