This book by Shiller is a must read for anyone trying to make sense of current economic problems and what should be done about them. Shiller is well respected in Economics; he is a Professor of Economics at Yale University. He also wrote Irrational Exuberance which I previously reported on and The New Financial Order, which I have purchased and is now beckoning me.
Robert J. Schiller, “The Subprime Solution” (How Today’s Global Financial Crisis Happened, and What to Do about It), Princeton Univ Press, 2008
Pg. 11: While the implications of the subprime crisis are global, the crisis itself must be understood in its place and time of origin, twentieth-century America. Before the current problem, the last major housing crisis in the U.S. took place in 1925-33. Home prices fell a total of 30% over this interval, and the unemployment rate rose to 25% at the peak of the Great Depression. The crisis revealed glaring defects in the financial institutions of the period. At that time most people borrowed with short term mortgages of five years or less, which they expected to roll over shortly before they came due. As the crisis took hold, borrowers increasingly found that they were unable to refinance their mortgages, and so they stood to lose their homes.
No public institutions were in place at the time of the Great Depression to prevent borrowers from being evicted from their homes owing to their inability to secure new mortgages. But because concerted efforts were made by leaders to change the institutional framework, mass evictions were avoided and recovery was eventually achieved. The policy responses to that historical crisis are an inspiration for the kind of solutions that should be promoted to address the current crisis.
Pg. 32: U.S. home prices in real terms stayed about the same from 1890 to 1997 (there was a 30% drop from 1925 to 1933) then took off like a rocket in 1997 increasing 85% in real terms between 1997 and the peak in 2006. If we totally return to normal, we are not even half way there as we enter 2009. (See: Shiller U.S. National Home Price Index)
Pg. 36: There is considerable differences in home price changes between high-priced and low-priced home segments. The lowest priced tier of houses showed the biggest increases during the recent boom and the biggest drop beginning in 2006. The steep increases are due to the rapid expansion since 2001 of subprime loans to lower income buyers. However, even though there have been differences in price behavior across price tiers, the behavior of all price tiers is basically similar. The boom is unraveling in all these markets.
Pg. 49: The interest rate cuts by the Fed cannot explain the general nine-year upward trend that we have seen in the housing market. The housing boom period was three times as long as the period of low interest rates, and the housing boom was accelerating when the Fed was increasing interest rates in 1999. Moreover, long-term interest rates, which determine the rates for fixed-rate conventional mortgages, did not respond in any substantial way to these rate cuts until the late stages of the boom.
Adjustable-rate mortgages were common because those who had been influenced by bubble thinking and wanted to get into real estate investments as heavily as possible were demanding them. The mere fact that interest payments would be going up soon did not deter them. They expected to be compensated by rapidly increasing home prices, and they believed that those higher prices would permit them to refinance at a lower rate. Subprime borrowers wanted these mortgages in disproportionate numbers both because they were less quantitatively sophisticated and because they were consumed by the mere thought of somehow gaining a foothold in the housing market.
Pg. 116: As the events leading up to the subprime crisis make plain, it is remarkable that the imperfections of our basic economic institutions have not been more widely discussed. While markets bubble and burst, most people have only minimal protections against their biggest economic risks, hold dangerously undiversified portfolios, and risk ruin when they lose their jobs or fall ill.
Below are ways of rectifying this.
Pg. 121: Proposed Reforms:
A New Information Infrastructure is needed consisting of:
• promoting comprehensive financial advice: middle class and low earners must gain access to fee-only financial planners. This may involve switching the current incentive for financial advice from an itemized deduction to a refundable tax credit that is obtainable even if the taxpayer does not itemize.
• establishing a consumer-oriented government financial watchdog: a financial product safety commission needs to be set up modeled after the Consumer Product Safety Commission.
• adopting default conventions and standards that work well for most individuals: a lot of people just don’t pay attention and are more likely to accept whatever financial contract is offered first, or seems standard or conventional. . Default decisions like fixed rate mortgages, automatic 401k enrollment, increasing deductions automatically with pay raises, etc
• improving the disclosure of information regarding financial securities: Apparently almost no one had an economic incentive to do the investigative work to unearth and interpret information about the off-balance-sheet accounting of Enron in 2001. Nor was there anyone with an economic incentive to reveal the excesses of the structured investment vehicles that banks were using to move certain risks off their balance sheets before the 2007 crisis. Word never got out in a way that was useful to the broad public.
• creating large national databases of fine-grained data pertaining to individuals’ economic situations: this could expand FICO type concepts and open new risk management opportunities for all individuals.
• creating a new system of economic units of measurement: people just do not understand inflation. To help them, the government needs to set up a new system of economic units of measurement. Such a system would help prevent human error in economic thinking, which underlies many economic problems, including the subprime crisis. Chile and other Latin American governments are using an inflation-indexed unit of account called the UF. The UF is just the daily price of a market basket of goods and services, as measured by an interpolated Chilean consumer price index. People in Chile commonly quote prices in UFs, although they still make actual payments in pesos. Thus the people automatically think in indexed terms and has made Chile the most inflation-aware country in the world.
Pg. 145: We get the false impression that homes have been a spectacular investment when in fact their increase in value, measured in baskets of goods and services, even over many decades, would generally have been—at least until the recent housing boom—nil.
In 2008 the National Association of Realtors (NAR) launched a $40 million public awareness campaign entitled “Home Values.” The campaign ads repeated the slogan “On average home values nearly double every ten years.” The association claims that this statement is supported by their data for the past thirty years. Indeed it should be, for in the past thirty years consumer prices (inflation) have nearly doubled twice, and we are at the end of a home-price bubble that caused real values to double once: that’s three decades of doubling in nominal terms. It is deceptive to suggest from these data that homes will be spectacular investments, but the NAR can get away with it because of public confusion about inflation. (And the people behind the campaign probably believe it themselves).
If we had been accustomed to quoting home prices in baskets of goods and services since 1890, then people would generally have known that home prices haven’t basically changed in a hundred years (until the recent bubble), and they would never have gotten the idea that home prices always go up and they must get on the train now.
Pg. 168: Imagine our society equipped with a well-established information infrastructure that reached out to all its members; derivative markets for both owner-occupied and commercial real estate; well-developed retail products, like continuous-workout mortgages, home equity insurance, and livelihood insurance, that facilitate risk management for individuals; and default options that naturally lead people to use risk-management devices intelligently.
Pg. 174: We must institutionalize generosity to the unfortunate. Doing so ultimately means producing risk-management contracts. Doing this is a natural extension of the trend in our society, over the past two hundred years, of replacing many of our charitable institutions with insurance based institutions.
Pg. 178: It may be difficult in the present climate of public anger directed at our financial markets, for political candidates to win support on the promise of expanding and developing our financial markets. But that is exactly what is needed now to solve the subprime crisis and prevent a recurrence of similar economic crises in the future.
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