The Market in Toxic Cars

Mark Thoma has an extremely useful post that helps elucidate the structure of different plans for dealing with “toxic assets” by way of a little analogy. Here’s the setup:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars – the engines blow up and the cars are then worthless – and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer’s “balance sheet” – the cars on its lot – are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.

If all the cars were in perfect shape, they would sell for $20,000 each. Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to one way of doing the accounting, but that doesn’t necessarily represent the true value of the cars on the lot.

The town where this dealership is located relies upon this business for jobs, it is essential, but, unfortunately, business has fallen off to nothing. Nobody is willing to risk losing $20,000 by purchasing a car that might die just after purchase, so the price has fallen. The expected value of a car is $10,000, but it’s an all or nothing proposition, the car runs or it dies, and since people are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is willing to accept.

Thoma outlines three different ways the government might try to intervene in the market and create a situation where at the end of the day the bad cars are on the crap heap, the good cars are in the hands of customers, and the car dealership has enough financing to get more inventory.

You really need to click over to read the full analysis, but the choice between the Geithner Plan and a nationalization plan winds up mostly hinging, in my view, on how you feel about the management of the car dealership. You might find the idea of a government-owned car dealership—even just temporarily owned—very troubling. The dealership would be managed according to political dictates and subject to the whim of the local legislators. This might wind up being a very poorly managed car dealership, indeed. And you could create a situation in which nobody wants to buy the dealership under the conditions the legislature is attaching, but nobody wants to compete with it either since the dealership can operate with government subsidies. Hence, you’ve got a situation where the town depends for employment on make-work jobs at an inefficiently-run state-owned car dealership.

Another view you might take is that there’s something badly wrong with the managers of the car dealership. Somehow they wound up with all these undetectable bum cars in their inventory, even though the presence of such a mass of bum cars wrecks their entire business, and even though they’re allegedly experts in assessing cars. If you rescue the dealership in a way that keeps existing management in place, it’s not clear where this leaves you going forward. What’s their business going to be? Will they start buying good cars and reselling them at a profit? But if that’s their business, then how come they weren’t doing that in the first place? Are they going to go back to buying bum cars and trying to pass them off as good ones? How long is that going to last? And what problem have we really solved?

There are risks either way. The Saab Story sounds better to me, but people who have a higher regard for private enterprise and its titans than I do will see it another way.