The Subprime Solution

Notes from Robert J. Shiller, “The Subprime Solution”

– Subprime crisis is, at its core, the result of the deflating of a speculative bubble in the housing market that began in the United States in 2006.

– History proves the importance of economic policies for preserving the social fabric. Europe after World War I was seriously damaged by one peculiar economic arrangement: the Treaty of Versailles. The treaty, which ended the war, imposed on Germany punitive reparations far beyond its ability to pay. John Maynard Keynes resigned in protest from the British delegation at Versailles and, in 1919, wrote The Economic Consequences of the Peace, which predicted that the treaty would result in disaster. Keynes was largely ignored, the treaty remained in force, and indeed Germany never was able to pay the penalties imposed. The disaster he had predicted in fact came about—in the form of intense resentment and, a generation later, World War II.

– A comparable disaster — … many people, unable to repay their debts, are being pursued aggressively by creditors. Once again, they often feel that the situation is not of their own making, but the product of forces beyond their control. Once again, they see once-trusted economic institutions collapsing around them. Once again, they feel that they were lied to—fed overly optimistic stories that encouraged them to take excessive risks.

– What was the chain of events in the subprime crisis?
Overly aggressive mortgage lenders, compliant appraisers, and complacent borrowers proliferated to feed the housing boom. Mortgage originators, who planned to sell off the mortgages to securitizers, stopped worrying about repayment risk. They typically made only perfunctory efforts to assess borrowers’ ability to repay their loans—often failing to verify borrowers’ income with the Internal Revenue Service, even if they possessed signed authorization forms permitting them to do so. Sometimes these lenders enticed the naïve, with poor credit histories, to borrow in the ballooning subprime mortgage market. These mortgages were packaged, sold, and resold in sophisticated but arcane ways to investors around the world, setting the stage for a crisis of truly global proportions. The housing bubble, combined with the incentive system implicit in the securitization process, amplified moral hazard, further emboldening some of the worst actors among mortgage lenders.

– Borrowers, particularly subprime borrowers, began defaulting, often owing more than their homes were worth or unable to support their higher monthly payments with current incomes.

– Every crisis contains the seeds of change. Now is the time to restructure the institutional firmament of financial activity in positive ways that will stabilize the economy, rekindle the wealth of nations, reinforce the best of financial innovation, and leave society much better off than if there had not been such a crisis.

– The subprime solution is all about institutional reform: the vision to see beyond short-term fixes and the courage to undertake reform at the highest levels.

– A plan to dramatically reduce our vulnerability to financial crises like the current subprime crisis would rest on two principles.
In the immediate short run, government and business leaders must deal with the problem created by the bubble and its aftermath. The ship is sinking, and we have to save it before we do anything else. In fact, we have to bail out some people who have fared particularly badly, and we also have to arrange bailouts in certain extreme cases to prevent failure of our economic system. These bailouts must be done promptly and correctly, so that they do not come across as unjust or unfair. This situation also calls for a short-term government intervention designed to shore up those mortgages that are teetering on the edge of default, perhaps modeled after the Home Owners’ Loan Corporation of the 1930s.
In the longer run, as noted above, we need to develop stronger risk-management institutions to inhibit the growth of bubbles—the root cause of events such as the current subprime crisis—and to better enable the members of our society to insulate themselves against them when they do develop.

– objectives:
1. First, improving the financial information infrastructure so that the maximum number of people can avail themselves of sound financial practices, products, and services. This means delivering enhanced financial information, better financial advice, and greater consumer protection to larger segments of society, and also implementing an improved system of economic units of measurement.
2. Second, extending the scope of financial markets to cover a wider array of economic risks.
3. Third, creating retail financial instruments—including continuous-workout mortgages, home equity insurance, and livelihood insurance—to provide greater security to consumers.

– The rating agencies that pass judgment on securitized mortgages persisted in giving AAA ratings to mortgage securities that ultimately were vulnerable because they too believed that there would be no bursting of the bubble. Even if they did harbor some doubts about the continuation of the boom, they were not about to take the drastic step of cutting ratings on securitized mortgage products on the basis of the theory, not widely held, that home prices might actually fall. That would have been an unusually courageous step—and one that was all too easily postponed in favor of other business decisions that were easier to make, until it was too late.

– Setting the proper policy focus is also crucial. The purpose of the bailouts should not be to maintain high values in the housing market, the stock market, or any other speculative market. The essential purpose is to prevent a fundamental loss of economic confidence in our institutions and in each other, and to maintain a sense of social justice. As such, the bailouts should focus most intensely on preventing distress among people of modest means.

– With regard to housing prices, government policy should be just the opposite of supporting them. We need more planned large urban centers, and building more of these would increase supply and thereby bring urban home prices down. The framers of the 1968 Housing and Urban Development Act understood this need, and the act set up a mechanism whereby builders of whole new towns could apply to the Department of Housing and Urban Development for support. That legislation has led to some new urbancenters, but the act was not enough, and legislation is needed to support development of new urban communities.

– In terms of the immediate crisis, the problem is quite different. We have to be willing to spend money on securing economic justice. That means allocating resources to determining—to the extent that this is possible—who among mortgage borrowers were misled and mistreated, and then focusing the bailouts on them.

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