Here’s an interesting juxtaposition from today’s Salt Lake Tribune.  On the front page, we have an article about an alleged Ponzi scheme that lifted $170 million from investors.  On the front of the Money section, we have an article about today’s crowdfunding conference at the University of Utah, which unfortunately I’m not able to attend.  (You miss out on so much by having a job…)
Here’s a quote in the crowdfunding article by Berkeley Geddes, head of a professional association:

“The crowd has a powerful ability and can say, ‘I know this person’s past and I can vouch for him, or I know his past and I have some concerns,’  Geddes said. “The crowd has a unique ability to help make sure that the entrepreneurs asking for the money” are legitimate.

I presume there were people vouching for alleged Ponzi schemers, too.   Potential crowdfunders should probably worry about the incentives of the people doing the vouching, which raises the question of who’s going to vouch for the people doing the vouching.   And then who’s going to vouch for the people vouching for the people doing the vouching.  And so on.

City Weekly called a couple days ago with a few questions about the recently passed JOBS Act, and specifically about the new provisions for “crowdfunding” of small startups.  The article is here.

“Financial intermediaries” are institutions — banks, venture capitalists, private equity, angel investors — that make money by connecting investors with good investments.  If you have a deposit account at a bank, the bank is essentially borrowing money from you (paying you a low interest rate) and then lending it to someone else (and charging them a higher rate).  The bank makes a buck on the spread.

One question to ask with any sort of intermediary is why the parties on either side of the transaction can’t simply go around the intermediary.  That is, if the bank is paying you one percent but charging a borrower three percent, then why can’t you just call up the borrower and offer to lend at 2%?  You earn a higher interest rate on your money, and the borrower pays a lower rate.  This would cut out the middleman, and the banks would quickly go out of business.

This observation suggests that intermediaries can survive only if they’re doing something better than you could do it yourself.  In the case of financial intermediation, one of the big possibilities is that banks/VCs/angels are better at distinguishing good investments from bad.  If borrowers know better than potential lenders whether their investment opportunities are likely to pay off, then you can easily get a market for lemons, which is a subject I blogged about in long-winded, four-part fashion back in 2009.

So I think the whole crowdfunding thing is a bit more complicated than just saying “Hey, let’s use the internet to allow investors to connect directly with promising startups.”  Banks and VCs do things that us regular people just aren’t good at — like reading financial statements and assessing future market growth — and the internet isn’t by itself going to make us a lot better at these tricky tasks.

Financial intermediaries are really interesting to economists, probably because the very fact that intermediaries exist tells us something about when markets work well and when they don’t.  I’m attending the Financial Intermediation Research Society annual meeting next week, and you probably don’t need me to tell you what a good time that is….

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.