Lemons Problem Research Articles

The Origins and Evolution of the Market for Mortgage-Backed Securities

The first mortgage backed security (MBS) was issued in 1968. Thereafter, the MBS market grew rapidly with outstanding issuance's exceeding $9 trillion by 2010. The growth in the MBS market was accompanied by numerous innovations such as the collateralized mortgage obligations (CMOs) and the emergence of private label alternatives to MBS issued by government sponsored entities. We trace the evolution of the MBS market and we review debates surrounding such questions as whether the MBS market has reduced the cost of housing finance, whether the MBS market is a market for lemons, and what role, if any, MBS played in the run-up and subsequent decline of home prices during the decade of the 2000s. We also detail the evolution of models for MBS valuation as developed by academics and practitioners.

Waiting for News in the Market for Lemons

We study a dynamic setting in which stochastic information about the value of a privately-informed seller’s asset is gradually revealed to a market of buyers. We characterize the unique equilibrium in a continuous-time framework. The equilibrium involves periods of no trade or market failure. The no-trade period ends in one of two ways: either enough good news arrives restoring confidence and markets re-open, or bad news arrives making buyers more pessimistic forcing market capitulation i.e., a partial sell-off of low-value assets. Reservation values arise endogenously from the option to sell in the future. Our model encompasses both lemons and signaling environments - in a dynamic setting with sufficiently informative news, the two environments have the same equilibrium structure.

Imperfect Competition and Efficiency in Lemons Markets

This article studies the impact of competition on the degree of inefficiency in lemons markets. More precisely, we characterise the second‐best mechanism (i.e. the optimal mechanism with private information) in a stylised lemons market with finite numbers of buyers and sellers. We then study the relationship between the degree of efficiency of the second‐best mechanism and market competitiveness. A general message of our results is that increasing competition may not help lemons markets in some circumstances. Moreover, increasing competition beyond a certain degree increases the distance between the first‐best and second‐best levels of efficiency.

A Scent of Lemon—Seller Meets Buyer with a Noisy Quality Observation

We consider a market for lemons in which the seller is a monopolistic price setter and the buyer receives a private noisy signal of the product’s quality. We model this as a game and analyze perfect Bayesian equilibrium prices, trading probabilities and gains of trade. In particular, we vary the buyer’s signal precision, from being completely uninformative, as in standard models of lemons markets, to being perfectly informative. We show that high quality units are sold with positive probability even in the limit of uninformative signals, and we identify some discontinuities in the equilibrium predictions at the boundaries of completely uninformative and completely informative signals, respectively.

Law as Asymmetric Information: Theory, Application, and Results in the Context of Foreign Direct Investment in Real Estate

In his seminal 1970 article on lemon markets, George Akerlof posited the possibility of market failure in the presence of asymmetric information regarding a good’s value. In the intervening four decades, the importance of accurate valuation information has grown as transnational trade has boomed. The aim of the instant article is to assess the potential impact on transnational trade of asymmetric information regarding the legal attributes of a given good. Inaccurate or asymmetric information regarding relevant legal attributes may give rise to the same problem of market failure that Akerlof initially posited. If buyers are unsure of the ownership of a good, its conveyability, or their rights and obligations in a given transaction, they might decline to transact at all. If these legal uncertainties are pervasive, transactions in that market might cease to take place altogether.Nonetheless, consistent with the remainder of Akerlof’s article, the presence of certain counteracting institutions may lessen the impact of asymmetric information, thus forestalling market failure. These counteracting institutions in the context of asymmetric information regarding legal attributes would include a fully and fairly functioning judiciary, publicized and lucid laws and regulations, and other such mechanisms that would make clear the rights and obligations of all parties to a transaction. Thus, this article addresses the possibility of law as asymmetric information in the general sense and the specific, by assessing whether asymmetries regarding property law might contribute to market failure in the context of foreign direct investment in real estate. Regardless of whether that market is a lemons market, the conclusions of this article support systemic reform in the property regimes of developing and transition economies, to ensure that shortcomings in the institutional and legal frameworks of these states do not hinder fuller economic development.

The Interbank Market after the Financial Turmoil: Squeezing Liquidity in a 'Lemons Market' or Asking Liquidity 'on Tap'

After August 2007 the plumbing system that supplied banks with wholesale funding, the interbank market, failed because toxic assets obstructed the pipes. Banks were forced to squeeze liquidity in a 'lemons market' or to ask for liquidity 'on tap' from central banks. This paper disentangles the two components of the three-month Euribor-Eonia swap spread, credit and liquidity risk and then evaluates the decomposition. The main finding is that credit risk increased before the key events of the crisis, while liquidity risk was mainly responsible for the subsequent increases in the Euribor spread and then reacted to the systemic responses of the central banks, especially in October 2008. Moreover, the level of the spread between May 2009 and February 2010 was influenced mainly by credit risk, suggesting that European banks were still in a 'lemons market' and relied on liquidity 'on tap'.

Nonexclusive Competition in the Market for Lemons

A seller can trade an endowment of a perfectly divisible good, the quality of which she privately knows. Buyers compete by offering menus of nonexclusive contracts, so that the seller can privately trade with several buyers. In this setting, we show that an equilibrium exists under mild conditions and that aggregate equilibrium allocations are generically unique. Although the good for sale is divisible, in equilibrium the seller ends up trading her whole endowment or not trading at all. Trades take place at a price equal to the expected quality of the good, conditional on the seller being ready to trade at that price. Our model thus provides a novel strategic foundation for Akerlof's (1970) results. It also contrasts with competitive screening models in which contracts are assumed to be exclusive, as in Rothschild and Stiglitz (1976). Latent contracts that are issued but not traded in equilibrium play an important role in our analysis.

Testing for Moral Hazard at the Tourist Destination

The business of package tours has seen a wide range of inferior quality, including tour operators’ misrepresentation of product information, default on contracted services, misguiding consumptions and deceitful dealings at the destination, and what is called “zero-fare” group toms in the Chinese context. Drawing upon the Lemons problem that regards asymmetric information as the fundamental cause of inferior quality, this study presents a model of moral hazard in package tours to conceptualize the broad range of inferior quality supplied at the destination. Empirical investigation of the model was carried out in China’s outbound tourism market, in which data were collected by administering a cross-sectional survey to Chinese package tourists. This study bas predicted that the variation in service quality is greatly explained by the inclusion of tourists’ knowledge of inbound tour operators’ effort in the model to denote the effect of asymmetric information on the tourists’ side. On the other hand, it has verified the positive relationship between the decrease of asymmetric information and the improvement of service quality, and hence indicating moral hazard. This study therefore has shown the model of moral hazard being of validity and empirical significance in accounting for inferior quality at the destination.

Trading Dynamics in Decentralized Markets with Adverse Selection

The authors study a dynamic, decentralized lemons market with one-time entry and characterize its set of non-stationary equilibrium. This framework offers a theory of how a market suffering from adverse selection recovers over time endogenously; given an initial fraction of lemons, the model provides sharp predictions about how prices and the composition of assets evolve over time. Comparing economies in which the initial fraction of lemons varies, the authors study the relationship between the severity of the lemons problem and market liquidity. They use this framework to understand how asymmetric information contributed to the breakdown in trade of asset{backed securities during the recent financial crisis, and to evaluate the efficacy of one policy that was implemented in attempt to restore liquidity.

Asymmetric information, adverse selection, and the pricing of CMBS

We demonstrate that asymmetric information between sellers (loan originators) and purchasers (investors and securities issuers) of commercial mortgages gives rise to a standard lemons problem, whereby portfolio lenders use private information to liquidate lower quality loans in commercial mortgage-backed securities (CMBS) markets. Conduit lenders, who originate loans for direct sale into securitization markets, mitigate problems of asymmetric information and adverse selection in loan sales. Our theory provides an explanation for the pricing puzzle observed in CMBS markets, whereby conduit CMBS loans are priced higher than portfolio loans, despite widespread belief that conduit loans are originated at lower quality. Consistent with theoretical predictions of a lemons discount, our empirical analysis of 141 CMBS deals and 16,760 CMBS loans shows that, after controlling for observable determinants of loan pricing, conduit loans enjoyed a 34 basis points pricing advantage over portfolio loans in the CMBS market.

Entrepreneurial equity financing and securities regulation: An empirical analysis

To protect investors, securities regulation generally restrains entrepreneurial ventures from entering the stock market. Scholars and regulators contend that strong rules and requirements for listing are essential to prevent the market from failing. However, these constraints can also unduly impede the growth of new ventures. We use the Canadian case to examine the effects of the relaxation of the regulatory constraints. Unlike in other countries, firms in Canada can list at a very early stage, without revenues, with a minimal size and even without writing a prospectus using the reverse merger technique. This provides a unique opportunity to examine entrepreneurial ventures listed on a public market. The quality of firms, their post-listing operating performance and strategy, and their fate largely support the opinion that strong listing requirements are essential to prevent the emergence of a lemon market. Investors involved in this market obtain very poor returns. This indicates that they are neither able to set correct prices in this market nor deal with the high level of information asymmetry therein. The reluctance of most regulators to relax the requirements for small business finance can therefore, be justified.

What is the objective of professional licensing? Evidence from the US market for lawyers

According to public interest theory, professional licensing solves the lemon problem generated by asymmetric information. In contrast, the capture theory claims that licensing aims at increasing professional salaries by restricting supply. This paper shows that the two theories can be identified using data from one regulated profession and provides an empirical application to the US market for entry level lawyers. The empirical results support capture theory.

Inverse Adverse Selection: The Market for Gems

AbstractThis paper studies markets plagued with asymmetric information onthe quality of the goods traded. In Akerlof’s setting, sellers are betterinformed than buyers. In contrast, we examine cases where buyers arebetter informed than sellers. This creates an inverse adverse-selectionproblem: The market tends to disappear from the bottom rather thanfrom the top. In contrast to the traditional model, it is the high-valuegoods (gems) that remain longer on the market, rather than the low-value goods (lemons). We investigate the consequences of this inverseadverse-selection and its potential solutions. The uninformed buyer ina traditional market for lemons experiences the qualities of the good hepurchased; instead, the uninformed seller may never realize the quality ofthe good that he sold. This renders conventional warranties and some ofthe other market and legal solutions to the lemons problem ineffective inthe gems case. We explore the way in which screening, signaling, legalduties, auctions, and keeping experts offthe market may mitigate aninverse adverse-selection problem.JEL codes: D44, D82, D86, K12.Keywords: lemons, gems, adverse selection, asymmetric information,auction

Capital Constraints, Asymmetric Information, and Internal Capital Markets in Banking: New Evidence

A growing literature investigates the role of internal capital markets in mitigating financial constraints faced by the subsidiaries of a conglomerate. Most studies have relied on indirect tests based on correlations between the cash flows and the investment of the subsidiaries. In contrast, we avoid the widespread criticisms of such specifications by providing direct tests that focus on the mechanisms through which internal reallocations of funds occur. We find that internal capital markets are operative within multibank holding companies and that they are used to mitigate capital constraints faced by individual bank subsidiaries. Furthermore, we show that internal capital management within a multibank holding company involves not only the movement of capital to those subsidiaries with a relatively greater need for capital, but also the movement of assets (loans) from less capitalized to more capitalized subsidiaries by means of loan sales and purchases among the subsidiaries. This internal secondary loan market allows banks in holding companies to avoid the lemons problem faced by stand-alone banks by making transactions with their affiliate banks. This second mechanism has been overlooked in the existing literature on the operation of internal capital markets within banking organizations. Ignoring this mechanism may seriously understate the volume of activity in the internal capital markets within banking organizations.

Asymmetric Information, Adverse Selection, and the Pricing of CMBS

We demonstrate that asymmetric information between sellers (loan originators) and purchasers (investors and securities issuers) of commercial mortgages gives rise to a standard “lemons problem”, whereby portfolio lenders use private information to liquidate lower quality loans in CMBS markets. Conduit lenders, who originate loans for direct sale into securitization markets, mitigate problems of asymmetric information and adverse selection in loan sales. Our theory provides an explanation for the pricing puzzle observed in CMBS markets, whereby conduit CMBS loans are priced higher than portfolio loans, despite widespread belief that conduit loans are originated at lower quality. Consistent with theoretical predictions of a “lemons discount”, our empirical analysis of 141 CMBS deals and 16,760 CMBS loans shows that upon controlling for observable determinants of loan pricing, conduit loans enjoyed a 34 bps pricing advantage over portfolio loans in the CMBS market.

Hotel Quality Appraisal on the Internet: A Market for Lemons?

Potential guests have difficulties in obtaining reliable ex ante assessments of hotels because of the adverse selection problem. Consumers now have a new source of information about hotel quality: information providers on the Internet. The key issue is the degree of reliability of this information. Two types of Internet information providers can be distinguished: those that also sell the assessed services (‘sale Websites’) and those that do not sell services (‘advice Websites’). The former obtain their income via fees, while the latter obtain theirs via advertising (number of hits). It is argued that the information on advice Websites is more reliable than that on sale Websites because the latter suffer from a misalignment of incentives arising from the inverse relationship between income/reward and the quality of the report. Our results show that sale Websites (fee financed) provide an assessment of the quality of their hotels which is on average 7% higher than the equivalent assessment of advice Websites (advertising financed). This difference increases significantly with the hotel category, with up to a 9% increase for five-star hotels. It is also shown that there are systematic differences in the quality appraisal between these two types of information providers. The main implications for tourists and hotel managers are outlined.

Issuer Credit Quality and the Price of Asset Backed Securities

Following the financial market crisis of the past few years, critics and scholars have identified numerous problems related to all parties associated with securitization, including investors, rating agencies, issuers, underwriters, and borrowers. Some of this research focuses on the rating process itself. Adam Ashcraft, Paul Goldsmith-Pinkham, and James Vickery (2009) show that observable credit fundamentals deteriorated relative to ratings between 2005 and 2007. Efraim Benmelech and Jennifer Dlugosz (2009) find that collateralized debt obligations (CDOs) rated by only one rating agency are more likely both to be downgraded and to suffer more severe downgrades than CDOs rated by more than one agency. Joshua Coval, Jakub Jurek, and Erik Stafford (2009a) point out that ratings of CDOs were highly unreliable due to models that were highly sensitive to even small errors in economic projections or losses and that underestimated the correlation of risks across various debt securities. Other research focuses on the conflicts of interest between parties who participate in the underlying processes of originating and bundling loans and collecting payments from delinquent borrowers. Chris Downing, Dwight Jaffee, and Nancy Wallace (2009) find that some residential mortgage backed securities trade in a market for lemons where originators can use private information to determine which mortgage Issuer Credit Quality and the Price of Asset Backed Securities

DECENTRALIZED TRADE MITIGATES THE LEMONS PROBLEM*

In markets with adverse selection, only low‐quality units trade in the competitive equilibrium when the average quality of the good held by sellers is low. We show that under decentralized trade, however, both high‐ and low‐quality units trade, although with delay. Moreover, when frictions are small, the surplus realized is greater than the (static) competitive surplus. Thus, decentralized trade mitigates the lemons problem. Remarkably, payoffs are competitive as frictions vanish, even though both high‐ and low‐quality units continue to trade, and there is trade at several prices.

More Information, More Ripoffs: Experiments with Public and Private Information in Markets with Asymmetric Information

It is well known that asymmetric information can be a catalyst for producing a lemons market. What is much less well known is how different institutional arrangements and their concomitant information conditions affect the lemons outcome. We conduct a laboratory experiment to examine the role that two different types of markets—two-sided multilateral negotiations and posted offers—play in an environment with sufficient conditions to yield a lemons outcome. We also investigate the effect that publicly available prices and advertisements have on buyers and sellers in a posted-offer market.

How Trust is Abused in Free Markets: Enron’s 'Crooked 'E’'

A market can have a lemon's problem when one party to the transaction has far superior information to the other and defects are not obvious. The classic bad car, the lemon led to the name for this theory. A lemon's market is inefficient. Both consumers and reputable sellers of high quality goods are harmed by the consumer's inability to distinguish superior goods. Frauds, who sell poor quality goods by misrepresenting quality are the only winners. Markets beset by lemon's problems may be improved by government intervention, which can aid both consumers and honest sellers.In his article How Trust is Achieved in Free Markets, Dan Klein, a libertarian, argues that government intervention is not necessary to deal with lemon's problems because the markets do so. A variant of Dan's reasoning lies at the heart of modern corporate governance. Its leading scholars assert that fraud by controlling persons is minimal because legitimate firms successfully distinguish themselves from control frauds. They do so through three primary devices: hiring top-tier outside auditors, insuring that their CEOs own large amounts of the company's stock, and having the company take on large amounts of debt. The S&L debacle and the ongoing financial crises have shown that this confidence in the ability of markets to discern control frauds was misplaced.White-collar criminologists are less sanguine about the ability of honest firms to distinguish themselves from the control frauds in many contexts absent effective regulation. Fraud always involves the creation and abuse of trust. Fraudulent firms love it when legitimate firms adopt signaling devices that they can mimic. This creates greater trust and allows more lucrative fraud. Moral restraints and legal prohibitions, in a functional, representative government, are generally mutually supportive. They can also support, instead of supplant, voluntary agreement.