When to borrow from friends

When should I borrow from friends or from banks? With friends, I would typically get a lower interest rate, but I could risk losing a dear friendship. With banks, I pay more in interest and have to bring collateral, but I can walk away with relatively little damage. There are some situations where one should be preferred to the other.

Alexander Karaivanov and Anke Kessler study this question in the context of a world where borrowers can default strategically and there is limited enforcement of loan contracts. First they show that the optimal informal loan (from friends or relatives) features zero interest rate and zero collateral. This is because friendship is an efficient enforcement mechanism. That would typically happen with smaller, less risky loans. Then Karaivanov and Kessler show that if there is sufficient risk in the loan, one should go for a formal loan. The reason is that the collateral is divisible. In an informal loan, you either keep or lose the friendship. With a formal loan, you may still keep part of the collateral if things go bad. Using household data from Thailand, they find that their model lines up nicely with the data.

How many mortgage defaults resulted from lofty expectations?

A housing bubble is sustained by expectations of further increases in house prices. There is strong suspicion that this is what happened during the US housing boom preceding the last crisis, and that these expectations have triggered excessive mortgage borrowing. Actually verifying that claim is not that straightforward, though, as one needs to find extensive household level data.

Steven Laufer found this for Los Angeles County with panel data that tracks a property and all its mortgages. He comes to the sad conclusion that only 30% of mortgage defaults there were a result of household level shocks. The rest is all about borrowing and mostly extracted additional cash excessively with the expectation that the loan-to-value ratio would be reduced as house prices continue to grow. When this did not materialize, massive defaults resulted. Using the estimation model, Laufer finds that could have been mostly avoided by imposing the 80% loan-to-value ratio. Although this would have lowered house prices by a considerable 14%, this would have reduced defaults by 28%, as small number given the price drop but a large one considering the number of defaults. And house prices in LA are too high anyway.

Why so much policy focus on home ownership?

Some have blamed the Community Reinvestment Act (CRA) for the too risky lending to US homeowners during the house price run-up. Actual evidence for this is hard to come by, though. In this previous post, I discuss that there was indeed more risk taken, but it is not clear whether that additional risk was priced in or not. And were we to blame CRA, it would show in banks giving loans to neighborhoods that should not have received them for economic reasons, only to satisfy CRA.

Patrick Bayer, Fernando Ferreira and Stephen Ross look at the history of mortgages that they can link to credit scores and demographic characteristics. They find that for the same credit score, blacks and Hispanics were much more likely to run into mortgage trouble. While the authors do not mention this, the CRA was clearly targeting neighborhoods with such populations, and banks had to lend more there to comply. This would indicate that there is at least some truth to the CRA blaming. The authors frame this result rather by writing that this is evidence that favoring homeownership is not a good way to reduce wealth disparities. I would agree, but also because owning a home is very poor diversification, especially when this is all the wealth you can have. And there is no evidence that homeownership is good anyway, to the contrary.

Foreclosure procedures last too long

The handling of foreclosures in the recent housing crisis in the US has been a serious disaster. The drop in household income made that many households could not service their mortgage obligations and had to default. In addition, the drop in house values meant that many mortgages were worth more that the house that serves as collateral. This encouraged owners to walk away from payments. The mass of defaults lead mortgage servicers to resort to automatic treatment of foreclosures, leading to many errors, in particular foreclosing houses that not at issue. The reaction of many US states was to require longer foreclosure delays, first to make sure procedures are properly followed, second to allow owners to renegotiate, recoup and still make payments. The latter did not work out, as reported here previously. Were these state interventions worth it, in the end?

Larry Cordell, Liang Geng, Laurie Goodman and Lidan Yang use extensive databases of foreclosure procedures to quantify the lengthening of foreclosure delays and what this has cost. An important consideration is how foreclosures happen across states. In some, courts need to get involved (judicial states), in others the procedures only follow the stipulations of the mortgage contract (statutory states). In the former, the length of the procedure went from 26 to 44 months, in the latter from 16 to 22 months. During all this time, both parties are left in limbo, owners have incentives not to pay at all and neglect house maintenance, and lenders get no return on investment and may try to find whatever means to get any money out of the house, including reselling the mortgage. Also, there are externalities on neighborhoods as they get blighted. This is costly. The cost went up from 8% to 12% oh house value in statutory states, while it is from 17% to 30% in judicial states. These costs are estimated by adding unpaid property taxes, excess depreciation and unpaid insurance. This is thus the cost to the mortgage servicer, and does not even include capital costs. For a cost to society, one would also have to add the impact on other property values and deduct the fact that owners are living for free in these homes. There is no doubt the costs are considerable.

US local lenders knew about the housing bubble

Among the main culprits of the recent boom and bust in the US housing market that have been identified, the lenders and their excessive pushing of mortgages have been prominently featured. As pushing mortgages to people who cannot afford it seems to be a losing proposition, some pretty weird incentives must be in place for this to work. In other words, their must be some pretty sophisticated scheme in the lending business for some to make a gain from this. Local lenders, though, are not that sophisticated, as they handle most of the steps in the lending process themselves. As it turns out, they saw the debacle coming and pretty much got out of lending mortgages as soon as they felt things were getting excessive.

This is what you can conclude from the the analysis of Kristle Romero Cortés. She finds that where home prices where rising the fastest, the share of local lenders on the mortgage market was declining the fastest. In the subsequent bust, home prices were declining less in areas where local lenders were more present during loan origination. And looking at California only, foreclosures rates were lower where local lending was more prevalent. And all these results are even stronger where local lenders did not securitize the mortgages. What this shows is that there is still good value in homegrown lending, where the lender knows the markets intimately and knows to back off where things are getting dicey. Or, this can also be an indictment of the national mortgage chains like Countrywide Financial that were lending without thinking or had twisted incentives in place.

Banking for those unwilling to bank

While we worry about the unbanked population that faces significant costs for trivial transactions, there is also a not insignificant share of the population that is unwilling to have bank accounts for religious reasons. Islam and some strands of Christianity forbid the use of interest. Islamic banking has emerged in response and is offering deposit accounts that do not provide interest, but shares in the bank's profits. If this becomes more commonplace this could have important implications for how we think about banking, regulation and systemic risk in this sector.

Cagri Kumru and Saran Sarntisart show that if such a sizable population exists, then it is welfare improving to have an alternative banking system in place. It seems kind of obvious that it would be a loss to society not to capture these savings for growth-enhancing loans. The paper also shows that this alternative banking sector would emerge endogenously. The market forces are thus doing the right thing. What we need to be careful about is how to adjust the regulatory framework to not mess things up unnecessarily. And I see no reason why we should resist the emergence of such a banking sector.

Is the CRA responsible for the crisis?

An important component, if not reason, of the last recession has been the run-up in sub-prime mortgages until 2007. There has been much speculation what could have triggered this, for example distorted incentives in the supply of mortgages, poor evaluation of risk, or predatory lending practices. Also mentioned has been the Community Reinvestment Act, which was implemented to reduce discrimination of lending in poorer neighborhoods and, as its title indicates, encourage mortgage holding in these areas. Could the CRA be the big culprit?

Sumit Agarwal, Efraim Benmelech, Nittai Bergman and Amit Seru claim the CRA did lead to more risky lending. This is based on the fact that mortgages given around the time of CRA examinations were 15% more likely to default. That is not that much a surprise as poorer neighborhoods do have riskier mortgage holders and banks had incentives to lend more during those exam periods. The real question is whether the risk was assessed and priced correctly.

The paper is still of interest. It shows that the effect was the strongest among the large banks (those that got bailouts...) and was more important while mortgage securitization was booming. Banks thus are not clean here.

Why so many debt defaults?

In the United States, declaring personal bankruptcy is an appealing way to get out of a bad debt situation and start with a clean slate because previous debts are set to zero. One would thus expect to see bankruptcy seen rather frequently used when people are unemployed. Yet, it appears that defaulting on debts is much more frequent and is used as an informal way to get unemployment insurance.

Kyle Herkenhoff established this and finds also that the many reason for default is not negative equity, but job loss and facing a borrowing constraint while debt payments constitute a large fraction of income. But when a person is cornered in this way, why not declare bankruptcy? Herkenhoff shows with a labor search model with individually priced debt that using default as unemployment insurance is worth more than the subsequent higher cost of credit. Mortgage relief measures are thus welfare enhancing, even though they lead to higher and more persistent unemployment.

PS: The paper title page says "Preliminary, do not cite." Then why put it in a widely distributed working paper series? Leave it hidden on your web page.

The end of central banking as we knew it

The European Central Bank and the US Federal Reserve have massively changed their balance sheet in recent years. The first step was an increase in size, the second is a change in the structure of the balance sheet, holding not only government bonds but also other securities. Some have called this last step "qualitative easing," and others have argued that it is inconsequential because the price of the securities internalize everything relevant, à la Modigliani-Miller (most prominently Michael Woodford, whose recent Jackson Hole paper is being treated like gospel).

A counter-argument comes from Roger Farmer. Qualitative easing is a quasi-fiscal policy, because it favors a particular sector through the purchase of its assets instead of the "neutral" government bonds. Also, it transfers risk form the seller to ultimately the tax payer. This is not only welfare-improving, as it allows to fine-tune the economy, it can even be Pareto-improving despite the fact that it implies redistribution. Indeed, the policy allows to smooth asset price fluctuations as if the yet to be born were capable of trading. It also removes unnecessary fluctuations in the stock market that are due to sunspots ("irrational exuberance").

The question, though, is why the central bank would be tasked with such operations. A central bank's role is to ensure the short-term health of the economy in general. Fiscal policy can redistribute across sectors and ensure a healthy long-term environment. The Fed and the ECB have resorted to such operations because of a general failure of fiscal policy. In the US, Congress is incapable of setting any sensible policy. In Europe, the EU cannot conduct fiscal policy because it has no taxation powers. Central banks are forced into a role they should not have, even if it looks optimal according to Farmer. But wait until lobbies, politicians and other rent-seekers try to influence qualitative easing.

Avoiding sovereign debt dilution with debt seniority

There is a natural tendency for firms to borrow too much. This is known as the debt dilution problem. It occurs because the borrower does not factor in the impact on old debt of borrowing more. Indeed, it makes old more risky, and hence increases borrowing costs. The market response to this problem was to introduce debt seniority, wherein some debt classes have priority over others in liquidation. For example, primary mortgages have priority over secondary mortgages, and the latter carry higher interest rates. The fact that one has a secondary mortgage has then no bearing on the riskiness and cost of the primary mortgage.

Satyajit Chatterjee and Burcu Eyigungor point out that there is not such concept in sovereign debt, but it should. Indeed, debt dilution happens at a massive scale in sovereign debt, and the market response when debt dilution happens such as now in many countries is to have shorter terms. This increases costs significantly, as Southern European countries have recently witnessed. Chatterjee and Eyigungor show that if sovereign debt also had a seniority structure, the frequency of default would be significantly reduced, by 40% taking the example of Argentina. It also reduces the volatility of spreads by two thirds. That seems very interesting.

Optimism and debt overload

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.

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).

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.

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.

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.

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.

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.

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.

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.

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.