Econ 350: October 15  Chapter 8: Economic Analysis of Financial Structure  CRA  Newly posted article

Moral Values  McCloskey 2006  The Bourgeois Virtues: Ethics for an Age of Commerce  Since 1800 income (in real terms has gone from $3 to $137) How to account for how well off we are?  Ethical argument: Commerce requires reliability. Reasonableness, integrity.  Adam Smith the moral philosopher.

Asymmetric information  Adverse Selection  unknown quality causes unraveling: Lemons problem  Solutions Private production and sale of information Government regulation to increase information Financial intermediation Collateral and net worth  Moral hazard: principal &agent have different goals  Solutions Compensation schemes align incentives Don’t be a principal (use debt contracts instead of equity)

Bottom Line:  We devote a lot of resources to combating adverse selection and moral hazard.  Many of the institutions and “stylized facts” in our economy arise from or in response to these informational problems.

Did the CRA cause the crisis?  Community Reinvestment Act  Legislation is a response to “redlining” Banks refuse to lend to entire (low-income) neighborhoods  1977: Federal government requires banks to lend in neighborhoods where they take deposits If they want to participate in FDIC deposit insurance

CRA and the financial crisis  Did CRA requirements force banks to make poor loans?  What is the counterfactual?  What data do we need?

How do we model foreclosure?  Stylized facts, what causes foreclosure?  Characteristics of borrower  Characteristics of loan  Characteristics of lender  Characteristics of housing market  other stuff?

How do we model foreclosure?  Terminology  Probability of foreclosure “is a function of” other things  Foreclosure is the dependent variable  Characteristics (X’s) are the independent variables  Statistical approach  Foreclosure is a “dichotomous” or “indicator” variable  Y = 1 if foreclosure occurs and 0 otherwise  Estimation yields probability of foreclosure

Foreclosure study: Laderman & Reid, Federal Reserve Bank of San Francisco  X’s can be dichotomous, categorical or continuous  Income, credit score, race  Fixed rate, loan-to-value ratio, prepay penalty, required documentation.  CRA regulated, in CRA assessment area, retail vs. wholesale  Income, % owner occupied, age of housing stock, capitalization (rent vs. home price), prices

Background MethodsFindingsPolicy IMCs have higher foreclosure rates

Background MethodsFindingsPolicy Model Results I (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model Results I (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model Results I (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model Results I (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model Results I (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model Results incl. origination channel (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model 2: Results stratified by neighborhood income (dependent variable: foreclosure)

Background MethodsFindingsPolicy Model 2: Results stratified by neighborhood income (dependent variable: foreclosure)

Foreclosure study conclusion  Note that retail presence in the neighborhood is important  “… one of the more interesting findings of our research is the evidence that some aspect of “local” presence seems to matter in predicting the sustainability of a loan. Once a lender is removed from the community…or from the origination decision (wholesale loan)…foreclosure increase significantly.” How does this relate to our study of asymmetric information? The empirical evidence suggests that the informationgathered by local lenders and reduces moral hazard & adverse selection.

Conflict of Interest  Rating agencies  Government delegates task of rating bond quality Government is principal, Rating agency is agent  Bond issuer pays rating agency  Note: principal-agent issues arise in regulation  Who is the principal and who is the agent?  5