Today: Analyzing “contract regulation” But, first, some organizational reminders

Organizational issues Any doubts on team composition: email joan.tubau@upf.edu First seminar: Present briefly & discuss a more specific plan on how you will develop the project Do not forget: For whom? Try to define your “client” Which concepts and theories will you apply? Even: What are the hypotheses? Which methods to test them? Class attendance No need to justify two absences Weight in final grade: relevant but not mortal More important: good participation Good: inspired by theory, readings vs. Bad: out of the hat improvisation Good: critical analysis of project presentations vs. Bad: formalistic o laudatory comment of project presentations Compare private / public ordering in completion and enforcement 2

Analyzing “contract regulation”

Basics on contracts (1) The problem of potential traders Defining the exchange: When? Ex ante, ex post (relational contract) How? By contract, law (default vs. mandatory rules; retroactive) By whom? Parties, third party, one party (standard-form contracts) Enforcing the agreement: How? = By whom? Third party (judge), one or two of the parties (future trade), other market participants (reputation) What’re the parties’ possible objectives? Efficiency = maximizing gains from trade (surplus, “the pie”) Redistribution = Exploiting the counterparty (appropriating it) … always? Or do their goals change over time? Ex ante, priority on efficiency; ex post, on exploitation if final Compare private / public ordering in completion and enforcement 4

Basics on contracts (2): The dual role of contract clauses More than merely defining the content of exchange, introducing incentives ( surplus) dividing the surplus Example: “clauses” in a simple incentives model: Wage = α + β * Performance β motivates surplus α redistributes surplus

The case of “standard-form contracts” Costs & benefits of having one of the parties writing the contract: partiality vs. savings & knowledge Role of competition Why is “salience” important? Is it constant over time? Does it improve with regulation? At what cost? Will a monopolist draft inefficient clauses? Not if he can extract rents otherwise (α) Yes if need to increase its control over pricing: imagine that buyers willing to pay a higher price prefer strong warranty  monopolist may offer 2 contracts with high (low) price and strong (weak) warranty (a “tie in”) What about uniform clauses in an industry? Is it driven by collusion? Or by price competition in selling the optimal product?

Are judges a solution, a problem or both? When “ex ante”, parties want for judges to decide efficiently ex post (Counterfactual hypothesis) But when ex post, each party wants for the judge to decide… in her favor Judges’ difficulties  solutions? Self interest: corruption, applause, morality? Cognitive: e.g., hindsight bias Example: mortgage interest rate “floors”: Now it looks “obvious” that interest rates were going to be low Judicial “populism” after the recession? Efficiency vs. distribution. Judicial populism 7

Analyzing contract “regulation” (by judges or the law) Consider the rationale for default and mandatory rules: Default rules: reducing transaction costs Mandatory: avoiding externalities, rationality Key: Must identify effects on two types of contracts b/c enforcement causes Distribution in existing contracts  Justice? (In)efficiency in future contracts  Justice?

The case of mortgage clauses Information asymmetry  Mandatory intervention of a notary (even Shiller…) Lenders should offer variable-rate insurance Rates dropped  Clauses litigated, not enforced: Interest rate “floors” and “swaps” etc. Supreme Court says “notary intervention merely formal. Ergo, irrelevant. Transparent?” Courts do not enforce swaps Lessons on regulation? On judges?

Who could imagine this? Euribor at 3mos.

Does hindsight bias lead judges to see balanced transactions as unbalanced? Or do they use popular bias as an excuse to act “morally”, punish selfish bankers, etc.? Ex ante, probabilities = 0.5 (6, 0) Fair deal: (3, 3) (0, 6) but ex post, with hindsight, probability > 0.5, e.g. 5/6  Unfair deal: (1, 5)

Arruñada & Casari Credit enforcement experiment Socially optimal to lend b/c it produces a surplus of 24 = (34-10) Lender makes a profit (lends 10, gets back 17) The surplus goes mostly to the borrower (gets 17 instead of 0) Including minimum earnings, lenders are rich, borrowers are poor: 33 50 16 67 50 60 With loan & return With loan & default Without loan 12

Arruñada & Casari—Main result 1: Surplus in the economy GDP

Humans withdraw cooperation for good—our backward looking robots do not Human lenders (loans in blue, comply opinions in white squares): Robot lenders:

Conclusions Very different results despite judges’ incentives being “correct” in all treatments “Paradox of the borrowers:” When borrowers hold rights, they reduce market efficiency When lenders hold rights, borrowers end up better off Lesson: allocation of rights relevant even if incentives are “correct.” Why? Our explanation: people in some roles are better placed to decide & enable market exchange 15

Evolution of residential mortgage market, Spain 2007 2015 % house sales paid with cash 50,32% 58,33% % of mortgages not linked to purchases 68,43% 39,90% % purchases with seller being legal person 27,69% 31,61% % purchases with mortgage & seller being legal person 20,76% 32,77%

A case for project 7 and others: reputational blackmail—Ausbanc Are consumer organizations “angels”? Dangers of a Manicheam view of economic agents Role of institutions—in particular, judges A case of judicial failure? A media failure?