Off to Jackson Hole on Thursday

I am going to this year's Kansas City Fed symposium, where I am giving a paper with Susan Wachter called the Housing Finance Revolution. I have pretty much wanted to do something like this since I was a kid (I know, I'm a strange kid).

Preliminary Syllabus for Finance 397

Finance 397

Applied Microeconomic for Business

Professor Richard K. Green

Office: 507 Funger

drgreen@gwu.edu

Keynesian.richard@gmail.com

202-994-2377

202-994-9141

301-467-3582

Office Hours: 1-3 Tuesday or by Appointment

This is a course in the application of microeconomic theory to academic business disciplines. As such, it is not a traditional graduate microeconomics course, such as Economics 301. All business disciplines—even management and marketing—contain some economic theory in their literatures. For example, papers in marketing are often applications of industrial organization theory, and papers in management often deal with principal-agency and asymmetric information issues.

The class will contain four requirements: two exams (25 percent each), an 8-10 page critical review paper (30 percent), and a 15 minute presentation, such as one would give at an academic meeting (20 percent).

Texts: (*)-ed readings are required.

1. Introduction to Economic Analysis, by R. Preston McAfee, (an open source principles text downloadable from http://www.introecon.com/). (*)

2. Game Theory for Applied Economists, by Robert Gibbons, Princeton University Press (1992, paperback). ISBN 0-691-00395-5. (*)

3. Identification Problems in the Social Sciences, by Charles F. Manski, Harvard University Press, (1995, paperback). ISBN 0-674-44284-9.(*)

4. Iowa State Economics 500 and 501 Lecture Notes. http://www.econ.iastate.edu/classes/econ501/Hallam(*)

Week 1: Introduction to Optimization and the Robinson Crusoe Economy

http://www.econ.iastate.edu/classes/econ500/hallam/documents/Opt_Simple_Multi_000.pdf

http://www.econ.iastate.edu/classes/econ500/hallam/documents/opt_con_gen_000.pdf

http://www.econ.ucla.edu/doepke/teaching/resources/e102ch1.pdf

Week 2: Optimization and Theory of the Firm

McAfee Chapter 4 and 6

Griliches, Zvi and Jacques Mairesse (1995) Production Functions: The Search for

Identication, NBER Working Paper No.w5067.

Week 3: Industrial Organization I

http://www.econ.iastate.edu/classes/econ501/Hallam/documents/Competition_000.pdf

Borenstein, Severin, Hubs and High Fares: Dominance and Market Power in

the U.S. Airline Industry, Rand Journal of Economics, 2(3) (1989), 344-365.

Week 4: Theory of the Consumer

McAfee Chapter 5

http://www.econ.iastate.edu/classes/econ501/Hallam/documents/FunctionalForms.pdf

Laurits R. Christensen; Dale W. Jorgenson; Lawrence J. Lau, Transcendental Logarithmic Utility Functions, The American Economic Review, Vol. 65, No. 3. (Jun., 1975), pp. 367-383

Week 5 Industrial Organization II

http://www.econ.iastate.edu/classes/econ501/Hallam/documents/Oligopoply.pdf

.

Zettelmeyer, Florian, Fiona Scott Morton, and Jorge Silva-Risso (2005) Cowboys

or Cowards: Why are Internet Car Prices Lower?

Akerloff, GA The Market for "Lemons": Quality Uncertainty and the Market Mechanism

The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), pp. 488-500

Week 6 Topics in Game Theory I

Gibbons Chapter 1

McAfee Chapter 7

Week 7 Exam I

Week 8 Topics in Game Theory II

Gibbons Chapter 2

Shapley, L. S. and M. Shubik (1972) The Assignment Game I: The Core, Interna-

tional Journal of Game Theory, 1: 111-130.

Week 9 Adverse Selection

Gibbons Chapters 3 and 4.

Week 10 Moral Hazard

Stoughton, Neal, Moral Hazard and the Portfolio Management Problem, The Journal of Finance, Vol. 48, No. 5. (Dec., 1993), pp. 2009-2028

Week 11 Identification I

Manski 1,2

James J. Heckman (2000) Causal Parameters and Policy Analysis In Economics:

A Twentieth Century Retrospective, The Quarterly Journal of Economics, 115(1),

45-97.

Week 12 Identification II

Manski 3-7

Week 13 Student Presentations of Applied Microeconomic Papers (choose from list)

Week 14 Exam II

Papers to choose from for presentation

Avery, Christopher, Mark Glickman, Caroline Hoxby and Andrew Metrick, A Revealed Preference Ranking of US Colleges and Universities, Working Paper.

Borenstein, Severin and Andrea Shepard (1996) Dynamic Pricing in Retail Gasoline

Markets, Rand Journal of Economics, 27(Autumn): 429-51.

Donohue, J.J. and Steven Levitt, The Impact of Legalized Abortion on Crime." Quarterly Journal of Economics, 2001, 116(2), pp. 379-420.

Gandal, Neil, M. Kende and Rafael Rob (2000) The Dynamics of Technological

Adoption in Hardware/Software Systems: The Case of Compact Disk Players, Rand

Journal of Economics, 31(1): 43-61.

Graddy, K. (1995) Testing for Imperfect Competition at the Fulton Fish Market,

Rand Journal of Economics, 26 (Spring): 75-92.

Green RK and MJ White, Measuring the Benefits of Homeowning: Effects on Children, Journal of Urban Economics,

Krugman, Paul, Scale Economies, Product Differentiation, and the Pattern of Trade

The American Economic Review, Vol. 70, No. 5. (Dec., 1980), pp. 950-959.

Mankiw, G and D Weil, The Baby Boom, the Baby Bust and the Housing Market, Regional Science and Urban Economics

If you want to be scared about subprime...

Read this:

http://bigpicture.typepad.com/comments/2007/08/cdo-insiders-we.html

The story I heard from a bond trader is that the Chinese were willing to buy paper at very low spreads just to keep the RMB from appreciating. I have no idea whether this is really true, but it makes for a good story.

Subprime--I was probably wrong

I long have taken a caveat emptor view about mortgage lending. I assumed borrowers understood that loan brokers where in sales, and they would therefore try to get as much money out of borrowers as possible. Just as one should be wary with a car salesman, so too should he be wary of a mortgage saleman.

The problem is that borrowers did not understand what the sales people where selling them. Loans are complicated--even the "sticker price," the APR, doesn't really tell the story. And so borrowers, particularly those without any financial training, are at a disticnt disadvantage when dealing with lenders.

I am not sure what to do about this. I have long thought that the sub-prime market could give borrowers access to cheaper credit than they would get elsewhere; nevertheless, the market also led people to make what were clearly bad decisions. I am not sure how reasonable it was to expect borrowers to understand how bad their decisions would turn out to be.

And so we must figure out a mechanism for helping borrowers navigate the mortgage waters better. I am not sure what that is. One possibility: tie loan broker compensation not just to loan origination, but loan performance. They don't get fully paid until the loan is fully paid. This would reduce the incentive for them to make loans that will turn into defaults.

Teaching and Research Again

I just read the introduction to Richard Feynman's Six Not So Easy Pieces. In it is a wonderful exposition of how great research can lead to great teaching.

Dhaka's getting worse

Students are protesting continuing military rule in Bangladesh. The military took power last January, allegedly in order to prepare the country for unrigged elections. Alas, this has not happened. http://news.bbc.co.uk/2/hi/south_asia/6958206.stm

When I visited Dhaka in 2004, it was a place of unspeakable poverty, and according to Transparency International, had among the world's worst corruption. But so far as I could tell, people could move, speak and organize reasonably freely. The press was certainly vigorous and regularly criticized the government. It was hardly a paragon of human rights. To me, human rights include the right to have enough to eat and the right of all children to go to school. But among all the world's poor countries, its human rights record was not too bad.

Still, I left Dhaka thinking that life would get better there. It has actually shown itself capable of competing in the textile business in the absence of the multifibre agreement. The people there were also remarkably gracious. I thought there was a chance for corruption to be reduced, and for the middle-class to grow. I hope that I will someday be proved correct, but today I don't have a lot of hope.

How does the NFL get away with charging for the Preseason?

I've spent the past three days writing, and needed to zone out, so I turned on the Colts-Bears pre-season game. It absolutely stunk, and after the first quarter most of the starters were gone.

As it happens, a student of mine, Jason Berkowitz, did some regressions of how well the preseason predicted the real season. The answer is that it doesn't--a team's winning percentage in the preseason has almost no predictive power of regular season fortunes.

So the question is--why do fans pay full ticket prices to see these fake games? It is not like spring training in baseball, when going to games in in part an excuse to get away from the cold north. I know this is not the most important issue facing the NFL today, but after watching that game, I just had to wonder....

Sub-prime returns.

I just did a little experiment on a 2-28 with the following assumptions:

Five year life (stiff prepayment penalties before year five), after which everyone who survives refinances.

Coupon rate starts at 6 for two years, goes to 9 for a year and then 12 for two years.

10 percent default rate over five years with 70 percent loss severity.

Mortgage is tranched into two pieces. Piece A gets the first 80 percent of the equity and a six percent coupon; Piece B gets all the rest.

The IRR on this set up fro the B-piece comes in around 9 percent. Not great, given the risk, but not bad either. It should be enough to pay any leverage taken on to buy it. So...where am I going wrong? I will be happy to share the spreadsheet with anyone who can help me out.

The Jumbo Market and House Prices

Spreads on Jumbo mortgages rose about 50 basis points in the past week. This is likely a market over-reaction: 80 percent LTV loans to borrowers with high FICO scores remain low risk mortgages.

But the impact on prices could be serious. Consider what happens when the cost of capital increases quickly by 50 basis points, from 6.5 to 7 percent. The cost of capital has gone up 7.7 percent. But lets say that expectations are for 2 percent house value growth. Then the cap rate for houses goes from 4.5 percent to 5 percent--an 11.1 percent increase. This translates into a ten percent decline in house prices (CF/5)/(CF/4.5) =4.5/5 = .9.

But this phenomenon could change expectations about futue house price expectations. As expectations worsen, the cap rate will rise further, and house prices will fall further. The next few months might be pretty ugly for the coasts.

Can Las Vegas Keep Building Apartments?

Metropolitan Las Vegas has about .6 percent of the US population. Last year, about 2.9 percent of units in buildings with more than five units built in the US were built in Las Vegas. The pace has slowed considerably this year, but it suggests an interesting question: how much growth does Las Vegas have left in it?

The answer is: a lot. The basic industry is, of course, accomodation. Las Vegas has around 140,000 hotel rooms (http://cber.unlv.edu/stats.html) with an cccupany rate in excess of 90 percent. Hotels are profitable at occupancy rates of around 65 percent, meaning that Las Vegas could support something like 50,000 more hotel rooms with no increase in demand.

Let's cut that to 25,000 rooms to be conservative. There are roughly two jobs in the hotel business for every room in Las Vegas, meaning that 25,000 rooms will directly create about 50,000 jobs.

Economic base analysis (http://faculty.washington.edu/krumme/350/econbase.html) for Las Vegas predicts that every basic job produces an additional 2.5 non-basic jobs. So the Las Vegas market has room for another 175,000 jobs over the near-to-medium term (say 5 years).

The ratio of jobs to population in Las Vegas is .47; let's round and say population growth produced by hotel room growth will be 350,000. The average Household Size is a little more than 2.5 (census) and about 35 percent of households live in multifamily buildings (again, census). Put this all together, and there will be demand for about 50,000 multi-family units over the medium term--again assuming no growth in demand for hotel rooms. Vacancy rates for apartments in Las Vegas is a little less than 7 percent--this is close to a natural vacancy rate, meaning that the market is currently in equilibrium. The fact that inflation adjusted rents have risen by a bit more than inflation in the past year also indicates that the apartment market is not oversupplied. Assuming hotel developers respond to demand, there should be strong demand for apartments for some years to come.

There are issues, of course, not the least of which is water (although if people would stop watering their lawns, there would be plenty of water for awhile). But it is remarkable how much Las Vegas' strong population growth (and therefore demand for housing construction) is grounded in fundamentals.

A nice mortgage blog by Rhonda Porter

This is worth a look:

http://www.mortgageporter.com/