Information Asymmetry and Bear Stearns

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Includes: BSC, JPM
by: Rick Konrad, CFA

Asymmetric information gets to the root of Friday's market problem in Bear Stearns (NYSE:BSC). George Akerlof, Michael Spence, and Joseph Stiglitz won the 2001 Nobel Prize in Economics for their work in this area.

Akerlof, who wrote the earliest paper in this area, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" describes the market for used cars as a market that is distorted by quality uncertainty. Owners of decent used cars are unable to get a "decent" price to make selling these cars worthwhile, therefore they don't place these cars in the market. Because "quality" is not readily ascertainable, the quality of traded automobiles should be sub-average.

A lemon market will be produced by the following:

1. Asymmetry of information:

  • No buyers can accurately assess the value of a product through examination before sale is made.

  • All sellers can more accurately assess the value of a product prior to sale.

  • 2. An incentive exists for the seller to pass off a low quality product as a higher quality one.

    3. Sellers have no credible disclosure technology (sellers with a great car have no way to credibly disclose this to buyers).

    4. A deficiency of effective public quality assurances (by reputation or regulation) exists.

    5. A deficiency of effective guarantees/warranties exists.

    The market in financial services stocks has become a lemons market. Questions about asset value prevail, liquidity concerns arise, and the true condition of the assets is enigmatic. Despite 225-basis points of Fed Funds rates, and co-ordinated central bank liquidity, and a broad Term Security Lending Facility, the impact on market sentiment and credit spreads has been negligible.

    There is but one solution to the problem - transparency and disclosure, being more open in what is going on and why. The mystery that surrounds the arrangement between JPMorgan (NYSE:JPM) and Bear Stearns contaminates the rumor mill and raises investors' concerns.

    Bear Stearns may have $84 in book value which certainly gets the Ben Graham instincts going, but the reality is much more uncertain. Valuation in a financial services stock is wholly dependent on future cash flow streams. There is precious little in tangible assets. There is huge uncertainty about valuation of assets comprised of pyramids of paper assets. Given the uncertainty, Bear Stearns' counterparty ratings are clipped and may be viewed by some as almost toxic.

    I cannot imagine how difficult it is for BSC employees as they watch their franchise quake in the crisis. We have friends and associates who either work there or have spent part of their careers there. My thoughts are with you.

    But in the grand scheme of things, the market will survive this much as it has prior brokerage and banking crises. Great names like Drexel, LF Rothschild, Robertson Stephens, Gruntal, Hutton, and Continental Illinois are no longer part of today's world, having blown up.

    Great investors understand the businesses in which they invest and ignore the noise. Focus, do your own work, and understand what it is you own. Emphasize the underlying economics of what you own, and avoid the expensive distractions of today's tape.

    Disclaimer: I, my family, or clients do not have a position in any of the securities mentioned in this post.