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December 22, 2007

Economist's View - 5 new articles

Immigration Reform and Guest Workers

From Free Exchange, a discussion of immigration reform and guest worker programs:

Visitation rights, by Free Exchange: However one feels about the politics of immigration, there can be no question that giving migrants from poor nations the ability to work in rich countries constitutes a massive upward mobility event and a significant source of aid to developing nations. It would therefore be a welcome turn of events if developed nations could find a politically acceptable way to accommodate such labour movements. ...

In next month's issue of Reason, Kerry Howley makes an important contribution to the discussion in constructing a compelling case for the adoption of a guest worker programme. Using Singapore's system as a case study, she helpfully notes the advantages and drawbacks of temporary residence visas in a piece that comes across primarily as a challenge to pro-immigrant groups on the left, who tend to oppose guest worker programmes as inimical to the American ideal and a poor substitute for a general liberalisation of border policies.

Certainly there's something to that. The potential gains to invited labourers should appeal to liberal sensibilities... Ms Howley ... recognises the potential for abuse--both of the programme's terms and of workers themselves--in such a system, but she argues convincingly that these difficulties can be overcome through appropriate regulation of the process... Just as important, she makes the point that an easier path into the American labour market should facilitate the return of immigrant labourers to their home country, as they needn't fear being shut out for good upon exiting.

Reading Ms Howley, one begins to bristle at the pettiness of liberal guest worker critics, who place their moral qualms regarding the corrupting influence of a large population of "second-class citizens" above concerns for the material well-being of poor labourers. This, however, is ... not an accurate description of the state of anti-immigration sentiment on the talk-show right. Rather, one hears again and again of the growing use of Spanish, the questionable loyalties of incoming migrants, and the negative effects they have on "traditional" American neighbourhoods. The most outspoken nativists, like Republican presidential candidate Tom Tancredo, call for reductions in legal immigration as well as illegal.

The conflict at the bottom of immigration disagreements, then, is not primarily economic, but cultural. Immigration opponents on the right detest the otherness of the immigrant, and a guest worker programme does nothing to eliminate that sentiment. In the end, immigration reform did not fail in America due to liberal quandaries on the ethics of guest worker programs; it failed because the Republican Party took a hard right turn on the issue. It seems odd to assume Republican intransigence and argue that Democratic politicians should pursue a guest-worker middle ground, when the real angst on the right is not over the status of the immigrants but their very presence.

Ms Howley does point out that the American public, in general, is amenable to a guest worker program. In general, polling on the issue indicates that a hardline position on immigration is a loser for Republican candidates. All the same, it is the position which has come to dominate the agenda of the national party. ... As it stands, I think liberal politicians are justified in worrying that a willingness to entertain a second-class role for immigrant labour may only empower the ugliest elements of the nativist movement.

A guest worker programme also leaves some of the most troublesome policy problems unaddressed. What, for example, should we do about the millions of undocumented workers already in the country? Are we willing to issue enough temporary visas to satisfy the demand for work in America? Otherwise, we can expect the flow of undocumented workers to continue... Is it conceivable that Americans could tolerate the strict, even ruthless rigorousness with which Singapore polices its guest worker program? And if guest workers come, work hard, and wish to stay, then what? ...

Given the large and growing immigrant population in this country, and a demonstrated willingness among immigrant groups to stand up for their interests, the debate over a guest worker program may soon enough be moot. In 2006, Republican candidates running on a restrictionist platform performed dismally... Ultimately, it seems probable that the Republicans will do the compromising, or the losing, or perhaps both.

From an economic standpoint, as I believe Ms Howley would agree, a guest worker programme is the second best-outcome. Constraints on labour mobility reduce the efficiency of resource allocations and impede development, while forcing governments to spend billions policing lines in the desert. If a guest worker programme is also politically second best--if Democrats can increase their majorities by letting Republicans hang themselves with a restrictionist rope--then the best advice may well be to wait until next year and see if we cannot do better than second best.

"Traffic Jam Mystery Solved"

Since I'm on the road today, this caught my attention. Apparently, there's a reason for traffic jams that seem to occur for no reason at all:

Traffic jam mystery solved by mathematicians, EurekAlert: Mathematicians ... have solved the mystery of traffic jams by developing a model to show how major delays occur on our roads, with no apparent cause. Many traffic jams leave drivers baffled as they finally reach the end of a tail-back to find no visible cause for their delay. Now, a team of mathematicians from the Universities of Exeter, Bristol and Budapest, have found the answer and published their findings...

The team developed a mathematical model to show the impact of unexpected events such as a lorry pulling out of its lane on a dual carriageway. Their model revealed that slowing down below a critical speed when reacting to such an event, a driver would force the car behind to slow down further and the next car back to reduce its speed further still. The result of this is that several miles back, cars would finally grind to a halt, with drivers oblivious to the reason for their delay. ... The jam moves backwards through the traffic creating a so-called 'backward travelling wave', which drivers may encounter many miles upstream, several minutes after it was triggered.

Dr Gábor Orosz of the University of Exeter said: "...Our model shows that overreaction of a single driver can have enormous impact on the rest of the traffic, leading to massive delays."

Drivers and policy-makers have not previously known why jams like this occur, though many have put it down to the sheer volume of traffic. While this clearly plays a part in this new theory, the main issue is around the smoothness of traffic flow. According to the model, heavy traffic will not automatically lead to congestion but can be smooth-flowing. ...

Dr Orosz continued: "When you tap your brake, the traffic may come to a full stand-still several miles behind you. It really matters how hard you brake - a slight braking from a driver who has identified a problem early will allow the traffic flow to remain smooth. Heavier braking, usually caused by a driver reacting late to a problem, can affect traffic flow for many miles." ...

But what is the critical speed, how low does a car's speed have to get after slamming on the brakes to cause a decent sized backward traveling wave to occur? I hope I don't find out from something that happens today.

Paul Krugman: Blindly Into the Bubble

The ideological basis for the subprime crisis:

Blindly Into the Bubble, by Paul Krugman, Commentary, NY Times: When announcing Japan's surrender in 1945, Emperor Hirohito famously explained...: "The war situation has developed not necessarily to Japan's advantage."

There was a definite Hirohito feel to the explanation Ben Bernanke ... gave this week for the Fed's locking-the-barn-door-after-the-horse-is-gone decision to modestly strengthen regulation of the mortgage industry: "Market discipline has in some cases broken down, and the incentives to follow prudent lending procedures have, at times, eroded."

That's quite an understatement. In fact, the explosion of "innovative" home lending ... was an unmitigated disaster. ... Apologists for the mortgage industry claim, as Mr. Greenspan does..., that "the benefits of broadened home ownership" justified the risks of unregulated lending.

But homeownership didn't broaden. The great bulk of dubious subprime lending took place from 2004 to 2006 — yet homeownership rates are already back down to mid-2003 levels. With millions more foreclosures likely, it's a good bet that homeownership will be lower at the Bush administration's end than it was at the start.

Meanwhile, during the bubble years, the mortgage industry lured millions of people into borrowing more than they could afford, and simultaneously duped investors into investing vast sums in risky assets wrongly labeled AAA. ... So where were the regulators as one of the greatest financial disasters since the Great Depression unfolded? They were blinded by ideology. ...

Mr. Greenspan... [is] a disciple of Ayn Rand, the high priestess of unfettered capitalism... In a 1963 essay for Ms. Rand's newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."

It's no wonder, then, that he brushed off warnings about deceptive lending practices... In Mr. Greenspan's world, predatory lending — like attempts to sell consumers poison toys and tainted seafood — just doesn't happen.

But Mr. Greenspan wasn't the only top official who put ideology above public protection. Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.

Also in attendance were representatives of financial industry trade associations, which had been lobbying for deregulation. As far as I can tell..., there were no representatives of consumer interests on the scene.

Two months after that event the Office of the Comptroller of the Currency, one of the tree-shears-wielding agencies, moved to exempt national banks from state regulations that protect consumers against predatory lending. If, say, New York State wanted to protect its own residents — well, sorry, that wasn't allowed.

Of course, now that it has all gone bad, people ... are rethinking their belief in the perfection of free markets. Mr. Greenspan has come out in favor of, yes, a government bailout. "Cash is available," he says — meaning taxpayer money — "and we should use that in larger amounts, as is necessary, to solve the problems of the stress of this."

Given the role of conservative ideology in the mortgage disaster, it's puzzling that Democrats haven't been more aggressive about making the disaster an issue for the 2008 election. They should be: It's hard to imagine a more graphic demonstration of what's wrong with their opponents' economic beliefs.

Walking Away from the Mortgage Contract

As noted below, lenders are concerned that there has been a change in the willingness of homeowners to walk away from their mortgage contracts. Why is this happening? The decision to walk away from a mortgage can be viewed as an unexercised option contract, and that approach can shed light on the source the change in the number of homeowners choosing to default.

I'm sure most of you know what an option contract is, but just in case, here' a quick review. There are two types of options, calls and puts. A call option gives you the right to purchase an asset at a pre-specified price, called the strike or exercise price. The purchase must be made on or before a specific expiration date. For example, a March call option for Google stock with an exercise price of $75 gives you the option to purchase Google stock for $75 at any time up to and including the March expiration date. It doesn't matter what the actual market price of the stock is, you can always purchase at $75 so long as it's on or before the expiration date (there are actually two types of options, an American call option gives you the option to purchase the stock up to and including the expiration date, a European option can only be exercised on the expiration date, not before).

Options do not have to be exercised, the holder of the option chooses whether to exercise it or not. When would this option be exercised? Suppose the price of the stock increases to $100 after you purchase the option (when the market price of the stock exceeds the strike price it is said to be "in the money"). If you choose to exercise the option and purchase at $75, you could then sell the stock at $100 on the market making a gross gain of $25. Thus, whenever the market price exceeds the exercise price, the option is in the money and can be redeemed for a gain.

The purchase price of the option is called the premium. There are ways to value options and set the premium, and I will skip that, but let's just say that the price of the option, i.e. the premium, is $10 for illustration.

Recapping, you purchase a call option for $10 that allows you to buy the stock for $75 at any time between now and March. Then, after the option is purchased but before the expiration date, the stock rises to $100 so you exercise the option making a profit of $25-$10=$15. [If, on the other hand, the price never rises above $75 before expiration date in March, the option will be left unexercised and you will lose your $10.]

A put option is just the opposite, an option to sell rather than buy at a specified price on or before a specified date. For example, you might pay $10 for the right to sell the stock at $75 at any time through March, i.e. you hold a March put option. In this case, the option will be exercised only if the stock price falls below the exercise price. Thus, if the price falls to $50, you can buy the stock for $50 on the stock market, then turn around and sell it for $75 according to the option contract realizing a profit of $25-$10=$15. However, if the price stays above the exercise price, the option will remain unexercised through the end of the contract. [If my quick explanations aren't clear, the Wikipedia explanations linked above might help.]

Now, how does this relate to walking away from a mortgage? A mortgage contract grants an implicit call option contract to the borrower. [Any non-recourse loan backed by collateral has this property. A non-recourse loan means the lender may not sue the borrower for further payment beyond the value of the collateral even if the collateral is not enough to cover the loan]. To put the mortgage in option terms, think of the borrower as turning over the collateral (the house) to the lender with the option to reclaim the collateral by repaying the loan. If the loan is not repaid, if the borrower uses the option to walk away, then the lender keeps the collateral (is stuck with the house).

When should the borrower walk away? If the value of the loan is less than the value of the collateral, the best option for the borrower is to leave the option unexercised, i.e. to walk away without using the option to repay the loan and claim the collateral (you want the house only if it's worth more than the loan). I should note, however, that this abstracts from any future reputational effects (i.e. a bad credit rating in the future represents a cost that must be considered) or ethical behavior (you pay the loan even if it costs more than the collateral is worth to honor the contract you signed). That is, this is the case where the borrower and lender agree in advance that walking away is not a sign of bad faith. If that is not true, if walking away has future costs or is constrained by ethics, this must be considered in the analysis. But both the reputational and ethical effects are easy to incorporate, it just means that the loan value must exceed the collateral value by some critical amount (by the value of losing reputation or behaving unethically) before the borrower will choose to walk away from the contract.

Interestingly, there are indications that the reputational or ethical effects are becoming less of a constraint to borrowers walking away:

Jingle mail, jingle mail, jingle mail — eek!, by Paul Krugman: Via Calculated Risk: The WSJ reports that homeowners whose mortgages are bigger than their houses are worth are starting to walk away from their houses, even if they could afford the mortgage payments. ...

Here's a bit more from CR:

One of the greatest fears for lenders (and investors in mortgage backed securities) is that it will become socially acceptable for upside down middle class Americans to walk away from their homes.

See these comments from Bank of America CEO Kenneth Lewis via the WSJ: Now, Even Borrowers With Good Credit Pose Risks

"There's been a change in social attitudes toward default," Mr. Lewis says. Bankers typically have believed that cash-strapped borrowers would fall behind on their credit cards, car payments and other debts -- but would regard mortgage defaults as calamities to be avoided at all costs. That isn't always so anymore, he says.

"We're seeing people who are current on their credit cards but are defaulting on their mortgages," Mr. Lewis says. "I'm astonished that people would walk away from their homes." The clear implication: At least a few cash-strapped borrowers now believe bailing out on a house is one of the easier ways to get their finances back under control.

... there is a new class of homeowners in name only. Because these people never put up much of their own money, they don't act like owners, committed to their property for the long haul. ...

So, there are three separate factors that could contributing to the increase in homeowners walking away from mortgage contracts, a fall in the price, a decreased concern with future reputation, and a decline in ethical behavior. Obviously the fall in price is a big factor, and it appears that an unexpected fall in the ethical or reputational effects may be contributing as well.

The last question to ask, I suppose, is why has there been a decline in the stigma from walking away? One potential reason is that the news media has played this as largely arising from predatory behavior by lenders, and therefore going into default is not seen as a personal failing as in the past, but rather as being a victim of unscrupulous behavior. Second, mortgage problems are being reported as widespread, not isolated, and the "everyone else is doing it" effect lessens the stigma. Third, that a more general decline in social behavior has caused what's individually rational from an economic perspective to be valued more, and concerns based upon the social stigma from being a "deadbeat" valued less. That is, general societal changes have caused individualism to become more important, and social interactions (e.g. what other people think of you) less important. But I'm not so sure about the last one, or that the three together capture all of the reasons for the change in behavior. Any other ideas?

links for 2007-12-21

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