AIG-LEH-Federal Reserve and Asymmetric Information. Special thanks to John Silvia, Dennis Gartman, George Akerlof and (we hope) Janet Yellen

Author: David Kotok, Post Date: September 16, 2008

September 16, 2008-a critical FOMC meeting day

“How did we get into this big of a mess?” asked the journalist.   “Asymmetric information” we quickly answered.  

Huh?  What’s that?

My friend, John Silvia, is not only my fishing partner.  He also is one smart economist and an encyclopedia of research references.   “Look at George Akerlof’s “Lemons” for guidance” he said.

Noble Laureate Akerlof wrote about how the imbalance in information between the buyer and the seller (asymmetry) can result in lesser quality paper crowding out higher quality.  His theory explains some of the financial market dysfunction we see today.  

The theory says that a security seller may know the quality, credit risk, payment stream, collateral support, etc. better than the buyer.  Hence the seller will sell if the buyer is over paying in the seller’s eyes.  The seller can unload lesser quality stuff on the buyer at a price that reflects a higher quality level.  Over time, the lower quality stuff crowds out the higher quality stuff and, eventually, the market fails to clear in a normal way.  The information asymmetry is that the seller knows more information than the buyer (nothing new there).  The financial market impact hits when the buyer realizes his information is incomplete and his guarantee is uncertain.  Then, risk premia sky rocket.  That describes today.

John Silvia’s summation: “This may be what we have witnessed in the credit markets over the past year and may be seeing again this week.  The seller of an asset that may be impaired cannot find a buyer.  The seller knows the quality of the portfolio but the buyer does not.  Quality information is asymmetric and therefore the buyer is unwilling to take risk in the trade.”

Uncertainty is heightened when the central bank constantly changes the rules and when it fails to explain itself clearly.   The result is that market agents read into the actions and the uncertainty premium rises.  The market agents presume that the Fed knows more than they do.  Right or wrong that is how markets operate. 

Fed inconsistency and insufficient explanation therefore fail to calm markets and may exacerbate their volatility and enlarge the turmoil.  We see that today in the extremely wide credit spreads.  

The Fed has done that this year by saving Bears Stearns (BSC) in March and allowing Lehman (LEH) to fail in September.  In both cases the share price suffered immensely.  No market uncertainty there.   But in the BSC case the toxic portfolio portion was placed in a Delaware LLC called Maiden Lane and the Federal Reserve funded it with $29 billion.  It appears on the Fed’s balance sheet as the Fed slowly works off the position.  

This transaction allowed the rest of BSC to be merged into JP Morgan Chase and that meant the debt of BSC and the derivative contracts in which they were counter parties did not fail.  The Fed action with BSC calmed markets temporarily and narrowed risk premia.

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