The Subprime Solution

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.