Buying and Selling Used Cars and CDOs
Team Latte
March 4, 2008

Sometimes in early December 2007 we asked two groups of around 75 market professionals, mostly sell side derivatives sales and structuring professionals, in Asia and Europe two simple questions. The first question, asked to the first group, was:

Q#1: “If you had only two career choices in your life ,and both jobs paying identical amount of salary (but a variable bonus), one being a salesman selling Collateralized Debt Obligations (CDOs) and the other being a salesman selling used cars, then would you rather sell CDOs or used cars?”

Almost 98% of the respondents came back with the answer “CDOs”. They would much rather sell CDOs for a living than sell used cars. Only a very few, two economists and a handful of hedge fund managers responded by saying they would prefer to sell “used cars”

Then we asked an identical group of professionals (matching the former group in job profile, age group, professional background and organizational profile) the second question was:

Q#2: “If you had only two choices for investment (buying assets) then with your funds, would you rather buy CDOs or a used car(s) with equivalent market value?”

This time more than 80% of the respondents said that they would rather buy used cars with their money than invest in CDOs. Some, and interestingly, quite a few traders, said that they are comfortable with buying CDOs. We had also asked the respondents to give us a brief – one line – explanation for the reason behind their choice. And every member of both the groups responded.

We didn’t know what to make of the above response; of course, the sample (population) size for both the groups was very small and hence it may not be statistically significant. But the responses were nevertheless very interesting.

Many of the respondents from the first group thought this was a bizarre question to ask. How could one compare a product like CDOs with used cars? Some thought we were nuts to compare the two products on a complexity scale; CDOs were, in the words of one derivatives professional, a million times more complex than a user car? Very interestingly, quite a few of the respondents gave detailed explanations to us – in a manner that a father would explain to his five year old kid – as to why selling CDOs is an intellectually stimulating task given the market and the product complexity.

Respondents from the second group came up with equally interesting explanations. Almost, all who responded by saying that they would rather buy a used car than a CDO explained that they would prefer to buy a used car because if need be they can flog it in the market and get more cash from the sale than if they were to sell their CDOs. In other words, a used car would have a higher re-sale value than a CDO.

After receiving the responses we asked ourselves these questions: why perfectly rational and economically savvy professionals would want to sell CDOs for a living but would not want to buy them for their own portfolio? Is it that we like to sell complex products (CDO) to others but when it comes to owning an asset or buying a product we would like to own or buy a simple one (used car)?

Let’s talk a bit about the used cars first.

Why do people prefer to purchase new cars over used cars? This was a question that was asked by George Akerlof in the late Nineteen Sixties. It was also the question that would eventually make him win a Nobel Prize in 2001. And it is a question so profound that no financial market practitioner, be it an economist, a trader, a derivatives salesman, a regulator or an investment banker can afford to ignore.

Take a hypothetical – though a very good replica of any real – used car market. There are good used cars and defective or bad used cars (what Akerlof called “lemons”). The buyer of a used car does not know whether a car is good or bad, though the seller possesses that information. The seller of a car knows, beforehand, whether his or her car is good or bad (i.e. it is a “lemon”). Hence, a priori there exists asymmetric information in the market. Sellers have an advantage over the buyers. The buyer of a user car recognizes this fact and hence, in the absence of perfect and accurate information, he would treat all used cars available in the market of average quality. Hence, he would only offer an average price for a used car that he wants to buy.

This would create a problem for the seller of a good used car. He would want a higher price than the average price for his car, because his car is indeed good. But he cannot get that price because the buyer will not offer him a price more than the average. Therefore, all the sellers of good used cars will withdraw their cars from the market. This means that only bad used cars and moderately good used cars will remain. And because of the withdrawal of the good used cars from the market the buyer will revise down his average estimate for the price of a used car. Then the sellers of moderately good used cars will not get their price, because the buyer has lowered his bidding (average) price. And so they will then withdraw their cars from the market. This process will go on and it will be like a vicious cycle.

Eventually, the entire market for the used cars will disappear or come to a standstill. This is one of the reasons why most people would prefer to buy a new car than a used car. In a new car market there is no apparent asymmetric information between the buyers and the sellers.

Akerlof’s insight was that asymmetric information on either side of the divide – the buyers and sellers of used cars – will cause the market for the used car to break down. Isn’t it what has happened in the CDO markets recently? On February 11, 2008 the Financial Times reported that “…..issuance of collateralised debt obligations grinding to a near halt worldwide.” In January 2007, CDOs worth US$22 billion were sold worldwide. In January 2008, only three CDO deals were structured, worth only US$1.3 billion.*

It seems – and this may seem totally counter-intuitive – that the biggest factor in decision making for consumers and investors is how much information they have, a priori, at the time of purchase, about the product or an asset. Issues like complexity or sophistry of the product, its utility to the buyer, etc. are all secondary issues.

Now let’s consider the case of comparing CDOs and used cars.

When it comes to buying, all other things being equal, you would prefer to buy a used car over a CDO because you believe you have more information about a used car than a CDO. The CDO market itself has become like the used car market. The buyers of CDOs, the institutional investors, hedge funds, etc., in the aftermath of the present credit markets crisis, have very little or no information about how these instruments are priced and modelled and therefore would not be able to tell a good CDO (if there is one!) from a bad CDO and would offer an average price. In fact, given the current extreme market conditions, buyers of CDOs would perhaps offer and extremely low price on such an instrument which would leave no incentive for a seller of a CDO to come to the market.

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