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?

Putting Your Money Where Your Mouth Is

Robin Hanson touches on euvoluntary exchange without intending it. Is gambling euvoluntary?

Many of the arguments trotted out by opponents to betting markets are reminiscent of knee-jerk reaction people have to rising prices (gouging). Their moral intuitions are all wrapped around their hippocampuses, making rational thought about the consequences of trade or failure-to-trade very difficult consider.

She Sewed My New Blue Jeans

Take the spectrum of gambling activities: on one end, sordid back-alley dice, cockfighting, pool hustling and mob-run numbers rackets. On the other end lie state-operated lotteries, church raffles, gentlemen's wagers and NASDAQ. Betwixt would be office fantasy football leagues, casinos, InTrade, OTB, Jai-Alai et al.

The sordid sorts of gambling (dog fighting for example) could be objectionable because of the context of the contest: it's cruel to force animals to disfigure or kill each other for sport (naturally, this presumes quite a bit about an implied counterfactual state of the world, but let's leave that alone for now). Other forms may rely on other analysis. Consider the following arguments:

1. Gambling acts as a transfer scheme that moves wealth from stupid (and usually poor) people who don't understand the laws of probability and expected value calculations well enough to make informed decisions. This implies paternalist responsibilities to prevent disadvantaged people from being fleeced.
2. Allowing low-status people to collect producer surplus in a gambling market is objectionable. The mafioso who run numbers are collecting rents rather than producing useful services. It might be fine for the state to collect lottery earnings since those will be used to provide essential public goods, but the Don will just spend it on lavish wedding receptions for his daughters.
3. Gambling is dynamically inefficient. Instead of building human capital, players will forgo the acquisition of work skills to blow their meager paychecks on a sliver of hope for striking it rich. This is another pinion in the engine of poverty.
4. On this point, I owe consideration to my friend and colleague Tom Duncan. There is a non-trivial probability that people find certain types of gambling objectionable based strictly on their explicit legal status. Some gambling markets are wrong just because the legislature says so.
5. Gambling varies by social class and wealth. The rich can gamble to their hearts' content since their BATNA might imply not being able to take that vacation to the Bahamas this year, but for poor folks, it means the baby won't get formula this week.

Of all these, #4 is both the most preposterous and the most plausible. It's preposterous because it suggests that folks don't give much consideration to their beliefs and it's the most plausible because, well, people probably actually don't give much consideration to their beliefs. It can be mentally efficient to outsource morality to elected officials. Some of the recent Public Choice work supports this notion (see, eg The GTM's recent JEBO article, Persuasion, Psychology, and the Future of Public Choice {sorry, I can't find an ungated link. If you have access to JSTOR then check there, otherwise there's a possibility the author may be willing to send you a copy}).

At any rate, there's a curious question in there somewhere. What are the elements of games of chance that make one gambling scheme acceptable and another not? What is the role of local knowledge and morality that explain geographical and cultural variance? Can gambling ever be truly euvoluntary?