Adjustable-Rate Mortgages

I am a home owner. Or if I've been playing too many video games, I am a home pwner (your domination is my vacation). Because of this, I tend to get reams of junk mail offering me fantastic refinancing deals. Hooray!

Now, since you've likely deduced that I've a bit of a training in economics, it naturally follows that I have no idea what the yield curve looks like on any particular day. I am however unusually blessed with an eagle-eyed spouse who takes every opportunity to keep from forking over cash moneys to lenders. She loathes interest, whereas I'm stupid enough to think its social benefit is all unicorn glitter and ballerinas pirouetting in a, I don't know, a glade or something. I flatter myself to think I'm on the side of a larger truth, whereas she actually keeps our household ledger in the black. It should be immediately obvious to anyone that she far and away provides a much larger marginal benefit to our household, so it should come as no surprise that she tracked down a few of these offers and looked a little closer.

Surprise, surprise, the ones that sound too good to be true are precisely that. They're either 15 year mortgages (we're not even remotely able to handle that) or they're adjustable rate.

For those of you who've never had to wrangle with the niceties of home financing, an ARM works a little like this: you start out for a couple of years with a relatively low fixed (say, 3%) interest rate on your loan, and when this sweetheart period is up, you start paying interest a bit over the floating market rate. Here, look at this:

That's what a yield curve looks like when it's at home. Source. How you'd calculate your floating rate is that you'd consult your crystal ball to see what this guy will look like each payment cycle down the life of your loan, find the time left on your mortgage on the abscissa, follow it up to the curve then head West young man to the rate on the ordinate. Since you're not the US Treasury, you pay some basis points above that (I'm not sufficiently familiar with the system to say exactly how much). If you're lucky enough, the yield curve will remain nice and low so that you don't get rear-ended by bigger and bigger interest components of your mortgage payment.

Which is what happened to folks in 2008.

Five years ago.

I'll not try to parse the substance of the response to the financial crisis. What I will do is ask why the Ban Barnstormers haven't so much as wiggled their wings at what seems to be an exploitative lending practice. Compared to, say, payday lending, the ARM seems a hell of a lot more deceptive.

Or does it? There's really no information asymmetry to speak of, right? Borrowers in effect become speculators, taking rather large uncovered positions over future market movements (think of the tremendous downside risk implicit here), but it's not like they're being tricked by lenders. In contrast, under a fixed rate mortgage, it is the lender (well, actually the taxpayer so long as we have Fannie and Freddy) who accepts the long-tail downside risk. But who should (normative claim alert!!!) accept the downside risk? It seems to me as if most folks hew to the opinion that it ought to be the big, faceless, indifferent corporations. People get all bent askew over Glass-Steagall (really!), but not so much as a lifted eyebrow when there's this huge industry-wide practice that heaps systemic risks on the shoulders of ordinary citizens.

Don't get me wrong, I think that as long as folks actually understand what it is they're agreeing to (and they have a pretty strong incentive to learn about what it is they're agreeing to for the next thirty years!), any ex post regret is their own ever-loving fault. But I also think that this moral and economic calculus applies in equal measure to other lending markets that people have at various times lit the pitchforks and grabbed the torches over.

So how about it? Are the regrets felt by ARM holders of the right type to make this type of loan non-euvoluntary? What does that imply for the regulatory scheme? Do we have different caveat emptor goalposts here? What to do about it?

Of Hume and Bugs Bunny

If Hume is to be believed, the states of antiquity would hoard treasure to be spent in times of war. By the time he penned Of Public Credit, Wm. of Orange had long ascended the throne and debt financing of state-led aggression was well-established. It is in this post-Glorious Revolution environment that he wrote:

There are also, we may observe, in ENGLAND and in all states, which have both commerce and public debts, a set of men, who are half merchants, half stock-holders, and may be supposed willing to trade for small profits; because commerce is not their principal or sole support, and their revenues in the funds are a sure resource for themselves and their families. Were there no funds, great merchants would have no expedient for realizing or securing any part of their profit, but by making purchases of land; and land has many disadvantages in comparison of funds. Requiring more care and inspection, it divides the time and attention of the merchant; upon any tempting offer or extraordinary accident in trade, it is not so easily converted into money; and as it attracts too much, both by the many natural pleasures it affords, and the authority it gives, it soon converts the citizen into the country gentleman. More men, therefore, with large stocks and incomes, may naturally be supposed to continue in trade, where there are public debts; and this, it must be owned, is of some advantage to commerce, by diminishing its profits, promoting circulation, and encouraging industry.

If you recognize the theme here, it's a proto-MMT argument, that liquidity is important. Debt financing supports commerce. In our terms here, it features positive externalities. It's good.

But much like Hume anticipated Keynes and Sumner, so too he anticipated Bastiat and Hayek.

But, in opposition to these two favourable circumstances, perhaps of no very great importance, weigh the many disadvantages which attend our public debts, in the whole interior œconomy of the state: You will find no comparison between the ill and the good which result from them.

He then goes on to list five shortcomings of debt financing, including: redistribution from the modest to the elite, an early version of Gresham's Law, oppressive ex post taxation, obeisance to foreign bondholders, and an argument ad segnitium (that bondholders will live an indolent life and produce little).

ATSRTWT

The rest of the essay is set to mockery of public credit and those who enjoin to live lives of culpable comfort on the rents claimed by the excise of taxes. He warns of the perils of sovereign default and contrasts nicely the bankruptcies of the crown with the private landowner.

So what does this have to do with B. Bunny? With euvoluntary exchange?

During the big, early-20th century wars, ordinary folks would go see shorts like the one above before their feature films and know that Johnny who had gone off to fight Hitler or Tojo would have a few extra bullets in the chambers of their M1 Garands or a fresh set of tracks draping their (notably crappy) M4 Shermans. Euvoluntary. Sure, there might be a fungibilty filter as the purchase twists its way through the general fund on its way to the Pentagon, but folks pretty much knew what they were getting with the ossification of their savings: an increased probability of battlefield victory.

How about debt financing in peacetime? When you snag a T-bill these days, what are you buying? Liquidity? Funding for regulatory agencies? Stimulus? Do you even know? How would the post-Space Jam Bugs sell QE? I guess part of the point of the apparatus of modern banking is that he doesn't have to.

I wonder if anyone else has ever attempted to link Mel Blanc and David Hume. Hm.

Reverse Carloan

KPC blogger and U of OK Professor of Economics Kevin "Angus" Grier is in my neck of the woods for the nonce and he was kind enough to join me for lunch, during which he directed my attention to something I've not heard of before: reverse car loans. These work sort of like reverse home mortgages, except they use the equity you have in your car rather than the equity you have in your home. From what I've gathered in a quick Internet search, they seem to be aimed at people who don't qualify for payday lending.

There's a lot going on here. The first immediate comparison is with the payday loans: a reverse auto loan is secured, meaning that if the borrower defaults, the lender can obtain a lien on the automobile. This suggests that interest rates can be (comparatively) lower. However, you can easily see how folks might make claims of exploitation: it's bad enough that poor folks have a hard time making ends meet and now these predatory lenders will take your car if you don't make payments.

How do they stack up against reverse home mortgages? From time to time, I've heard grumbling about reverse mortgages, about how they get retirees to "destroy" all the value they've put into their homes over the years and how these lending practices exploit the elderly. I'm not sure I understand the arguments fully, perhaps the elderly are somehow considered feeble by default, therefore prone to coercion by trickery? I think folks would have a hard time making a BATNA disparity argument, since if someone outright owns their home, it's fair to say they're reasonably wealthy. The same isn't necessarily true for these reverse auto loans. For these, we've got people so credit constrained that they can't even get a payday loan. That sounds to me like fertile grounds for claims of BATNA disparity.  Aggravating the problem is the nature of the collateral: to get a job, most folks need a car. If you're out of work and you just put your Civic in hock to pay this month's phone bill, you're up the creek if the repo man comes to collect.

And does it matter what the borrower spends the money on? Carlos is diligently applying for a job as a taco truck driver and he puts the equity in his Acura towards a legitimate job search, whereas Becky uses her loan to buy a new puppy and a bag of kibble. If things go poorly for either one, Carlos has the moral advantage of thrift. Becky might be what economists call a "hyperbolic discounter", which is a fancy way of saying that she's not quite so good at planning and foresight. Paternalistic instincts might have us look at Becky and say, "she ought to know better, so let's just not let her have the option of taking this loan." Unfortunately, even assuming it's the role of the state to protect people against the consequences of their own decisions, distinguishing between the Carloses and the Beckys of the world is likely to be prohibitively expensive (note that a low-cost way of self-identification is to just have a guaranteed basic minimum income).

So, are reverse auto loans euvoluntary? If not, is it so by regret aversion or BATNA disparity (or both)? Something else? As lenders continue to find ways to extend credit to poor folks, does the increased scope of the low end of the loanable funds market present a problem for a destination euvoluntaryist? How about for a directional euvoluntaryist? What actually is the likely alternative for not having access to this sort of credit? Does its relative novelty have bearing on the attractiveness of alternatives? If so, is novelty an important part of the BATNA calculus?

I think I'll post a little more on this latter question in a future post. I suspect it might be important.