DEFINITION of 'Lemon'

A lemon is a very disappointing investment in which your expected return is not even close to being achieved, and more than likely ends up costing you some or all of the capital committed. Lemon investments can be associated with poor money management, economic factors, financial fraud or just plain bad luck.

BREAKING DOWN 'Lemon'

The most common and well-known example of a lemon is in the used car industry, where defective or poorly conditioned vehicles are bought and sold by the purchaser without prior knowledge of the true state of the vehicle. There are, however, regulations in the United States that attempt to protect consumers in the event they purchase a defective vehicle, known as lemon laws. When a person buys or sells a lemon, he may be at a disadvantage if he does not have the same information necessary to make an informed decision as the other party to the transaction. This information asymmetry is sometimes called the lemons problem, a term coined in the 1970s by economist George Akerlof.

Lemon Investments

In investing, the lemons problem commonly arises in the areas of insurance and corporate finance, most notably in investment banking. For example, many entities lost substantial sums of money in the wake of the 2008 U.S financial crisis after purchasing mortgage-backed securities derived from mortgages that were rated low risk when the risks were actually substantial. In many cases, individuals working for investment banks possessed information indicating the risks were high, but the buyers of the these banks' products lacked the same information.

Lemon Laws

The federal government, as well as state governments, has enacted laws designed to reduce lemons problems. Sometimes these laws are labeled lemon laws by legislators, particularly when they are designed to provide a process by which consumers can rectify recurring problems they experienced after purchasing a car, boat or other large-ticket item. For example, the North Carolina Lemon Law applies to new cars, trucks, motorcycles and vans bought in the state, and requires manufacturers to repair most defects occurring within the first 24 months or 24,000 miles.

Not all lemon laws are labeled as such. The federal Magnuson-Moss Warranty Act requires sellers of products that include full warranties to fix any problems with these products within a reasonable time and without charge. The Texas Deceptive Trade Practices Act (DTPA) applies to a potentially wide swath of activity that could cause lemons problems. The DTPA allows consumers to sue for triple damages if they suffer a harm as a result of buying a good or service they would not have bought if the seller had disclosed negative information he knew at the time of the sale. The federal Dodd-Frank Act passed in the wake of the 2008 financial crisis established the Consumer Financial Protection Bureau, the mission of which, in part, is to protect consumers from lemon investments.

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