Economics for Accountants (Part 4)

Finally returning to the much promised Part 4.

The last point I want to make about the Market for Lemons is how it helps us understand the recent financial crisis. You really can't appreciate how the crisis impacted credit markets without understanding the Market for Lemons, and here's why.

One of my favorite articles about the crisis was published in the NYT way back in October:

As Credit Crisis Spiraled, Alarm Led to Action

The great thing about this article is the description of how the entire financial system came to a screeching halt after Lehman Bros. failed. It's the regular old Market for Lemons logic, applied to credit markets. If I'm a bank, I'm happy to lend money to "plum" credit risks. What do I mean by "a plum credit risk?" It's a borrower who is very likely to have the funds to be able to pay me back. And I'm happy to lend money to lemon risks, as long as I get terms that are favorable enough to the lender --- usually, very high interest rates and a lot down. But I'd never want to lend money at a plum rate to a lemon credit risk.

And if I can't tell the difference between plum risks and lemon risks? Then the market for plums ceases to function, and borrowers with plum risks cannot borrow at plum rates.

People with lots of money --- college endowments and hedge funds --- deposit funds with big banks all the time. Making a "deposit" with a financial institution is just like loaning money to the institution, so the hedge-fund/endowment lenders will want to think about whether their commercial-and-investment-bank borrowers are plums or lemons. Because of federal deposit insurance, most of us don't worry about this issue when we put our paychecks in the bank. But if you have millions and millions of dollars, you're way beyond the upper limit of deposit insurance. And this means you could lose out --- big time --- if the bank where you've deposited your money fails.

And normally, the huge financial firms that make up the backbone of our financial system are viewed (themselves) as plum credit risks. Prior to a couple years ago, the possibility of failure for a big bank like Bear Stearns or Lehman Bros was viewed as quite remote. Banks did fail, due most commonly to rogue traders, but it wasn't something that people worried a lot about. And as a result, these firms were able to borrow funds from depositors at plum (that is, low) rates, and were therefore able to lend more cheaply.

But last September, depositors suddenly found they had no idea whether Goldman or Citi or Wells Fargo or Merrill was a lemon risk or a plum risk. If Bear Sterns and Lehman fail, who knows what's next? Lenders refused to lend to anyone (except the US Federal Government) at plum rates --- and banks' sources of capital dried up. The "freezing up" of the credit markets was 100% exactly a case of the failure of a market for plums.