Findings

By the Bookie

Kevin Lewis

February 01, 2010

A marketing scheme for making money off innocent people: A user's manual

Kaushik Basu
Economics Letters, forthcoming

Abstract:
Firms often give away free goods with the product they sell. Firms often give stock options to their managers and employees. Mixing these two practices - giving stocks to consumers who buy the firm's product - creates a deadly brew. People can be lured into buying this product, giving the entrepreneur huge profits and the consumers a growing profit share. But this is a camouflaged Ponzi that will ultimately crash. It is argued, by analogy, that the common practice of giving stock options to employees can be a factor behind financial crashes. Understanding this can help create a better regulatory structure.

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Diversification and its Discontents: Idiosyncratic and Entrepreneurial Risk in the Quest for Social Status

Nikolai Roussanov
Journal of Finance, forthcoming

Abstract:
Social status concerns effect investors' decisions by driving a wedge in attitudes towards aggregate and idiosyncratic risks. I model such concerns by emphasizing the desire to ``get ahead of the Joneses,'' which implies that aversion to idiosyncratic risk is lower than aversion to aggregate risk. The model predicts that investors hold concentrated portfolios in equilibrium, which helps rationalize the puzzlingly small premium for undiversified entrepreneurial risk. In the model, status concerns are more important for the wealthier households. Consequently, these households own a disproportionate share of risky assets, particularly private equity, and experience greater volatility of wealth and consumption growth, consistently with empirical evidence.

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Bailouts, the incentive to manage risk, and financial crises

Stavros Panageas
Journal of Financial Economics, March 2010, Pages 296-311

Abstract:
A firm's termination leads to bankruptcy costs. This may create an incentive for outside stakeholders or the firm's debtholders to bail out the firm as bankruptcy looms. Because of this implicit guarantee, firm shareholders have an incentive to increase volatility in order to exploit the implicit protection. However, if they increase volatility too much they may induce the guarantee-extending parties to "walk away." I derive the optimal risk management rule in such a framework and show that it allows high volatility choices, while net worth is high. However, risk limits tighten abruptly when the firm's net worth declines below an endogenously determined threshold. Hence, the model reproduces the qualitative features of existing risk management rules, and can account for phenomena such as "flight to quality."

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Personal Bankruptcy and Credit Market Competition

Astrid Dick & Andreas Lehnert
Journal of Finance, forthcoming

Abstract:
We document a link between U.S. credit supply and rising personal bankruptcy rates. We exploit the exogenous variation in market contestability brought on by banking deregulation - the relaxation of entry restrictions in the 1980s and 1990s - at the state level. We find deregulation explains at least 10% of the rise in bankruptcy rates. We also find that deregulation leads to increased lending, lower loss rates on loans, and higher lending productivity. Our findings indicate that increased competition prompted banks to adopt sophisticated credit rating technology, allowing for new credit extension to existing and previously excluded households.

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Exploiting Naivete about Self-Control in the Credit Market

Paul Heidhues & Botond Koszegi
American Economic Review, forthcoming

Abstract:
We analyze contract choices, loan-repayment behavior, and welfare in a model of a competitive credit market when borrowers have a taste for immediate gratification. Consistent with many credit cards and subprime mortgages, for most types of non-sophisticated borrowers the baseline repayment terms are cheap, but they are also inefficiently front-loaded and delays require paying large penalties. Although credit is for future consumption, non-sophisticated consumers overborrow, pay the penalties, and back-load repayment, suffering large welfare losses. Prohibiting large penalties for deferring small amounts of repayment -- akin to recent regulations in the US credit-card and mortgage markets -- can raise welfare.

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The Cost of Being Late? The Case of Credit Card Penalty Fees

Nadia Massoud, Anthony Saunders & Barry Scholnick
Journal of Financial Stability, forthcoming

Abstract:
This paper is the first in the literature to examine the determinants of US credit card penalty fees. Many critics of credit card fees - including a number of US Senators - have argued that credit card penalty fees reflect banks' market share. Using a unique data set we find that fees are increasing in customer risk which supports the position of defenders of penalty fees, such as banks. However, our finding that fees are increasing in a bank's market share is consistent with the concerns expressed by politicians and regulators. We also find card penalty fees are direct substitutes for card interest rates.

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Information Disclosure, Cognitive Biases and Payday Borrowing

Marianne Bertrand & Adair Morse
University of Chicago Working Paper, October 2009

Abstract:
If people face cognitive limitations or biases that lead to financial mistakes, what are possible ways lawmakers can help? One approach is to remove the option of the bad decision; another approach is to increase financial education such that individuals can reason through choices when they arise. A third, less discussed, approach is to mandate disclosure of information in a form that enables people to overcome limitations or biases at the point of the decision. This third approach is the topic of this paper. We study whether and what information can be disclosed to payday loan borrowers to lower their use of high-cost debt via a field experiment at a national chain of payday lenders. We find that information that helps people think less narrowly (over time) about the cost of payday borrowing, and in particular information that reinforces the adding-up effect over pay cycles of the dollar fees incurred on a payday loan, reduces the take-up of payday loans by about 10 percent in a 4 month-window following exposure to the new information. Overall, our results suggest that consumer information regulations based on a deeper understanding of cognitive biases might be an effective policy tool when it comes to regulating payday borrowing, and possibly other financial and non-financial products.

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The macroeconomic determinants of volatility in precious metals markets

Jonathan Batten, Cetin Ciner & Brian Lucey
Resources Policy, forthcoming

Abstract:
This paper models the monthly price volatilities of four precious metals (gold, silver, platinum and palladium prices) and investigates the macroeconomic determinants (business cycle, monetary environment and financialnext term market sentiment) of these volatilities. Gold volatility is shown to be explained by monetary variables, but this is not true for silver. Overall, there is limited evidence that the same macroeconomic factors jointly influence the volatility processes of the four precious metal price series, although there is evidence of volatility feedback between the precious metals. These results are consistent with the view that precious metals are too distinct to be considered a single asset class, or represented by a single index. This finding is of importance for portfolio managers and investors.

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The Reality Game

Dmitriy Cherkashin, Doyne Farmer & Seth Lloyd
Sante Fe Institute Working Paper, February 2009

Abstract:
We introduce an evolutionary game with feedback between perception and reality, which we call the reality game. It is a game of chance in which the probabilities for different objective outcomes (e.g., heads or tails in a coin toss) depend on the amount wagered on those outcomes. By varying the 'reality map', which relates the amount wagered to the probability of the outcome, it is possible to move continuously from a purely objective game in which probabilities have no dependence on wagers to a purely subjective game in which probabilities equal the amount wagered. We study self-reinforcing games, in which betting more on an outcome increases its odds, and self-defeating games, in which the opposite is true. This is investigated in and out of equilibrium, with and without rational players, and both numerically and analytically. We introduce a method of measuring the inefficiency of the game, similar to measuring the magnitude of the arbitrage opportunities in a financial market. We prove that the inefficiency converges to equilibrium as a power law with an extremely slow rate of convergence: The more subjective the game, the slower the convergence.

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Collective Hallucinations and Inefficient Markets: The British Railway Mania of the 1840s

Andrew Odlyzko
University of Minnesota Working Paper, January 2010

Abstract:
The British Railway Mania of the 1840s was by many measures the greatest technology mania in history, and its collapse was one of the greatest financial crashes. It has attracted surprisingly little scholarly interest. In particular, it has not been noted that it provides a convincing demonstration of market inefficiency. There were trustworthy quantitative measures to show investors (who included Charles Darwin, John Stuart Mill, and the Bronte sisters) that there would not be enough demand for railway transport to provide the expected revenues and profits. But the power of the revolutionary new technology, assisted by artful manipulation of public perception by interested parties, induced a collective hallucination that made investors ignore such considerations. They persisted in ignoring them for several years, until the lines were placed in service and the inevitable disaster struck. In contrast to many other bubbles, the British Railway Mania had many powerful, vocal, and insightful critics. But the most influential of them suffered from another delusion, which misled them about the threat the Mania posed. As a result, their warnings were not persuasive, and were likely even counterproductive, as they may have stimulated increased investments. The delusions that led to the financial disaster of the Railway Mania arose from experience with the railway mania of the mid-1830s. Seldom even mentioned in the literature, it was about half the size of the big Railway Mania of the 1840s (and thus still far larger than the Internet bubble). The initial financially exuberant phase of it did collapse. But it appears to have been unique among large manias in that a few years later it was seen as having collapsed prematurely, as projects started during its exuberant phase became successful. That mania demonstrates the difficulty in identifying bubbles that are truly irrational. Both railway manias provide a variety of other lessons about the interaction of technology and financial markets.

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Saving Up for Bankruptcy

Ronald Mann & Katherine Porter
Georgetown Law Journal, forthcoming

Abstract:
This paper probes the puzzle of why only a few of those for whom bankruptcy would be economically valuable ever choose to file. We use empirical evidence about the patterns of bankruptcy filings to understand what drives the point in time at which the filings occur, and to generate policy recommendations about how the bankruptcy and debt-collection system sorts those that need relief from those that do not. The paper combines three kinds of data. First, quantitative data collected from judicial filing records that show the weekly, monthly, and annual patterns of bankruptcy filings. Second, 40 interviews with industry professionals (consumer and creditor attorneys, trustees, and judges) from five states (Georgia, Iowa, Massachusetts, Nevada, and Texas). The interviews probe why people file when they do and what distinguishes those that choose to file from those that hold off. Third, survey data from the 2007 Consumer Bankruptcy Project, the first nationally representative sample of bankrupt households. The survey data explores the struggles families endure before they choose to file. The data support two empirical findings. The first is about the role of aggressive collection in motivating bankruptcy filings. Generally, apart from foreclosure-related filings, the emergency bankruptcy filing is largely a myth. Creditor collection activity does not force people into an immediate bankruptcy. On the contrary, it wears them down slowly but ineluctably, like water dripping on a stone. Second, the primary factor that affects the date on which people actually file is their ability to save up the money to pay their attorneys and filing fees. Thus, among other things, we see an annual peak shortly after families receive their tax refunds, and a semi-monthly peak related to the receipt of paychecks. Finally, we build two important policy recommendations on those findings. First, we argue that the existing collection process is flawed by a prisoner's dilemma that leads to excessive and wasteful "dunning" by creditors. Because each creditor has an incentive to be first in line to collect, and because the creditors can dun their debtors at little or no cost to themselves, creditors as a group naturally engage in dunning activities that debtors find intolerable - a level of activities from which a rational single creditor would refrain. We recommend a variety of solutions to strengthen the FDCPA. Some are at the level of detail (extending it to in-house collection, increasing the statutory damages, and the like). But the most important is a "do-not-call" rule modeled on the do-not-call list for telemarketers. Specifically, we recommend a low-transaction-cost mechanism (activated by telephone call or Internet site) that would automatically and immediately stop all creditor collection activity. Second, corollary to our argument that excessive collection causes inappropriate filings, we also believe that the excessive filing costs deter socially valuable filings. To respond to that problem, building on earlier work, we argue that low-income low-asset filers should have access to a simplified administrative process that provides prompt relief without the costs and delay of judicial process.


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