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/

Are the Average SATs for your school really that high?

Have you ever wondered how so many Universities can have such intimidatingly high SAT scores? Well, perhaps they can't. I was reading one of the many brochures colleges are sending to my kids nowadays, and I noticed that the SAT range it presented was for those who were admitted, not for those that matriculated. So I looked at another. And another. And what I found was that in their literature, almost all schools report SATs of admitted students.

Self-sorting on the part of students should mean that in general, average scores for matriculants will be lower than average scores for admits.

If you really want to know how students who enter a university performed on the SAT, look to see whether it publishes a "Common Data Set" (here is University of Nebraska-Lincoln: http://irp.unl.edu/pdfs/CDS2006-07.pdf). It reports only scores of entering degree candidates.

Understanding the Mortgage Interest Deduction

Homeowners get a tax advantage relative to rents. But those with mortgage are not at an advantage relative to those who finance with equity. From an article I wrote for the Encyclopedia of Tax Policy (Cordes and Gravelle, eds.):

In the popular press, the mortgage interest deduction
is often characterized as being the principal tax
benefit accruing to homeowners. This is certainly
not correct. First, fewer than 50 percent of homeowners
itemize on their tax returns; the remainder
use the standard deduction. This is because the value
of itemized deductions for low- to moderate-income
homeowners in states with low marginal tax rates
will almost certainly be less than the value of the
standard deduction, which in 2003 was $9,500 for
married couples filing jointly. Also, according to tabulations from
the Survey of Consumer Finances, many households
with elderly heads own their homes entirely with
equity (i.e., do not have mortgages), and for these
households, the mortgage interest deduction has no
value.

Second, even for those who do itemize, the
mortgage interest deduction does not necessarily
produce the largest tax benefit arising from owning.
The imputed rent that households earn from their
owner-occupied housing (i.e., the rents that households
are not required to pay anyone else because
they own) goes untaxed. This rent is therefore
favored relative to most other types of income,
including ordinary income, taxable bond income,
dividend income, and capital gains income, which,
while favored and deferrable, is still generally taxed.
The average loan-to-value ratio in the United States
is less than 50 percent. Thus, even if all owners with
mortgages itemized on their tax returns, the value of
the nontaxation of imputed rent would be larger than
that of the mortgage interest deduction.

Effect of the benefit on choice of financing

One could argue that the effect of the mortgage interest
deduction is to put debt on a level playing
field with equity as a way to finance housing. This
contrasts with the tax treatment of corporate income,
where interest is deductible and the opportunity cost
of equity capital is not. Many analysts have shown
that the U.S. tax system encourages corporations to
take on debt. Capozza et al. (1996) have shown
how the combination of nontaxation of imputed rent
and the absence of a mortgage interest deduction
would discourage households from financing housing
with debt. In Australia, imputed rent is not taxed
and mortgage interest is not deductible, and households
there generally pay off their mortgages more quickly than in the United States.

Fixed rate mortgages vs ARMS

Floyd Norris's NYT column today is good:

http://select.nytimes.com/2007/07/27/business/27norris.html

I have long held a view that hosueholds should look at themselves as financial intermediaries, and match the duration of assets and liabilities. Houses are an asset of long duration, and as such, have values that are sensitive to changes in interest rates. Thus people who plan on living in a house for a long time should match it with a liability that has long duration--a long-term fixed rate mortgage.

If people know they will be in a house for five years, a hybrid 5 year ARM is fine. But it all cases, households should make sure they can afford a house based on a long-term mortgage before they buy. If the only thing that gets them into the house is a variable rate interest only loan, they are looking for trouble (FWIW, these thoughts occured to me at the time Chairman Greenspan was recommending ARMs to people in 2004).

Means and medians

The popular press seems to have a hard time understanding when a median (the 50th percentile) is better, and when to use a mean (the sum of everything in a population divided by the size of the population) is better. Both are measures of central tendency.

If one worries about large mistakes exponentially more than small mistakes, means are better. To give one example, if one is underwriting an 80 percent loan-to-value ratio loan, a small mistake in valuation matters little, but a big mistake matters a lot. Predicting house values based on a mean (likely a conditional mean, i.e., a mean based on knowlege about the characteristics of this house) thus makes more sense for underwriting than predicting house values based on a median. But if one just wants to know what someone in the middle of the homebuying pack would pay, the median is far better.

Median income is a much better reflection of middle class living standards than mean income. Reporters seem to have a hard time understanding this. But then so do some business school professors I know...

Trigger events

During past mortgage default spikes, having an "in-the-money" default option (that is, having a house that was worth less than the mortgage balance) was not always sufficient to bring about default. Usually, households that defaulted had also faced a "trigger event:" a job loss, a divorce, or a serious health issue. The high default rates in Michigan and Ohio in the late 1970s and in Texas in the mid-1980s were a function of both falling house prices and high unemployment.

The open question is whether people have become more ruthless about default. We'll know for sure after the next few years...

Brad Delong channels Jared Bernstein who channels Timothy Egan

http://delong.typepad.com/sdj/2007/07/the-minimum-wag.html

I was eating at the bar of a restaurant in San Francisco a few weeks ago. The bartender, a Russian, had moved from New York to SF. I asked her why she moved (and figured she would say something about weather). She said it was because the minimum wage in California was higher. I wondered then and there whether this anecdote revealed anything about the larger economy. Perhaps it does.

What is it with these people?

I happened upon a poll on CNN last night. 79 percent of say they are Americans are OK with a woman president, 86 percent (I think) say they are OK with a black president. This means that somewhere between 21 and 35 percent of Americans think race or sex is a disqualification for President. Who are these people????

The Excellent Ken Small on Transportation Policy

This is really good:



I think his points about more heterogeneous urban highways (not all arterials need to be freeways; not every highway needs to be designed to carry trucks) are particularly good.

Research and Teaching

A smart colleague of mine, James Bailey, argues that teaching excellence and research excellence are uncorrelated. Specifically, he cites work that shows that research productivity is not a good predictor of teaching evaluations or peer review. That doesn't particularly surprise me. But I do think there is both reason behind and evidence for the idea that a research environment produces a richer intellectual environment for students.

For starters, those who do research are being kept honest on a regular basis. When one sends a paper off to be refereed or presents a paper at a conference, he is exposing himself to the possibility of getting beaten up intellectually. But if one's ideas can survive scrutiny, and have foundation in evidence (there I am, going all positivist on you), then one is probably reasonably well qualified to teach.

Second, research almost forces one to keep current. I am not saying that everyone needs to print a refereed paper every year--but one every five years is not unreasonable, and would help people stay current (BTW, my mother was an English professor at a "comprehensive" teaching university, and she still managed to crank out an article every now and then. She wasn't particularly rewarded for doing so, it was just important to her.)

Third, I don't think it is an accident that the greatest University in England was home to Newton and Keynes, among others; nor is it an accident that MIT, Stanford, Berkeley, Chicago, etc. attract the best motivated and brightest students from all over the world.

So I am curious about what the (likely small number of) people who look at this blog think. Do (did) they get a better classroom experience from faculty who produce research. Or at least from those that produce well-known research?