Mortgage refinancing is not that hard

We continuously take economic decisions. Most of the time, they are trivial. Sometimes they are important, and any sensible person thinks hard before settling on an option. Purchasing a home is complex, for example. Can one afford it? Is it the right price? How will it evolve? How is the financing? Comparatively, refinancing a mortgage is relatively easy: what is the interest saving? What are the fix costs? How long does one expect to hold this mortgage?

Yet, it appears a substantial fraction of those refinancing their home mortgage make lightheaded mistakes, according to Sumit Agarwal, Richard J. Rosen and Vincent Yao. Using a dataset that covers homeowners who only refinance to reduce mortgage payments, they find that 52% pick the wrong interest rate (off by at least 50 basis points) and 17% wait at least six months too long, likely because they do not monitor rates. That could be excused by inattention, but when you consider the amounts involved, they would need to have some very lucrative alternative uses of their time. That is quite disappointing for those who model optimizing agents.

Exchange rates and scapegoats

It is notoriously difficult to understand exchange rate fluctuations, especially in the shorter term. Predicting them is even worse, to the point that a random walk has consistently been shown to be the best predictor (with isolated exceptions). Consistently beating the random walk is seen as the holy grail in international finance.

Philippe Bacchetta and Eric Van Wincoop came up with an intriguing theory: there is no point in trying to relate exchange rate movements to observable fundamentals. Market participants react to rate changes by rationalizing them with some observed fundamental even when the true reason may be unobservable. And market participants keep changing the variables they look at. Everyone has made fun of press reports that explain that the dollar went up because of some event, and then the same event explains why the dollar went down the next day. This is what Bacchetta and Van Wincoop call scapegoating.

This is pretty much all theory. Marcel Fratzscher, Lucio Sarno and Gabriele Zinna have now found a way to test empirically this theory of scapegoats. The reason it took so long is that you need the right data: first a monthly survey of market participants on what they think is driving exchange rate movements, second the order flow data of a major market participant. The data supports remarkably well the scapegoat theory. When there is a large volume of orders, which are not public information and should thus be treated as unobservables that influence market outcomes, and one of the fundamentals moves more than usual in one way or the other, markets participants often link the latter to exchange movements. This is purely after the fact rationalizing, or as used in other contexts, superstition. How this is going to help us in forecasting exchange rate movements is not clear, though.

Foreclosure crisis: it is not about irrationality and sneaky bankers

Why has there been a foreclosure crisis in the United States? Two popular explanations are that 1) evil mortgage brokers forced people to take mortgages they could not possibly honor, and 2) those taking the mortgages did not understand what they were doing. As an economist who insists on logic and rationality, it is difficult to adopt these points of view, except that a point could be made about perverse incentives in the mortgage industry where the risk is masked and pushed unto unsuspecting people. But were mortgage holders really that stupid to think they would be able to make it? After all, I know several PhD economists who are still underwater, and they do not look stupid to me.

Christopher Foote, Kristopher Gerardi and Paul Willen come to the rescue. They argue that market participants made perfectly rational decisions given the information they had a the time, and in particular given the beliefs they had. The latter turned out to be too optimistic in retrospect though. Foote, Gerardi and Willen come to this conclusion with an interesting data analysis. They draw 12 "facts" that together contradict the popular explanations. Foremost, it does not appear that there is any correlation between exploding mortgage rates and mounting foreclosures. Also, even borrowers with spotty credit have had a remarkably good repayment history. One should thus not conclude that mortgages were designed to fail. Furthermore, all the instruments and innovations in the mortgage industry were introduced well before the past decade, and there was no significant regulatory change. Market participants knew what they were doing, had plenty of information and understood the risks. They were too optimistic though. Finally, no top-rated mortgage-backed security turned out to be toxic. The same cannot be said about similar bond-based securities.

All in all, there was nothing really wrong with the mortgage market apart from being too optimistic. In other words, there was a bubble, which can be a perfectly rational outcome. So there. But we still need to better cope with the eventuality of a bubble.

Is pardoning prisoners the best way to keep jail costs low?

I mentioned yesterday that we do not know whether capital punishment is a deterrent or not. What about imprisonment sentences? That is much harder to establish without very precise coding of convictions in multiple jurisdictions with different sentences for the same crime. Finding or establishing such a dataset should be very difficult. But maybe we can find some partial answers in indirect ways.

Nadia Campaniello, Theodoros Diasakos and Giovanni Mastrobuoni use an interesting natural experiment in Italy. There, the parliament occasionally decides on mass pardons to reduce jail crowding. When such proposals are being discussed, suicide rates in Italian prisons drop. That means clearly that prisoners do not like ex-post being in prison, and sufficiently to make life depend on it. If this matters also ex-ante (before they head to jail and in particular before the decide to commit a crime), we should see a deterrence effect. But this may be a big if.

The housing bubble: fooled by efficiency

In retrospect, the large rise in housing prices before 2007 looks suspect, many would even call this a bubble. But when you observe it in real time, it is much more difficult to judge whether house price inflation is excessive, although economists have been calling for it. A characteristic of many bubbles is that expect prices to increases forever, while it clearly cannot be true, at least in this magnitude. So somehow people are fooled.

Brian Peterson rationalizes this in a search model where the search frictions allow prices to deviate from their fundamental. The innovation of this model is that people are assumed to believe that price are not affected by the search frictions: they think markets are fully efficient.This means that instead of bargaining over the house price level, buyers and sellers bargain over house price increases. One interesting consequence of this is that turn-over volume and price inflation are then positively correlated. And once you quantify the model, about 70% of he price run-up can be explained by this "foolish" behavior.

Economists' political bias and model choice

One can count on Gilles Saint-Paul for innovative research topics. During his career, he has addressed and impressive array of topics that range far beyond Economics strictu sensu. For this reason, I have reported several times about his latest research.

His latest opus is an introspection in our profession and how our political biases influence our modelling choices. He claims that an economist with conservative inclinations will favor a model with smaller fiscal multipliers. While the ethical thing to do would be to be driven by empirical evidence, this may just be a subconscious choice. But at least economists strive to be logically consistent, and if one choose a large multiplier, then then must also claim that demand shocks are substantial, as models with large multipliers rely on this. Looking at evidence from the Survey of Professional Forecasters, Saint-Paul finds that forecasters who believe that expansions are more inflationary also adhere to the belief that public expenses are less expansionary.

Saint-Paul goes further, though. His claim is that we live in a self-confirming equilibrium. We devise theories to understand our surrounding and take decisions, and those decisions then shape the economic environment. Theories can thus survive even if they deviate from the true structure as long as the decisions make it conform. This is a statement about a lack of uniqueness of the path to the rational expectations equilibrium. In a sense, this is not too disturbing, as long as decisions are still optimal and outcomes do not differ too much from the rational expectations first best. And if this true, we will never know what the rational expectations first best is. Of broader implications would be if the political agenda of an economist would lead an economy on an different path, on a different self-confirming equilibrium. Is this why Europe and the United States are different? Were Keynes and von Hayek that influential?

Near rational agents and house price booms

House price run-ups, especially when they appear excessive, are difficult to explain. It is it even more difficult to explain how they are not coordinated across countries in a globalized world. Indeed, right now house prices are severely depressed in the United States, while you can have strong suspicions of bubbles in China, Norway and Switzerland. Bubbles are substantial deviations from fundamentals that could be due to some deviations from rationality or herd behavior, or both. But "rationalizing" this is a major challenge because of the apparent randomness of the occurrence of such house price booms.

Klaus Adam, Pei Kuang and Albert Marcet think they have a way to explain this using the concept of internally rationally agent. Such a agent, like the economist, does not know the true process of prices but tries to infer it from past observation using Bayes' rule. The belief about prices then becomes part of the state space and leads to some sort of path dependence. With shocks that are not perfectly correlated, it is then possible for different countries to experience different paths for house prices.

Emotions in economic interactions

How do you get people to cooperate. By increasing utility, of course, but that is difficult to measure, obviously, and there may some components beyond rationality in emotional contexts. However, we have some interesting ways to get some neurological hints about positive and negative emotions by measuring the conductance of skin. This may help to explain why people are sometimes willing to hurt themselves in order to punish others.

Mateus Joffily, David Masclet, Charles Noussair and Marie-Claire Villeval conduct an experiment where cooperation, free-riding and punishment can happen. They measure skin conductance to reveal the intensity of emotions and let players reveal whether their emotions are positive or negative. Cooperation and punishment of free-riding elicit positive emotions, the latter indicating that emotions can override self-interest. That is also because punishment relieves some of the negative emotions from observing free-riding. And one does not like being punished, which lends one to cooperate more in the future. Finally, people like being in a set-up where sanctions are possible, in particular because it allows a virtuous circle of emotions that reinforce each other and lead to more cooperation.

Inattention and bank overdrafts

It happens to everyone: you are not careful and despite having sufficient funds, your checking account is drying up at the wrong moment and you incur an overdraft fee from the bank. Oh well, you say, the penalty is somewhat stiff, but bad planning has consequences. But for those who have genuine liquidity problems or those that are really bad at planning, those fees can add up quickly and become substantial. Even on an aggregate level, it is important. Apparently, US banks earn $35 billion a year from overdraft fees, or a staggering $100 per capita.

Victor Stango and Jonathan Zinman study what can make that people avoid those fees. A lot has of course to do with education and self-discipline, thus reminders become an important tool. Indeed, they notice that people who were exposed to information about overdraft fees in surveys are less likely to incur such fees in the next month, by 12%, and this effect builds up over multiple exposures. This works best with those who need it the most: low education and low financial literacy. And as people avoid overdrafts by making fewer transactions, not increasing balances, it indicates they lower their expenses as a reaction to realizing that they may not afford that much spending. In other words, financial and economic literacy are important and should be favored.

The high welfare cost of small information failures

Are stock markets efficient in the sense that stock prices reflect all available information? This question has preoccupied finance lately as many have started to doubt the efficient market hypothesis during the latest crisis. One critical aspect of this is whether current tests of the hypothesis actually give an accurate picture, and if not whether this matters in a significant way.

Tarek Hassan and Thomas Mertens
claim that it is possible for stock markets to aggregate information properly, that small errors at the household level can accumulate and amplify if these errors are correlated, and that the welfare consequences can be substantial even if the initial errors were small. This cost emerges for a portfolio misallocation due to the higher volatility of stock prices. To get to such a result, they take a standard real business cycle model, add to it that households get a noisy private signal about future total factor productivity. They then look at the stock market for additional information to form expectations. If you allow households to be on average more optimistic than rationality in some state, and more pessimistic in others, you get the above results. Interestingly, Hassan and Mertens show that households face little incentives to correct individually for these small common errors (0.01% of average consumption), but collectively the consequences are large (2.4%). Talk about an amplification.

Bubbles with collateral and infinite credit

Rational bubbles occur when people believe that prices will increase into the infinite future, which makes that they invest in more assets and prices really increase. But equilibrium models have difficulties replicating such phenomena because this increased wealth also induces, at some point, people to consume more, and then the budget constraint bites and halts the bubble. So how could one still get a rational bubble? By relaxing the budget constraint.

This is what Christopher Reicher does in a way that is reminiscent of the US before the crisis: through the provision of unlimited credit, which is possible if real estate is used as collateral. This sounds rather intuitive, as long as lenders are willing to go along. What is more interesting is that the model shows that there are monetary and fiscal policies that can prevent bubbles from happening. One is to apply the fiscal theory of the price level to credit markets, that is, to make sure the price level instantaneously responds to land prices to deflate the debt. If this is difficult to implement, and it would, another way to deflate a bubble is the make sure the returns of assets are lower by increasing interest rates of bonds, which makes them more interesting than real estate. Of course, one could also tax away the bubble. And one has first to recognize that there is a bubble.

You are more trustworthy if you are drunk

One advice I give to job market candidates is to make sure they do not drink to much at dinner, or they may say stupid things. It turns out I may be wrong on that one.

Jan Heufer makes the point that being drunk or under the influence of a drug is a very good commitment device if you are trying to show truth telling. He finds that this is a possibly good argument for the legalization of some drug that is not addictive if consumed in moderate quantitites. There is a loss of efficiency because people are sometimes under the influence, but there is a gain because better contracts are written.

How simultaneously borrowing and saving can be rational

Why would one have simultaneously debt and savings? We covered previously why people have simultaneously a savings acocunt and credit card debt, in which case it is perfectly rational. Can there another case be made for rationality?

Karna Basu claim that if you know you are time-inconsistent and want to do something about it, you can set up a scheme whereby you save your wealth and then borrow when investment opportunities arise. How would this make sense? The goal is to prevent over-consumption. To do this, you need some commitment device, and in this case it is unsafe lending. People save, but because of the uncertainty about losing their holdings, their are penalized when they fail to invest. This disciplines future selves. Indeed, one could simply indulge on current consumption using the loan. However, because this is borrowed, and savings may be lost, it is too risky to be caught bankrupt next period, and one limits one's consumption. Without the risk on the savings, nothing would prevent one from over-consuming. Thus, the risk on savings is beneficial. A subtle and counterintuitive conclusion.

Economists are less generous, but not by indoctrination

From many experiments, it is known that economists are more selfish than others. the interesting question is whether selfish people select themselves into Economics, or whether Economics students get indoctrinated by the material they are covering in classes.

Yoram Bauman and Elaina Rose use data from students at the University of Washington to elucidate this. There, students can donate to social programs each quarter. This is tracked along with their taking Economics classes. While Economics majors are indeed less generous, this does not appear to evolve over time. One can thus conclude this is a section effect. However, non-majors become more selfish once exposed to Economics. In other words, economists are quite convincing.

The Bible and the price volatility

There has been a lot of talk about irrational exuberance in the housing market, of irrational fears in the current recession, and animal spirits in general. Given this, it seems natural to study whether religiosity would have had any impact on these developments. Concentration on evangelical protestants, Christopher Crowe finds that they are much more level-headed than the general population: wherever they population share is higher, house price volatility is lower.

The reasoning here is that their behavior is countercyclical. Evangelical protestants believe that we live in the end times, so any bad news is good news to them, and vice-versa. But the argument needs to be more subtle than that. Imagine that the current bad economic news is some sign of the end of the world. Then asset price should be going further down, as the horizon on which future expected returns are cumulated is shortened. This would lead to more volatility. Crowe argues instead that evangelical protestants are taught to live normally through the end times, and that they are more "joyful" when bad news, such as 9/11, occur. And this would make them spend more, including on housing.

I find this argument rather hard to swallow. But clearly, the empirics seem to be consistent with that. Also, interesting to see that the IMF is interested in this type of topic.

Momentum traders and the housing market bubble

Bubbles are very difficult to recognize, by definition: you need prices to depart from fundamentals, and in the case of housing, expectations of fundamentals play the most important role. Determining whether expectations are overblown is thus quite subjective. But I think we have now a wide consensus that there has been a bubble in the housing market for several countries. The question is obviously how this could happen.

Monika Piazzesi and Martin Schneider argue that very little is required to get a bubble. A small number of so-called momentum-traders is sufficient. Using the Michigan Survey of Consumer, they find that there are always households who think is to a good idea to buy because price will rise further, but there number doubled during the bubble. They then proceed to write down a simple search model where they demonstrate that these momentum traders, even if outnumbered, have a strong impact on prices.

This is not unlike the rise of chartists on stock and currency markets who believe that future asset prices can be determined by past trends. Eventually markets started behaving in the way they were predicting once a sufficient, but not large, number of investors where following these rules. But once these self-fulfilling propecies start deviating too far from fundamentals, the markets correct themselves and get back to fundamentals. We have seen this again and again, but some people are always going to follow Mickey Mouse financial strategies, and unfortunately they seem to influence markets.

What households are financially sophisticated?

In the current crisis, some blame has been put on households who took rather strange financial decisions, especially with respect to house purchases and mortgage products. Essentially, they were lacking financial sophistication (or even common sense). This begs the question, what are the characteristics of financially sophisticated and unsophisticated households?

Laurent E. Calvet, John Y. Campbell and Paolo Sodini answer this question using household finance panel data from Sweden. They distinguish three types of mistakes: under-diversification, inertia in risk taking and disposition effect (the unwillingness to realize losses and too high willingness to realize gains). It would not surprise you to learn that richer households are more sophisticated in financial matters, after all this is probably the reason they got rich. But, interestingly, other factors are more important. Household size matters a lot: the more children, the more sophisticated the finances. Education and financial experience matter less. Of course, exception abound, like the California octuplets mom proves. But is shows that people are much more careful when financial decisions matter: you have children, you have some wealth, you have perspectives of future wealth (being educated). If the worst that can happen to you is foreclosure and you have little to start with, foolish financial decisions will not matter much.

People overvalue their own homes

A lot of blame in the current financial crisis has been put on mortgage providers, who have been myopic and thought, erroneously, that house prices would always increase. Rationality would dictate that homeowners should have a better idea about the value of their own home and their capacity to service the mortgage (unless they were counting on foreclosure). So it is a natural question to ask whether home owners are rational: do they properly value their home? They can make errors, but they should not be systematic, as in the rational expectation hypothesis.

Hugo Benítez-Silva, Selcuk Eren, Frank Heiland and Sergi Jiménez-Martín answer this question by stating that homeowners overvalue by 5-10%. Interestingly, they also find that the homes tend to be undervalued when bought in hard times. Thus, by their own recognition, homeowners evaluate home prices with excess volatility. Why mortgage professionals were so myopic becomes an even bigger mystery.

Why you lost the office pool

Are you getting frustrated because you never win in the office sports pool despite being an expert? The problem is that office sport experts typically have some allegiance to a team or a country, and the subjective winning probabilities are higher for your idols than the objective probabilities. The receptionist, however, looks at rankings or seeds and objectively makes the best guesses.

Now think in more aggregate terms. Imagine the qualification for Euro 2008, the football tournament where countries need to play several games to reach the finals. People bet on those games and the market determines equilibrium odds. Are the markets odds the same everywhere? Sebastian Braun and Michael Kvasnicka claim that there are not, and typically the odds of the local country are too high. Thus there are clear arbitrage opportunities available, but not for long now that this is known.

We are impatient because our brains are schizophrenic

There is ample evidence that humans are impatient. The traditional assumption in Economics has been to assume that we have preferences that exogenously feature a discount factor. Isabelle Brocas and Juan Castillo claim to explain endogenously impatience by thinking about how the brain functions.

Essentially, the brain is composed of competing entities. Say that there is a principal maximizing undiscounted intertemporal utility on a finite horizon. Then, there are distinct agents in each periods, all myopic in the sense that only contemporaneous utility matters. The principal can impose choices on agents, but the latter have private information on marginal utilities. The problem is closed with an intertemporal budget constraint with a strictly positive interest rate.

Impatience emerges as a result of this asymmetric information. Each agent has independent valuation, so there is no information to be gained from one agent that would be useful on the others. However, the principal can elicit some valuation revelation by granting more immediate utility to the agent. Thus, impatience is the result of asymmetric information between the principal and the independent agents.

In the particular implementation of this problem, the only intertemporal binding is the interest rate. This is the reason why the principal wants some savings. In the model, this positive interest rate is exogenously imposed. If it is zero, there is no impatience. Then, why would the interest rate be positive in the first place? Isn't it to reward patience among impatients? Aren't we going in circles here?