Throughout the last crisis, there has been much talk about excessive borrowing by individuals (and countries), and how this seems to follow some irrational behavior. We have to understand here that irrationality is a very strong concept, in the sense that people would knowingly take decisions that are against their best interest. I am not saying this does not happen, but ignorance and wrong beliefs can lead to behavior that looks irrational but is in fact perfectly rational.
Ari Hyytinen and Hanna Putkuri explore some data from Finland and find that those who borrow excessively do so because they are much more optimistic about future outcomes. Believing that future incomes will be high seems a perfectly rational justification for borrowing, especially when the lender seems to share this assessment. What is more worrisome though is that those overly optimistic households have more difficulties revising their expectations when faced with evidence. Maybe they hate it to be proven wrong (who does not?). Maybe it is Finnish bankruptcy law that encourages them to go for broke once a point of no return is reached. The latter would be perfectly rational again.
Showing posts with label credit markets. Show all posts
Showing posts with label credit markets. Show all posts
Wealth exemptions do not matter in bankruptcy
The major aspect in bankruptcy law variation across states in the US is the wealth exemption. Some states protect substantial wealth from the creditors, the prime example being Texas where housing is exempted without limits, plus $30,000 per spouse. Maryland, however, exempts only $11,000 total personal property plus about $20,000 in owner-occupied housing. This considerable source of variation ought to lead to cross-state variation in bankruptcy rates, as several models would predict, yet the data does not show it.
Jochen Mankart explains why. He uses a life-cycle model where households borrow and save, and they are subject to a variety of shocks, the most relevant being health expense shocks, the most common trigger of bankruptcy in the United States. Varying bankruptcy exemptions, he finds no significant change in bankruptcy rates. The reason is quite simple: those who file for bankruptcy are so poor they have nothing left anyway, thus exemptions do not matter to them. Where it matters though is in the savings rate. Higher exemptions encourages especially the poor to save more. To boot, the model solves the credit card puzzle (see posts 1 and 2).
Jochen Mankart explains why. He uses a life-cycle model where households borrow and save, and they are subject to a variety of shocks, the most relevant being health expense shocks, the most common trigger of bankruptcy in the United States. Varying bankruptcy exemptions, he finds no significant change in bankruptcy rates. The reason is quite simple: those who file for bankruptcy are so poor they have nothing left anyway, thus exemptions do not matter to them. Where it matters though is in the savings rate. Higher exemptions encourages especially the poor to save more. To boot, the model solves the credit card puzzle (see posts 1 and 2).
Banking crises and income inequality
With the Occupy X movement, discussion about the unequal distribution of income has flared up. At the same time, we are still not over the banking crisis. Several people have linked the two, saying that the large banking sector has lead to more income inequality and that the rich have benefited form the crisis at the expense of the poor. We probably do not yet the data to corroborate any of this, but we have data that allow to look at income inequality through other banking crises.
This is what Luca Agnello and Ricardo Sousa set out to do with a panel dataset from OECD and non-OECD countries. They find some regularities: there is a run-up of income inequality before the crisis hits especially in non-OECD countries; it declines fast thereafter, especially in OECD countries; better access to credit reduces income inequality; and the size of government has no impact on income inequality. The estimates of the paper are rather crude, there is just a lag on the Gini coefficient. I am sure one can tease out more interesting dynamics with a structural vector auto-regression. But the results are still interesting as is.
This is what Luca Agnello and Ricardo Sousa set out to do with a panel dataset from OECD and non-OECD countries. They find some regularities: there is a run-up of income inequality before the crisis hits especially in non-OECD countries; it declines fast thereafter, especially in OECD countries; better access to credit reduces income inequality; and the size of government has no impact on income inequality. The estimates of the paper are rather crude, there is just a lag on the Gini coefficient. I am sure one can tease out more interesting dynamics with a structural vector auto-regression. But the results are still interesting as is.
Why more bad mortgages? Too much reliance on credit scores
The current financial crisis is at least partially blamed on lax lending practices in the US mortgage industry. More mortgages were provided to less credit-worthy individuals with smaller down-payments than ever before, until this house of cards fell apart. Of course, this is not the whole story, but at least there is some partial truth to it, right? Now I am not so sure.
Indeed, Geetesh Bhardwaj and Rajdeep Sengupta look at a large fraction of the sub-prime mortgages originated from 2000 to 2006. And they find that the credit-worthiness of their holders, as measured by the FICO score, actually increased (and more so than the general population). How could this be possible? One hypothesis is that mortgage issuers have gradually relied more and more on simple metrics they could enter into some software instead on analyzing other details on an application file. And if you end up relying on a single criterion, the selected applicant will look much better according to this criterion. But if this criterion is not well correlated with actual credit-worthiness and relevant information is neglected, your loan pool becomes more risky.
Indeed, Geetesh Bhardwaj and Rajdeep Sengupta look at a large fraction of the sub-prime mortgages originated from 2000 to 2006. And they find that the credit-worthiness of their holders, as measured by the FICO score, actually increased (and more so than the general population). How could this be possible? One hypothesis is that mortgage issuers have gradually relied more and more on simple metrics they could enter into some software instead on analyzing other details on an application file. And if you end up relying on a single criterion, the selected applicant will look much better according to this criterion. But if this criterion is not well correlated with actual credit-worthiness and relevant information is neglected, your loan pool becomes more risky.
European credit ratings: a case of self-fulfilling expectations
Europe is a mess, and one has to wonder why. First, there is no reason that the credit difficulties of Greece should have any consequences on the Euro. I doubt the US Federal Reserve would feel compelled to do anything if a state were to default on its debt, and nobody would claim it should. Why should it be different in Europe? Because politics want it.
To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.
To make things worse, the credit rating agencies generate self-fulfilling expectations. These are of a different kind of those that make that Greece will have to default. Witness yesterday's announcement by Moody's while threatening a downgrade of French debt: "Elevated borrowing costs persisting for an extended period would amplify the fiscal challenges the French government faces amid a deteriorating growth outlook, with negative credit implications." In other words, high credit costs would lead to a downgrade and this would lead to even higher credit costs, etc. The rating is not about the intrinsic risk of default (what rating agencies are supposed to measure) but about the expectation of where the rating should, as signaled by the cost of credit. And this after Standard and Poor's downgraded the same debt "by error." The rating agencies are clearly not helping at this point.
Why is funeral insurance so popular in Africa?
Probably the oldest form of insurance is existence is funeral insurance, which takes cares of burial (and now cremation) costs at death. In developed economies, its popularity has vanished, while it is still very common in Africa. One reason could be that when life insurance is available, people believe it is sufficient to cover funeral costs, and the beneficiaries are committed to take care of this. When life insurance is not available or when not commitment can be elicited from descendants, then funeral insurance ensure your body is properly disposed of.
Erlend Berg writes a model along those lines and finds that only middle income should favor funeral insurance. The rich do not face a tight budget constraint and the poor cannot afford it. Then using a marketing survey conducted in South Africa finds results that are consistent with the model. This lack of commitment in Africa for financial matters is pervasive. It is, for example, at the heart of the strange institution that ROSCAs are.
Erlend Berg writes a model along those lines and finds that only middle income should favor funeral insurance. The rich do not face a tight budget constraint and the poor cannot afford it. Then using a marketing survey conducted in South Africa finds results that are consistent with the model. This lack of commitment in Africa for financial matters is pervasive. It is, for example, at the heart of the strange institution that ROSCAs are.
Should small businesses be encouraged?
Small businesses are thought to be rather inefficient because of fix and because of other issues that hamper the exploitation of increasing returns to scale in their size range. Yet, policies keep popping up that try to protect them. Why? Is it nostalgia, throwing us back to times were "better?" Or do we want to protect (inefficient) employment? Even this may be moot according to a previous post.
Ben Craig, William Jackson, and James Thomson claim that small businesses should be encourage because they have an inherent disadvantage on credit markets: there are information problems, more acute in downturns, that make access to credit more difficult for small businesses. Thus, it is good for a government agency to provide loan guarantees. Still, this does not address why we would want to have small businesses in the first place. If inefficient firms are getting rationed on credit markets, I am fine with that.
Ben Craig, William Jackson, and James Thomson claim that small businesses should be encourage because they have an inherent disadvantage on credit markets: there are information problems, more acute in downturns, that make access to credit more difficult for small businesses. Thus, it is good for a government agency to provide loan guarantees. Still, this does not address why we would want to have small businesses in the first place. If inefficient firms are getting rationed on credit markets, I am fine with that.
Optimal securitization
Before the crisis, securitization of debt was quite uniformly seen as a very good idea, after all it made house ownership available to many families. After the crisis the assessment is much more negative, in fact there is a large backlash against the idea, seeing at the root of all evil. Of course, the truth is somewhere in the middle. Securitization provides a powerful way to diversify risk, but as the crisis showed, it can make fraud easier.
Guillaume Plantin tries sort this out by looking at how banks react to the availability of securitization. He points out that the risk diversification gives less incentives to banks to screen well loans. This is not necessarily a bad thing, as the optimal contract literature would tell you that the bank would be required to bear some more risk. The fact that their would be more borrower failures would have to be weighted against the increased availability of credit, and society would overall likely be a winner from securitization. The problem is that these contracts were not optimal. There is evidence that banks have been negligent if not misleading with information about the underlying loans. The issue thus goes beyond the (fixable) moral hazard with selecting loans. Indeed, when banks have private information about the loans, we have a lemons problem wherein they push the worst loans to the securitization market (and when the US Treasury buys up those loans from the banks, of course it inherits the lemons as well). The policy prescription is clear: either restrict to some degree securitization or, better, alleviate the opaqueness of the securitization market.
Guillaume Plantin tries sort this out by looking at how banks react to the availability of securitization. He points out that the risk diversification gives less incentives to banks to screen well loans. This is not necessarily a bad thing, as the optimal contract literature would tell you that the bank would be required to bear some more risk. The fact that their would be more borrower failures would have to be weighted against the increased availability of credit, and society would overall likely be a winner from securitization. The problem is that these contracts were not optimal. There is evidence that banks have been negligent if not misleading with information about the underlying loans. The issue thus goes beyond the (fixable) moral hazard with selecting loans. Indeed, when banks have private information about the loans, we have a lemons problem wherein they push the worst loans to the securitization market (and when the US Treasury buys up those loans from the banks, of course it inherits the lemons as well). The policy prescription is clear: either restrict to some degree securitization or, better, alleviate the opaqueness of the securitization market.
The impact of credit card cash-backs
Banks seem to really push credit card use on their customers, seeing all the junk mail, the recruitment stands in malls, campuses and airports, and the various incentives (frequent flyer miles, cash-backs). Why are they doing this? One would think the marginal customer is less profitable, and may even be detrimental to the bottom line as he is more likely to default.
Sumit Agarwal, Sujit Chakravorti, and Anna Lunn look specifically at cash-backs using administrative data and find that a 1 percent increase in cash-back leads to a US$68 increase in spending and US$115 increase in debt in the first quarter. While one can understand this would increase spending, it is puzzling to see the debt increase even more. Why would people substitute debt away from other cards? Indeed debt is not tied to this cash-back. It turns out this comes mostly from people who have previously barely used the card, thus they basically switch allegiance both in spending and debt. A reduction in the interest rate has similar consequences.
Are cash-backs good or bad. This paper shows that they are mostly used to steal customers from other cards. Such competition is good. However, the ones who pay for these rewards are the merchants, who face basically a duopoly and are caught between a rock and a hard place. Ultimately, the consumer ends up paying for these cash-backs through higher prices in the store, and those using cash or debit cards lose out.
Sumit Agarwal, Sujit Chakravorti, and Anna Lunn look specifically at cash-backs using administrative data and find that a 1 percent increase in cash-back leads to a US$68 increase in spending and US$115 increase in debt in the first quarter. While one can understand this would increase spending, it is puzzling to see the debt increase even more. Why would people substitute debt away from other cards? Indeed debt is not tied to this cash-back. It turns out this comes mostly from people who have previously barely used the card, thus they basically switch allegiance both in spending and debt. A reduction in the interest rate has similar consequences.
Are cash-backs good or bad. This paper shows that they are mostly used to steal customers from other cards. Such competition is good. However, the ones who pay for these rewards are the merchants, who face basically a duopoly and are caught between a rock and a hard place. Ultimately, the consumer ends up paying for these cash-backs through higher prices in the store, and those using cash or debit cards lose out.
Are payday loans any good?
Payday loans are small loans that are offered with very short terms, usually until the next payday. But because they imply exorbitant interest rates, into the hundreds of oercent in annualized rates, they are severely criticized. Yes, the payday loan industry is thriving, obviously responding to a strong demand. So it would appear that payday loans are welfare improving, or people would not use them, just as much as credit card loans are welfare improving. But many people worry that payday loans, more so than credit card loans, lead borrowers into a vicious cycle of financial dependence. So, should they be regulated out of existence or not?
John Caskey writes that the issue is really about separating two kinds of people. There are first those who fully understand the terms and the cost of the loan, but happen to face a very short term liquidity crisis, having exhausted or having no access to other forms of credit. This can happen to the best people, and happened to me. For them, the payday loan is valuable and clearly welfare enhancing as it fills some market incompleteness. And there are other people who are tempted by the easy cash and immediately face long term issues in paying the loan back. The policy maker would want to prevent the second category to get such loans, but one may ask whether the payday loan industry would want to grant them business as well: they are clearly much riskier. The loaner would want to find a way to discriminate, in particular because this allows to reduce the interest rate on the good borrowers and thus attract more of their business.
But the data indicates the second category is worryingly big. Only one sixth of payday customers borrow once a year or less. And it is estimated 5% of the population would use those loans if they were freely available in every US state, like it is currently the case in some. That would be worrisome. But when Oregon regulated the payday loan industry away, people felt more constrained. And states with payday loans have significantly fewer checks bouncing, although they also have more bankruptcy filings. The paper offers plenty of other examples from the empirical literature, but overall, there is no clear sense whether payday loans are welfare improving or not. Maybe better discrimination of customers is the way to go.
John Caskey writes that the issue is really about separating two kinds of people. There are first those who fully understand the terms and the cost of the loan, but happen to face a very short term liquidity crisis, having exhausted or having no access to other forms of credit. This can happen to the best people, and happened to me. For them, the payday loan is valuable and clearly welfare enhancing as it fills some market incompleteness. And there are other people who are tempted by the easy cash and immediately face long term issues in paying the loan back. The policy maker would want to prevent the second category to get such loans, but one may ask whether the payday loan industry would want to grant them business as well: they are clearly much riskier. The loaner would want to find a way to discriminate, in particular because this allows to reduce the interest rate on the good borrowers and thus attract more of their business.
But the data indicates the second category is worryingly big. Only one sixth of payday customers borrow once a year or less. And it is estimated 5% of the population would use those loans if they were freely available in every US state, like it is currently the case in some. That would be worrisome. But when Oregon regulated the payday loan industry away, people felt more constrained. And states with payday loans have significantly fewer checks bouncing, although they also have more bankruptcy filings. The paper offers plenty of other examples from the empirical literature, but overall, there is no clear sense whether payday loans are welfare improving or not. Maybe better discrimination of customers is the way to go.
Financial development and fertility
Why an economy's financial development matter for its fertility? For one, if there is little in terms of savings technology, then households need to find other ways in which they can save for old age, and children have traditionally been a good way to do this. But as long as property rights are reasonably well established, this should be that important, as there are many ways beyond financial assets to accumulate wealth, such as land, real estate, jewelry and cattle. Where a financial system can really bring change is when it gives access to credit for households.
Valerio Filoso and Erasmo Papagni study this with a life-cycle model where there is altruism from parents to offspring and vice-versa. They show that all depends on whether children are an inferior or a normal good, like in poor respectively rich countries. In addition, a relaxation of borrowing constraints allows greater investment in children. There is therefore ambiguity, which is compounded by price and second order effects. To sort it all out, Filoso and Papagni use cross-country data to estimate the sum of all these effects and find indeed that financial development decreases notably fertility in poor economies and increases it in rich ones. This may be an explanation for a fact that puzzled me for some time, why the US has a higher fertility than other rich countries.
Valerio Filoso and Erasmo Papagni study this with a life-cycle model where there is altruism from parents to offspring and vice-versa. They show that all depends on whether children are an inferior or a normal good, like in poor respectively rich countries. In addition, a relaxation of borrowing constraints allows greater investment in children. There is therefore ambiguity, which is compounded by price and second order effects. To sort it all out, Filoso and Papagni use cross-country data to estimate the sum of all these effects and find indeed that financial development decreases notably fertility in poor economies and increases it in rich ones. This may be an explanation for a fact that puzzled me for some time, why the US has a higher fertility than other rich countries.
Rethinking college tuition and student loans
Britain and Ireland currently go through much soul searching on how to reform the financing of higher education. As for health care, education is becoming more expensive as it is a service, which we do not know yet to scale well, while manufacturing has benefited from tremendous improvements in mass-production and can be relocated to where it is the most efficient. If higher education is becoming more expensive, who should pay for it? Obviously, there is a large private benefit to getting an university degree. Thus the student should also pay a large share. There is a social benefit as well, as a well educated workforce brings all sorts of positive externalities, which means that society should subsidize higher education as well. But not too much, as these subsidies are regressive: while rich people pay more taxes, they benefits even more from higher education subsidies, as their children are more likely to attend university and stay there longer. But if university tuition is so expensive, what to do with those students who are credit constrained? Should they get subsidies, loans, or just deal with it?
Neil Shephard suggests a complete overhaul of the system. Here are its components:
I think this is a very good programme. It essentially boils down to students borrowing against future income, and seeing how the return to education is vastly superior to the financial cost, they should want to take this opportunity as long as there is a market. Universities are the ones providing this market and they are incentivized to provide a good educational product.
The suggestion is in fact very similar to the credit products that MyRichUncle offered before the financial crisis in the United States: it gave loans to students against a share of future income for a set time. The loan amount was determined by student performance and major, thus taking into account the expected value of a university degree. With the Shephard proposal, it is up to the university to provide this value.
Neil Shephard suggests a complete overhaul of the system. Here are its components:
- Students are charged the full cost of their education by universities.
- They get an explicit scholarship from the government for part of this tuition. This makes is visible that the state is helping.
- Students have the option of deferring the payments to the universities. As the universities are taking the risk when a student could default or make little money, they will make sure students will get a good education (and not admit students who should not go to college).
- This means that universities will make loans to their students. These loans should also cover living expenses.
I think this is a very good programme. It essentially boils down to students borrowing against future income, and seeing how the return to education is vastly superior to the financial cost, they should want to take this opportunity as long as there is a market. Universities are the ones providing this market and they are incentivized to provide a good educational product.
The suggestion is in fact very similar to the credit products that MyRichUncle offered before the financial crisis in the United States: it gave loans to students against a share of future income for a set time. The loan amount was determined by student performance and major, thus taking into account the expected value of a university degree. With the Shephard proposal, it is up to the university to provide this value.
More on the credit card puzzle
Why do people simultaneously hold substantial cash and high interest credit card debt? I previously reported that this could be explained by the demand for liquidity as some goods cannot be purchased on credit. While that explanation seemed to be a good one quantitatively, it does not mean that thtere is no room for other ones as well.
Scott Fulford offers another one: liquidity is necessary for unexpected changes in borrowing limits. Basically, people keep cash or savings so that they have something to live from in case their credit line gets unexpectedly reduced. That seems to be a very poor strategy, though. Given the high interest rate on credit cards, why not lower the credit balance with those savings? You pay less interest, and you end up with exactly the same balance when you are the most constraint. If fact you are even better off in the latter situation, because past interest payments are lower and the balance is thus lower. The reason why household in this model still hold cash is that there is a very peculiar way in which the debt limit is stochastic: it is either zero or some fixed number. Thus it is not some reduction in credit lines, it is a complete cancellation out of the blue. That is important for household choices. In fact, this may give some ideas to credit card companies, because this implies that households will want to have high interest credit card debt while having low interest savings. Crazy.
Scott Fulford offers another one: liquidity is necessary for unexpected changes in borrowing limits. Basically, people keep cash or savings so that they have something to live from in case their credit line gets unexpectedly reduced. That seems to be a very poor strategy, though. Given the high interest rate on credit cards, why not lower the credit balance with those savings? You pay less interest, and you end up with exactly the same balance when you are the most constraint. If fact you are even better off in the latter situation, because past interest payments are lower and the balance is thus lower. The reason why household in this model still hold cash is that there is a very peculiar way in which the debt limit is stochastic: it is either zero or some fixed number. Thus it is not some reduction in credit lines, it is a complete cancellation out of the blue. That is important for household choices. In fact, this may give some ideas to credit card companies, because this implies that households will want to have high interest credit card debt while having low interest savings. Crazy.
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