Great interview

with Steve Waldman, who I should read more.  Excerpts:

I think the government should define vanilla mortgages, whose terms are standard and widely understood and vary in a single dimension. For example, “vanilla” 30 year fixed mortgages from different banks would be identical except for the interest rate. Consumers would not be compelled to stick to the vanilla contracts, and it might not be necessary to compel banks to offer them. But since the terms of the vanilla contracts would be widely understood, risk-averse customers could comparison shop loans without fear that lower apparent costs are offset by some tricky hidden “revenue enhancer”.

I think the government has chronically oversubsidized mortgage lending and homeownership. We cannot know what would have been, but I think we’d have a different and better housing market if we didn’t tilt the scales of the buy/rent decision towards BUY BUY BUY. The business of shelter provision for middle class families is horribly inefficient, literally a cottage industry. Absent all the subsidies, middle-class housing might have become professionalized by now, which could lead to enormous savings in money and aggravation for people who now waste time fighting with plumbers and roofers on an ad hoc basis. It’s remarkable that homeownership rates have kept rising even as people’s tenure in jobs has fallen and mobility has grown more valuable. We’ve made homeownership a totem of middle class prosperity. In doing so, we may have, um, foreclosed consideration of a variety of superior arrangements.

I agree with both of these ideas (but am still troubled by the notion of "walking away" as something that's morally acceptable).

Hat tip:  Felix Salmon

Also hope to respond to Felix's post on neg am mortgages in the next day or two.  I can't get on board with his simple solution of simply banning neg am mortgages - I think it's both intrinsically a bad idea and politically impossible.  But more on that, hopefully, later.

Would a Consumer Financial Protection Agency end this?

One result of the recent financial crisis is a call for increased consumer protection.  I'm interested in this idea and, in general, wish that people were more numerate.  There are many things I want to say about consumer protection, but I'm having trouble organizing my thoughts.  So I wanted to post a single example and try to generate some discussion about whether/how the proposed consumer protection mechanisms would affect it.

About 3 years ago, I was considering buying a house and went through the process of getting pre-approved for a mortgage.  I was, obviously, given a (mortgage) dollar amount that I qualified for.  What I didn't expect, though, was that I was given a variety of schedules illustrating the various debt structures and their respective payoff features.  That is, I was given excel files for:

• An 80% 5-1 ARM with 10% down and a 10% 2nd mortgage
• An 80% 5-1 ARM with 5% down and a 15% 2nd mortgage
• An 80% 5-1 ARM with 0% down and a 20% 2nd mortgage
• An 80% interest only 5-1 ARM with 10% down and a 10% 2nd mortgage

I suspect that not all of these would be available to me right now.  But the one I'm most interested in is this one:

• 90% pay option ARM

Here's a snapshot of the Excel file.  (Click to enlarge)

(There's some type of misprint, because all the other files were based on $400k purchase price.  So I think the LTV should be 80% rather than 90%.  But put that aside for now.)

I think this is exactly the type of mortgage that caused so much trouble.  It's a negative amortization loan - if you make the minimum payment each month, your mortgage balance will increase over time.  Unless you are in the odd position of having very little money now and know that you will have substantially increasing money in the future, this is almost certainly a bad idea.  But look at how this document (advertisement?) compares the monthly payments to other mortgage options (Step 3) saying "LOOK, THIS OPTION IS BETTER THAN THE OTHER MORTGAGES YOU COULD GET.  YOUR MONTHLY PAYMENT WILL BE LOWER."  It helpfully does this with a nice green arrow.

In case the prospective borrowers find something fishy about this, Step 5 provides the monthly maximum payment.  It reassures the borrower that, even if the rate increases to the maximum, the Year 5 payment is still lower than the other options.  "THIS IS THE MAXIMUM MONTHLY PAYMENT YOU'LL MAKE, LOOK AT THE SAVINGS.  ALSO CONSIDER THAT MOST PEOPLE DON'T EVEN LIVE IN THEIR HOUSES FOR MORE THAN 5-7 YEARS."

So what's missing?  Step 6, the one that would say, "YOU ARE TOTALLY FUCKED AFTER YEAR 5."

My thoughts on this are similar to something I just read on Bronte Capital.   It involves another business model that, I would argue, is aimed at convincing people to make poor financial decisions:  the Rent-To-Own model.  As the post says:

The business model is disarmingly simple.  You have shops with 200-300 stock keeping units (running the shop is not the business).  They sell things on a very simple mark-up basis.  The advertised price of the thing (a TV, a couch) in the shop is 100 percent mark-up on the invoice price.  However the real price is 48 monthly (or more realistically 208 weekly) instalments based on recovering 400 percent of the invoice price.  If the TV wholesales for $1000 then the monthly instalments add to $4000.

My question is this:

Regarding this particular Pay Option mortgage, what would the consumer financial protection agency do?  The terms seem to be fairly well laid out and, presumably, are truthful.  It's a legal product that would possibly be useful to at least some (very small) part of the population.  Yet, just as the author of the Bronte Capital post, I am offended by this mortgage.  It doesn't feel right.  I've got a good financial background, so I understand the repercussions of this mortgage, but many people wouldn't.

But, for the life of me, I can't figure out on what grounds I should want to eliminate this type of mortgage.  I suppose you could make the argument that they shouldn't be able to nudge me in the direction of a dangerous financial product by using pretty illustrations, but at that point we're treating the lenders like cigarette makers who aren't allowed to direct advertising to minors.  (Bye, Joe Camel!)

Even if many people can't make sophisticated financial decisions consistently, we shouldn't protect them (literally) the same way that we protect children from cigarette advertising, right?

If this type of product would be covered by a financial protection agency, how would it work?

And if it wouldn't be covered by a financial protection agency, are we perhaps missing the forest for the trees?

A conservative safety net

When I think about proponents and opponents of "safety nets", in general I tend to think of liberals and conservatives, respectively.  Certainly the traditional safety nets of welfare, social security, and unemployment are typically on the liberal end of the spectrum.  Something like job training and relocation assistance for jobs lost to outsourcing are also liberal issues, I think, although they get some conservative support because they're often bundled with free trade advances.  (I think the biggest critics of bank bailouts have been conservatives, as well, although there's been criticism from across the political spectrum.  The conservative side, I think, views the bailouts as problematic because of moral hazard issues, while the liberal side views bailouts as problematic from an increasing wealth inequality perspective.)

So is it that liberals believe in a "theory of safety nets" and conservatives don't?  It seemed that way to me, but I think there's a very large counterexample:  medical tort reform.  In fact, I think it's a decent parallel to the issues of increasing incentives for investing.

Doctors are frequently accused of practicing defensive medicine, engaging in suboptimal processes in order to reduce expected litigation costs rather than improving expected patient outcomes.  It's a classic principal agent problem, where the incentives of the doctor are not aligned with the preferences of the patient.  So how do we incent doctors to make better medical decisions?  I think of the same choice set that I described earlier:
A.  Increase the benefits to good outcomes.
B.  Decrease the costs of bad outcomes.
C.  Increase the probability of a good outcome.

[An immediate concern:  outside of the extremes (death/full recovery), it is probably difficult to identify a good outcome from a bad outcome.  Even worse, it's probably very difficult to establish an appropriate benchmark.  For example, a patient comes in with poor health (let's think of video game terms and say they have 60 health out of a possible 100).  The doctor treats the patient and the patient subsequently has 55 health.  Is that a good outcome or a bad outcome?  The evaluation should be based on what the outcome would have been absent any treatment, or perhaps compared to other possible treatments, not to the original 60.  So it's a tough game to play.]

This is one case, it seems to me, that the conservatives fall squarely on the side of safety nets.  They want to enact tort reform so that if there's an unfavorable outcome the doctor is fairly protected:  a reduction in the cost of failure reduces the doctor's aversion to failing, which reduces the inclination to practice defensive medicine.  Seems pretty straightforward to me.

But, just as critics of welfare and social security point to the moral hazard problem (knowing that they will be supported by future taxpayers, individuals are likely to act irresponsibly and lazy), doctors who are shielded from the cost of failure are likely to act less carefully in their treatment.  

So why is it that proponents of tort reform believe that the incentive benefits outweigh the moral hazard costs?

More on risk and investing

Earlier, I wrote:

So why is it that I see so much push towards increasing payoffs to investment, but relatively little on enhancing the safety nets for failed outcomes?  I mean, it's understandable to think about the successes, but we can't ignore the "risk" in "risk-taking".  If we truly want to encourage people to take more risks, with the belief that risk-taking promotes economic growth, shouldn't we be using a full mix of incentives?  In other words, why so much "Incentive A" from above, but so little "Incentives B & C"?  Especially since, in my personal view, the likelihood that my future huge estate will be taxed upon my death is an infinitely minor reason for me not to strike out on my own. 

I recently saw an interesting post by James Kwak on this issue. He writes about how his experience contrasts with the conventional wisdom that "successful entrepreneurs get that way by taking big risks".  The punchline (for me) is here:

The best encouragements to productive risk-taking are measures that limit the cost of failure for people who are actually creating something new, and this is one reason why Silicon Valley has been so successful. The financial risks of starting a company aren’t that big, for most people. High-tech companies are typically started by people who could pull in low-six-figure salaries working for other companies, so they’re giving up a couple of hundred thousand dollars in opportunity cost; the rest is typically angel investor or venture capital money. More importantly, there is (historically, at least), little stigma attached to failure, so there’s little reputational downside to a failed startup. In a world full of risk-averse people, that’s very important.

Obviously, I agree.  I think we should be concerned about how to motivate product investment, but I currently believe that taxation policies (particular estate tax issues) are secondary to other (dis)incentives.**  So, again, my punchline is that the idea of a safety net is important.





**I'm speaking in terms of individuals deciding whether to start a business, not on corporations deciding whether to make incremental investments.  I think it's clear that taxation is a first-order effect on the large corporate level.  My thoughts are focused on what motivates individual and small business investing decisions because I keep hearing how those are the engines of the economy that will drive us out of the recession (although, technically, the recession is over I guess).  

Does it matter whether markets are efficient?

Reading the series of New Yorker articles with Chicago economics/finance faculty, I was struck by how frequently the idea of of efficient markets came up.  Something like, "How does the recent financial crisis influence your thoughts about market efficiency."  And the general response seems to be "Not very much."

There's a lot of criticism of academics and their rigid beliefs.  For example, you could stroll around the Motley Fool discussion boards and find numerous references to critiques of the theory.  It's a lot of wasted words, oftentimes with people talking past one another and arguing over semantics rather than ideas.  But my two pervasive thoughts on this are:

1. It would generate much less disagreement to describe markets as extremely competitive rather than as describing them as "efficient" or "inefficient".
2. Believing that markets are efficient is much less likely to cause troubles in your life than believing that markets are inefficient.**  If you're going to insist on a black-and-white world, you're better off believing in perfect efficiency.

**Not true if you are a credit analyst relying on spreads for your ratings.

Did the stimulus work? Make sure your priors are consistent

Lots of people have criticized the stimulus package and it’s hard for me to know whether the type of stimulus package we saw was likely to have helped us in the recent financial crisis.  But I have seen a couple of arguments pretty frequently that I think are inconsistent with one another.  And it seems to me, although I’m not positive, that these two arguments are made by the same types of critics. Of course, given that support of the stimulus (outside of those like Krugman who argued it should be larger) fell largely along liberal/conservative lines, it's not surprising that criticisms would come from one side of the aisle:

1. The stimulus package couldn’t have been successful because the bulk of it hasn’t even been spent yet.  (Perhaps represented by this type of article:  http://www.cnsnews.com/news/article/57617)
2. The Ricardian equivalence argument that every dollar of stimulus spent by the government dissuades a dollar of private investment because people rationally believe that the government’s spending will necessitate future tax increases. That anticipation causes people to save more to finance the future spending.  (This seems in line with John Cochrane in his recent New Yorker interview, here:  http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-john-cochrane.html.)

I don’t know if people rationally anticipate future inflows and outflows or if they don’t. The cheap answer (but one that’s probably right) is that they do sometimes or to some degree.  But if you’re trying to make a logical economic argument for why the stimulus couldn't have worked (rather than an empirical stab at measuring whether it *did* work), it’s a cheap argument to say that people sometimes anticipate the future and sometimes don’t.  If you have to hold or drop your belief about rationality depending on how well the implications fit your priors, that’s a bad sign.

So to be clear, if you believe that the stimulus couldn’t have worked because the bulk of spending hasn’t occurred yet, it seems that you don’t believe people anticipate the net present value of future stimulus, and act accordingly.  That is, they only change their current consumption and investment decisions when they receive the stimulus funds (e.g., as a worker or supplier).  Until they cash the check, they remain hunkered down in a state of capital preservation.

If you believe that stimulus perfectly crowds out private investment/consumption because of the expected future taxation, it seems you do believe that people anticipate future inflows/outflows and change their current behavior appropriately.  The second seems in line with the idea of people adjusting their behavior in line with changes in the anticipated permanent income.

Although I don’t have a quick example off-hand, I feel like I’ve seen both of these arguments coming out of the same corner.