In his seminal 1970 paper, Nobel laureate George Akerlof identified a whole class of economic problems as being driven by asymmetric information between two parties involved in an exchange. Applied to the market for second-hand cars, Akerlof noted that while quality varies, only the seller knows a car’s true quality. Confronted with superficially similar cars, the buyer has no way of knowing whether she’s getting a defective used car – a ‘lemon’ – or a good one for her money. Consequently she can expect only to get a car of average quality, and is therefore unwilling to pay more than an average price. But this willingness only to pay an average price has consequences for the kind of cars that are up for sale: sellers with good quality cars will take them off the market since they’re worth more than the average price. As the good quality ones leave the market, the average quality of the remaining cars for sale declines and, by this repeated process, the whole market ultimately collapses with only the lemons remaining.
Akerlof’s ‘lemons’ problem seems to be uppermost in Alistair Darling’s mind this week as he prepares to announce the results of the Treasury’s Housing Finance Review in his first Budget this Wednesday. The fear is that mortgage markets are frozen because, just as with the second hand cars, dodgy debt is driving safe debt from the market by raising the price for all debt. This credit supply shock threatens disaster for a UK housing market already teetering on the brink thanks to a retrenchment in credit demand due to record prices, high interest rates and declining confidence. The Review is expected to announce the government’s intention to introduce a ‘gold standard’ mortgage accreditation. The aim is to unblock the mortgage lending market for more credit-worthy borrowers by solving this classic economic problem.
This might be done by reserving the seal of approval for home-buyers who borrow no more than 90% of the value of the house, or those who borrow only a low multiple of their annual income. Thus identified, these safe borrowers would then be showered with cheap credit, saving the housing market from slump, the economy from a crash and the government from the ire of the voters. So will Mr Darling’s kite-mark solve the problem? Unlikely though it seems, the answer lies in the second hand car market again.
Despite Akerlof’s observation, a second hand car market does exist. This is because in this case the market finds ways around the problem he identified. For example, dealers have to consider their reputation with customers, which will affect future business. Further, they sometimes offer warranty as a way of taking responsibility for the quality of cars they sell. And so it is in financial markets: there are numerous ways of solving the information problem so the case for government action here remains unproven. For years ratings agencies such as Standard & Poor’s and Moody’s have been helping punters understand how risky their investments are precisely in order to solve Akerlof’s asymmetric information problem in financial markets.
Their reputation has taken a knock as the crisis has exposed a possible bias in their business model: they are paid by the debt-issuers, and appear to have had a tendency toward excessive optimism in estimating the probability of default. But it’s not clear why the government thinks it would do a better job than could these experts. In reality by pushing the kite-mark plan the government is busy solving yesterday’s problem.
In the years of free-flowing credit, banks lent money to safe and not-so-safe borrowers and then sold those IOUs on in the markets. While asset prices grew, investors and ratings agencies took their eye off the ball and questions about the variable quality of this debt went unasked. But as the US sub-prime crisis has gathered pace, banks have suddenly found themselves with billions in risky debt on their balance sheets, unable to be sold on, as wary investors fear for the quality of what they would be buying. As a result mortgage finance has all but dried up.
But investors’ caution about mortgage-backed securities is not now the result of insufficient information about the reliability of the original borrower. The necessary information about the quality of the mortgager is surely available, as evidenced by banks belatedly tightening up their lending to risky borrowers. The deterioration of credit conditions for other borrowers is, however, the result of investors responding rationally to getting their fingers burnt. For these mortgagers the current problems stem not from a lack of clarity over their creditworthiness, but from the chain of complexity between the mortgager and the ultimate lender, mediated by impenetrable legalese and arcane financial vehicles. No amount of government enticement is going to change that.
As Warren Buffet said, to change the metaphor, it’s only when the tide goes out that you find out who’s swimming naked. While it might have been helpful for the government to identify the skinny-dippers back in years of reckless lending, as we reach low-tide it’s a bit late for that. It might make the government feel better to look like they’re doing something, but pointing and shouting isn’t going to help anyone now.
Ian Mulheirn is Chief Economist at the Social Market Foundation think tank.
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