Dwight M. Jaffee

Imperfect Information, Uncertainty, and Credit Rationing

I. Introduction, 651.—II. The model of borrowing behavior, 652.—III. Lender and market behavior under competitive conditions, 658.—IV. Market solutions under monopoly, 663.—V. Conclusion, 664.—VI. Appendix, 665.

Methods of Estimation for Markets in Disequilibrium

This paper is concerned with the econometric problems associated with estimating supply and demand schedules in disequilibrium markets. Tbe general problem is that in the absence of aa equilibrium condition the ex ante demand and supply quantities cannot in general be equated to the observed quantity traded in the market. Four methods of estimation, differing primarily in tbW use of information on price-setting behavior, are developed in this paper. The first method is a generalization of an earlier method developed by R. Quandt and is based upon the maximization of a likelihood function. The method does not require any specitic assnm,,tion about pricwettin~ behatior,.and it allows the sample separation (into demand and supply regimes) to be estimated along with the ce.ztlMent estimates. The second and third methods use the change in price as a qualirotiue proxy in determining the sample separation. The fourth method uses the change in price as a quantitative proxy for the amount of excess demand (supply) in the market. In the final section of the paper the four methods arc used to estimate a model of the housing attd mortgage market in an effort to gauge the potential usefulnesr of each of the methods.

On the Application of Portfolio Theory to Depository Financial Intermediaries

It has long been recognized that the useful application of the portfolio selection theory of Markowitz [10] and Tobin [19], [20] is limited by the restrictive assumptions placed on the utility function, distribution of returns, wealth holdings, and dynamic behaviour of the individual economic unit. Recent research by numerous individuals has indicated, however, that many of the implications of the Markowitz-Tobin theory can be derived from a weaker set of assumptions. The net result is a remarkably strong set of propositions and theorems with a wide variety of applications including intuitive insights into the gains from diversification, empirically useful algorithms for common stock selection, and theoretical advances for understanding the demand for money and the general equilibrium of financial markets. In this paper we discuss the application of these principles of portfolio selection to the behaviour of a depository financial intermediary. This notion is not, of course, entirely novel. For one thing, the extensions of the Markowitz-Tobin theory to include short sales (see Lintner [9]) and mutual fund behaviour (see Merton [12] and the cited studies) indicate that at a sufficiently high level of abstraction the available theory may be directly applicable to financial intermediaries. For another, empirical studies are now available that attempt to explain financial intermediary behaviour on the basis of the principles of portfolio theory (see Parkin [13]). In the case of the extended Markowitz-Tobin model, however, it is to be stressed that it may be applied to depository financial intermediaries only by abstracting from many of the institutional and market factors that make these intermediaries unique, and thus there does remain the need to develop a theory that explicitly incorporates these factors. With respect to the empirical studies, the primary objective has been the estimation of demand functions for financial assets, and thus there has been little attempt to derive the theoretical propositions that become available when portfolio theory is applied to financial intermediaries.

Cyclical variations in the risk structure of interest rates

The risk structure of interest rates may be defined as the interest rate differentials that exist between securities that are identical in all relevant aspects except for the likelihood of default on the pa,yment of interest or principal. The risk structure of interest rates is thus directly analogous to the term structure of interest rates, in which term to maturity is the differentiating characteristic. In particular, macroeconomic results on the risk structure of interest rates, like term structure relationships, have a wide range of applications, as illustrated below. To date, however, most studies on the risk structure have been primarily concerned with explainin, 0 the risk of individual firms and bond issues on a microeconomic basis.l The present effort builds on these previous studies in terms .>f making use of risk category aggregates, and then investigates the cyclical variations in the interest rate differentials (hereafter, risk spreac~~) between the various risk categories.2 The study consists of three main parts. In section 2, we face immediately the key problem with risk structure work, namely that the distinguishing characteristic risk is not directly and objectively measurable. This situation contrasts strongly, for example, with term structure work, where the distinguishing feature term to maturity is explicit and well-defined. Our solution to this risk structure problem is to make use of the available bond ratings in the United States3 in particular Moody’s AAA to BAA ratings and the associated

The Interest Rate Risk of Fannie Mae and Freddie Mac

This paper evaluates the interest rate risk of Fannie Mae and Freddie Mac (F&F) and develops related public policy proposals. F&F merit special attention due to (1) their potentially very large interest rate risk, and (2) their status as U.S. government sponsored enterprises. The analysis focuses on the dynamic hedging strategy and extensive use of interest rate derivatives employed by F&F to control their interest rate risk. While dynamic hedging is highly cost effective for F&F, it creates imperfect hedges and thus could impose significant costs on U.S. taxpayers in a potential future F&F bailout. The policy discussion includes proposals to modify the F&F interest rate disclosures and the OFHEO stress test, and to create rate interest risk standards for F&F.

The Welfare Implications of Uneven Inflation

The assumption of ‘steady’ inflation has proven to be a common starting point for most welfare analysis of inflation. As defined, steady inflation has three basic properties (1) it is perfectly foreseen, so that the expected inflation rate, which alone influences behaviour, is in fact the inflation rate actually realised; (2) market institutions adjust sufficiently to accommodate the inflation; one example of such an adjustment would be the use of price-indexed contracts; other examples will be given below; (3) the effects of inflation are uniform over all commodity groups; that is, inflation causes no changes in relative prices.

Strategies to Develop Mortgage Markets in Transition Economies

The transformation of the planned economies of central and eastern Europe to market economies has focused on economic stabilization and liberalization, privatization, and financial sector development. The housing sector and the mortgage market have been factors in each of these processes but not always positive ones. The authors analyze the factors hindering the development of mortgage markets in these transition economies and propose a strategy to expedite that development. They show that banks in transition economies are reluctant to make mortgage loans because of the risks in mortgage lending (credit, interest rate, and liquidity risk). Together with the required primary market improvements, a secondary mortgage market is likely to help solve this problem. A secondary mortgage market separates the act of making mortgage loans (which can still be carried out by banks) from the act of holding mortgage loans (which can be carried out more effectively by capital market investors). The authors emphasize the potential role of the housing finance system in being an engine of innovation for the rest of the financial sector. But, if the housing finance system is stunted, other nonmarket devices would develop for financing and subsidizing the housing sector -creating negative externalities for the rest of the system. The authors point out that a market-based housing finance system is unlikely to emerge without initial government support. Moreover, the transition economies must first create an economic and legal infrastructure to support the long-term and complex market relationships and contracts that constitute a housing financial system.

Chapter 16 Credit rationing

Publisher Summary Credit markets differ from standard markets in two important respects. First, standard markets, which are the focus of classical competitive theory, involve a number of agents who are buying and selling a homogeneous commodity. Second, in standard markets, the delivery of a commodity by a seller and payment for the commodity by a buyer occur simultaneously. The analysis of credit allocation can go astray in trying to apply the standard supply and demand model that is not very appropriate for the market for promises. In the United States, a complicated, decentralized, and interrelated set of financial markets, institutions, and instruments have evolved to provide credit. Credit rationing focuses on one set of these instruments—loan contracts—where the promised repayments are fixed amounts. At the other extreme, equity securities are promises to repay a given fraction of a firms profits. A spectrum of securities, including convertible bonds and preferred shares, exists between loans and equity.

How responsive is higher education? The linkages between higher education and the labour market

Higher education is considered vital for developing a productive and dynamic labour force to meet the demands of the global economy. How effectively does the US higher education sector respond to labour market signals? We match US postsecondary degree completions from 1984 to 2008 with occupational employment statistics and employ an Instrumental Variable (IV) strategy to examine the supply response to changes in occupation specific demand. The supply of educated workers appears weakly responsive to short-term wage signals and moderately responsive to long-term employment conditions. Analysis reveals a sizeable degree of heterogeneity and lag in the responsiveness across specific occupation–degree pairings. Failure to respond rapidly to changes in labour demand may be one factor driving inequality in wages across occupations and in the aggregate economy. We suggest some simple policy measures to help increase the responsiveness of the higher education sector, both in terms of the output of specific degree programmes and the overall mix and composition of graduate completions.

Should Governments Provide Catastrophe Insurance

Thomas Russell and Dwight Jaffee argue that private markets should be able to insure against catastrophes like Hurricane Katrina or 9/11, but if government must, then it should follow the same actuarially based pricing and reserving rules that would be followed by a competitive private market.