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Risk Latte - Market for Lemons and Credit

Market for Lemons and Credit

Rahul Bhattacharya
September 16, 2007

A strange thing has happened recently. The market for LIBOR, the interbank market for borrowing and lending short term money between top tier banks in London has almost dried up. Almost! The Sterling , Euro and Dollar short term rates, as measured by Euribor and GBP and US Libor, have significantly shot up in the last month and have stayed there. Yet, given such attractive rates, a bank with excess liquidity is not willing to lend to another with a shortage of liquidity. Why would a bank with excess funds not lend to another bank (or for that matter any other institution) at such high interest rates?

As the credit crisis has unfolded in the U.S. and Europe the lenders of short term money have disappeared. And this has happened despite the fact that short term interest rates have become very attractive. This has made the equilibrium model of Traditional economics (neoclassical theory) stand on its head. Why?

The obvious answer is that a bank with excess funds is not sure that it will get back the funds on time, or get back the funds at all, if it lends to another which has an immediate need for it; essentially, the bank with money is not sure about the quality of the balance sheet of the bank which does not have money, even though, in all likelihood most banks do indeed have very high quality assets on their balance sheet. The realization that there is a distinct and a not so insignificant possibility that a Barclays, a Lehman or a Bear Stearns can default is driving the market for Libor aground.

A similar predicament grips the credit derivatives and structured finance market; the market for CDS, credit default obligations, leveraged loans, etc. Banks lending money for structured products transactions to special vehicles or to private equity firms (to finance leveraged transactions) are no longer sure about the quantum of the risk that they face (a truly scary scenario!) or (even scarier!!) where these risks ultimately lie. In simple terms, lenders of money are not sure if they have enough information about the borrowers (or the quality of the assets of the borrowers) and whether the borrowers are disclosing to the lenders full information.

In a famous paper, written in 1966-67, on information asymmetry in economics the Nobel prize winning economist George Akerlof talked about the market for "lemons". Imagine a used car market where there are good cars and bad cars ("lemons"). Buyers and sellers of used cars do not share information about a used car uniformly with each other. The buyers of the used cars think that the sellers have more information than them about the car that they are selling. Thus, in the absence of full and accurate information, the buyers are unable to distinguish between good cars and bad cars and therefore are willing to pay only the average price for a car. And given the fact that the buyers will only pay the average price of a car, regardless of it being good or bad, the owners (sellers) of good cars will withdraw from the market leaving only the bad cars. Eventually, the entire market for used cars will disappear.

Ever since that fateful paper forty years ago, almost to the date, we have been living in a world of asymmetrical information; where decision making is based on incomplete information and there is a fundamental disconnect, in terms of the knowledge about the product (or even a service), between buyers and sellers of goods and services. And this drives a knife right at the heart of all equilibrium models of Traditional economics.

Is this something that is happening in the credit and credit derivatives markets these days? Have credit and credit derivatives finally become "lemons"?

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