That’s an astute observation. I don’t have a ready answer, but I think your #2 will produce behavior much like #1. The seller once claimed he knew what the paper was worth. Now he says he has no idea.

There’s an old expression in negotiating, “Never bid against yourself.” In this case, buyers, who already have plenty of reason to distrust sellers (first they said they were experts, now they say they are idiots), could view this ‘I don’t know what this is worth” as a ploy to make the buyer make the first offer, hoping the buyer will offer more than what it is really worth.

In other words, buyers may suspect the seller claims of lack of a basis for pricing to be a ruse to extract a better bid.

But other thoughts very much appreciated.

1) The seller knows he’s selling junk and the buyers have now become suspicious (asymmetric info)
2) Neither the seller nor the buyer really knows the true value of these products (note how many sellers are out there claiming essentially their models are “broken”)
3) Both the seller and the buyer know exactly what the value is, but the seller doesn’t want to accept vulture offers of $0.10 on the dollar for fear of what having to mark-to-market would do for the rest of their portfolio.

We’ve seen evidence for all 3 possible scenarios. Are there specific outcomes/predictions that could be made using asymmetric information theory that would allow us to test if we’re indeed in market type 1?

Model the unwinding on the used car market in the US — it’s definitely got lemons but it works pretty well: The first owner takes a huge hit for the simple reason that he wants to sell which sends a really bad signal to the market. (i.e. new cars depreciate by up to 50% in the first three years of ownership.) After that hit, the market actually works pretty well. If there’s some product line with a lot of supply at two years old, you can pretty sure it had a lot of lemons and a low price. If there’s a line with little supply, it’ll probably have a higher price.

In other words the CDO market can probably recover after this and work just fine. Whether it will get set right in the next few months is an entirely different question. It looks to me like the issuers were counting on Uncle Ben to bail them out and didn’t bother to plan for the worst case scenario.

Thanks for continuing to have the most useful econ blog out there.

Thanks from Germany for your great blog