The market for lemons: How information contributes to efficiency

January 05, 2010

Information is to an economy as gas is to a car: An auto can't run without it, and impurities in the fuel can thwart efficient operations.

Consider, for a moment, all of the many ways in which information contributes to the functioning of the economy. Investors need it to assess the quality of the issuers of stocks and bonds. Employers want it to evaluate potential employees. Consumers seek it to help them pick reliable products and trustworthy service providers. Colleges use it to pick the best applicants.

A lack of solid information can undercut a market's efficiency. Some financial experts, including William Boyes, an economics professor at the W. P. Carey School of Business, say that's at least part of what happened in the years leading up to the financial crisis: investors couldn't get accurate information on the quality of mortgage-backed bonds and related derivative securities and thus didn't know that their bonds were destined to default.

Specifically, Boyes says, the three ratings agencies that evaluate bonds -- Moody's, Fitch and Standard & Poor's -- did a bad job, failing to accurately assess the risk of mortgage-backed bonds and derivatives. That prevented investors from being able to assess the true risk of these securities. The investors then bought too many of them and faced big losses when subprime borrowers started defaulting on their mortgages.

In effect, bad information ended up contributing to the financial crisis and the recession, which many economists say is the worst in the United States since the Great Depression.

How the mortgage market works

To understand why Boyes and others believe that bad information existed, you have to know a little more about how the mortgage market works.

Through a process called securitization, most home mortgages are pooled with others, and shares in those pools are sold as bonds. When this works, it's an essential engine in a capitalist economy: millions of borrowers receive money for mortgages at reasonable rates, and investors enjoy a better return on their money than they would by, say, buying bank certificates of deposit.

The three rating agencies -- Moody's, Fitch and Standard & Poor's -- assess and rank the quality of bonds, including mortgage bonds. Though each rater uses a slightly different nomenclature, the best bonds are referred to as Triple A. Investors rely on these ratings when deciding which bonds to buy. Some investors, including pension funds, even face a U.S. government mandate saying that they can buy only bonds ranked as "investment grade" by the "Big Three."

"The government dictates the fact that there are only three rating agencies," Boyes explains. "There are a lot of other companies that could do the ratings, but they're not allowed to get into the market. So full information isn't provided to potential investors."

Inaccurate information -- the Big Three badly underestimated the risk of bonds backed by subprime mortgages -- lulled investors into thinking that mortgage bonds were safer than they really were. As a result, investors loaded up on the securities. When subprime mortgages started to go bad in large numbers, those investors, including some of the countries' biggest banks, incurred big losses. Mortgage-backed bonds (and related derivative securities) contributed to the bankruptcy of Lehman Brothers and the woes of Bear Sterns and Merrill Lynch as well as those of a host of other financial firms.

Boyes argues that, if the federal government had opened the ratings market to greater competition, as has been proposed in the wake of the financial crisis, more firms would have entered it. This, he says, could've provided a greater diversity of opinion and insight and could've forced the Big Three to improve the quality of their ratings.

Had there been better information before the financial crisis, investors probably wouldn't have been willing to buy bonds backed by subprime mortgages, or they would've demanded that the bonds pay higher interest rates, Boyes adds. With better information, they would've understood that many subprime borrowers weren't creditworthy and were providing minimal down payments. "The bad mortgages wouldn't have been created," he explains. "Investors would've said, 'Wait a minute, I'm not going to provide these people at these low interest rates. I know that they're very risky.'"

Critical conflict of interest

Exacerbating the situation was a critical conflict of interest. Raters were paid by the investment banks that sold bonds, not by the investors who used ratings to assess risk. Some critics say that this arrangement gave the raters an incentive to bias their assessments upward: investment banks could sell highly rated bonds more readily than lowly ones. Thus, the critics say, banks would threaten to take their business to the other two agencies if one of them didn't give the desired rating.

John Makin, a visiting scholar at the American Enterprise Institute, a Washington think tank, was scathing, in a recent paper, in his assessment of this setup. "A situation in which creators of derivatives provide the monetary compensation for the very agencies that are tasked with determining the riskiness of their securities hardly constitutes a competitive market," he wrote. "Indeed, it constitutes dangerous collusive behavior."

The rating agencies have denied that this seemingly perverse incentive undercut the integrity of their analyses. But this much is plain: They did misjudge many mortgage bonds and derivatives. According to The New York Times, Moody's implicitly acknowledged that, in 2007, when it downgraded more than 5,000 mortgage securities.

The role of hidden information

Not all finance experts, of course, believe that the financial crisis stemmed mainly from limited ratings competition and misjudgments by the rating agencies. Some see hidden, or incomplete, information contributing to the "bank runs" that sank Lehman, Bear Sterns and Merrill Lynch.

Wall Street investment banks typically have financial statements that are difficult to sift through, explains Matt Rhodes-Kropf, a business professor at Harvard University. The banks own lots of different types of securities, many of them quite complex. On top of that, in the years before the financial crisis, the banks typically borrowed lots of money to fund their day-to-day trading of securities. (Debt ramps up their potential returns but also heightens the risk of bankruptcy in troubled times.)

When subprime borrowers started to default and mortgage securities started to go bad, people who had been lending to the investment banks panicked, Rhodes-Kropf says. Because of the opacity of the investment banks' operations, no one could know for sure whether the banks would be able to withstand a prolonged downturn. Lenders got scared and started demanding immediate repayment of loans. Financing dried up, and that started a chain reaction.

Panicked lenders not only couldn’t assess which banks were weak but they also couldn’t know how other investors would respond to the situation. That just redoubled the panic. A lender might believe that a particular bank was solvent, but if he thought that other lenders didn’t share his conviction, he might still refuse to provide funding. Once lots of funders bolt, a bank run ensues, and even a solvent bank can go belly up.      

"If I pull my money out and everybody else is thinking like me, that's a bank run, and you're going to lose your money regardless," he says. "If the bank's balance sheet were crystal clear, you could ignore what I might do. But as long as it's not, you have to care about what I might do and respond to it."     

Incomplete information caused by murky financial statements creates "a bad equilibrium but not an irrational situation," Rhodes-Kropf says. "Once everybody starts running, it's not irrational to run."

Information's role in the economy and its contribution to the efficiency of markets has long been a subject of research by scholars.

The market for lemons

In 2001, three economists shared a Nobel Prize for their insights into how hidden -- or "asymmetric" in economics' parlance -- information could bollix the functioning of markets. (Economists use the term "asymmetric" because some critical facts are often available to only one of the parties to a transaction. Thus their information isn't symmetrical.)

One of the three 2001 Nobel winners, George Akerlof, of the University of California at Berkeley, famously wrote about the used-car market -- or, as he termed it, the market for lemons -- to show how information asymmetries could thwart efficient outcomes.

Akerlof pointed out that used-car sellers have far more information about the history and reliability of their autos than potential buyers do. A buyer doesn't know whether any given car is a good one or a lemon. Without full information on a car, a buyer can only assume that its quality is average, if not worse. Thus the buyer will be willing to pay only an average amount for it.

Folks with good cars won't then be able to get the full value for them and won't put them on the market. Bad cars will end up driving out the good, and a market for lemons will result.

In retrospect, it's clear that the mortgage market was full of lemons, too. But without good information on subprime borrowers, the values of their properties and their likelihood of repaying their loans, few people understood that. Moreover, Boyes argues, with government interference in the market, competition could not sort the good from the bad loans. Instead, investors counted on the rating agencies to fully assess the risks. In the process, they forgot one of the cardinal rules of capitalism: buyer beware. 

Bottom Line:

  • Information contributes to the functioning of the economy: investors need it to assess the quality of the issuers of stocks and bonds; employers want it to evaluate potential employees; consumers seek it to help them pick reliable products and trustworthy service providers.
  •  A lack of solid information can undercut a market's efficiency.
  • The three rating agencies -- Moody's, Fitch and Standard & Poor's -- assess and rank the quality of bonds, including mortgage bonds. Investors rely on their ratings when deciding which bonds to buy.
  • Economist William Boyes explains that the government dictates the that there be only three rating agencies with official stature. When the Big Three underestimated the risk of bonds backed by subprime mortgages investors were lulled into thinking that mortgage bonds were safer than they really were.
  • Some experts say hidden, or incomplete, information contributed to the "bank runs" that sank Lehman, Bear Sterns and Merrill Lynch.
  • In 2001, three economists shared a Nobel Prize for their insights into how hidden -- or "asymmetric" in economics' parlance -- information could bollix the functioning of markets.

Illustration by Jessica Pullen