The Subprime Solution How Todays Global Financial Crisis Happened and What to Do about It
The subprime mortgage crisis has already wreaked havoc on the lives of millions of people and now it threatens to derail the U.S. economy and economies around the world. In this trenchant book, best-selling economist Robert Shiller reveals the origins of this crisis and puts forward bold measures to solve it. He calls for an aggressive response–a restructuring of the institutional foundations of the financial system that will not only allow people once again to buy and sell homes with confidence, but will create the conditions for greater prosperity in America and throughout the deeply interconnected world economy.
Shiller blames the subprime crisis on the irrational exuberance that drove the economy’s two most recent bubbles–in stocks in the 1990s and in housing between 2000 and 2007. He shows how these bubbles led to the dangerous overextension of credit now resulting in foreclosures, bankruptcies, and write-offs, as well as a global credit crunch. To restore confidence in the markets, Shiller argues, bailouts are needed in the short run. But he insists that these bailouts must be targeted at low-income victims of subprime deals. In the longer term, the subprime solution will require leaders to revamp the financial framework by deploying an ambitious package of initiatives to inhibit the formation of bubbles and limit risks, including better financial information; simplified legal contracts and regulations; expanded markets for managing risks; home equity insurance policies; income-linked home loans; and new measures to protect consumers against hidden inflationary effects.
This powerful book is essential reading for anyone who wants to understand how we got into the subprime mess–and how we can get out.
User Ratings and Reviews
3 Stars Everyone who paid too much for a house is responsible for the bubble
The bubble cannot be explained by interest rates (takes Alan Greenspan of the hook), population growth and construction costs. The professor thinks that psychological/sociological phenomenons such as social contagion, information cascades, zeitgeist and common opinion are the cause. And the public believes in the real estate myth that the price of real estate must inevitably trend trend strongly upward through time. Professor Shiller make a case that the public’s belief in real estate is not justified because inflation, income growth and “amounts” of housing consumed are not properly considered by the public. On page 70 he writes: “If one looks squarely at the issue, it is clear that the rise in value of existing urban areas has shown no tendency at all to make investors rich.” This statement severely discounts thousands and thousands of get rich real estate books. There is a disconnect. It could be that the author is not considering income property (that is rents)? Something is wrong. Too many real fortunes large and small have been amassed through real estate. There are too many exceptions to the “tendency” detected by Dr. Shiller. Squarely looking at the issue, I rechecked the Internal Rates of Return (IRR) on my eight investment condominiums depicted in my book: How to Invest in Condominiums, none of them go along with the professor’s tendency, all to this day continue to be highly profitable. How many exceptions must there be to a tendency to disprove it?
The various changes to the financial system proposed by the author to achieve “Financial Democracy” on the surface sounds good, but are quite technical and difficult for a non-expert to fully comprehend. The changes are significant. How would they really work when implemented? What unanticipated side-effect would there be?
Figures 2.1 US Real Home Prices and 2.2 Real Home Prices in a Sample of Cities are very revealing and instructive.
2 Stars Where’s the beef ?
For those reading this book hoping to find the root cause of this crisis I suspect they came away lacking. Reading this book was like eating cotton candy. A whole lot of chewing but not much substance. High level fluff without detail. Let me help you out. This phase of the mortgage crisis is due to subprime mortgages. 75% of subprime borrowers took out adjustable rate mortgages. The most popular of which was the 2/28 ARM. The first two years of this mortgage offered a low teaser rate. When the teaser rate expired the monthly mortgages payment went up on average 30%. Now here is the unbelievable part. All of these subprime lenders qualified people for the loan solely based on their ability to make the initial low teaser rate payment without worrying about whether they could make the payment once the mortgage reset. Which is why we have this massive default rate. Now the lenders knew this was going to happen. They were counting on refinancing the loan every two years when the mortgage reset. To help grab the borrowers equity they added a 3% prepayment penalty. They were going to milk them for fees every 2 years like a milk cow. This works as long as the house prices are going up. It doesn’t work when house prices go down because no one is going to give you a loan for more than the house is worth. Now did you get any of this detail out of the book?
5 Stars A Moving and Innovative Work
Everyone nowadays seems to agree on the root cause of the current economic crisis; it is the bursting of the real estate bubble. But what caused this bubble? What hazard does its bursting pose to the solvency of financial institutions? What steps can be taken to heal the economy and prevent similar calamities in the future?
In The Subprime Solution, Robert J. Shiller proposes answers to these questions. The answers that he offers represent a furthering of earlier research that he has done on the subject of bubbles that have occurred in other markets besides real estate. In the first edition of his earlier work, Irrational Exuberance (2000), Shiller correctly predicted the bursting of the bubble in technology stocks. According to Shiller, both the technology bubble and the housing bubble are due to the same basic cause, namely widespread and misplaced confidence among the investing public. As such, they can be characterized as speculative bubbles, the “speculative” modifier being the key point that distinguishes Shiller’s analysis from other competing theories.
Shiller explains that speculative bubbles are psychological in origin. When a home buying frenzy ensues in a given locale, home prices rise due to increased demand. The price increases support the widespread belief that declines in real estate value will not occur, in turn feeding the buying frenzy. In effect, the phenomenon is a vicious circle, which feeds upon itself. Eventually, the prices of homes become inflated far beyond what is explicable in terms of building costs, land availability, and other economic fundamentals. It is under such conditions that the market is ripe for a downturn.
The misplaced confidence in the real estate market not only affected individuals, but it affected lending institutions as well, and here lies the key to the current crisis. For years, there has been a culture among lenders of rubber-stamping home loan applications, and a failure take the obvious steps of verifying the borrower’s income and credit history. These practices resulted from a misplaced confidence in the quality of the home as an instrument of collateral, and accordingly the expectation that cases of default would not cause a significant loss to the lender. Lenders have relied on economic models that failed to take into account the devastating effects of a sharp downturn in home prices, on the assumption that such downturns would never occur.
What can be done to heal our economy, and to prevent similar calamities in the future? The first and obvious answer is better education for both individuals and institutions as to investment risks. Another, more controversial answer is bailouts, and Shiller supports their use. Shiller is quick to admit that bailouts are unfair, in that they penalize those who behave responsibly and forgive the misdeeds of the reckless. Interest rate cuts designed to ward off foreclosure for those with variable rate mortgages are one type of bailout. These represent a hidden transfer of wealth from the conservative money-market investor to the over-leveraged home buyer, and as such are unfair. But, according to Shiller, the rate cut is a necessary evil to prevent a devastating loss of confidence in our financial institutions.
We have all been led to believe that a house is a solid investment, and prominent writers on personal finance for the lay public have historically stressed this point. But for most individuals and families, home buying violates all the standard principles of investment science; it is a single, high-value undiversified asset with no available means to hedge changes in price. In light of these considerations, is there anything that can be done to make the risks for home buyers more reasonable? According to Shiller, there is, and this takes us to the most exciting and innovative part of of his work. In the chapter entitled the Promise of Financial Democracy, Shiller proposes the creation of new financial instruments that could lend sanity to the real estate markets. A detailed understanding of such instruments demands more knowledge of the field of finance than is at the disposal of most readers, so some explanation is in order.
If you ask a homeowner in New York what he thinks about the stability of his real estate investment, he is likely to tell you that it is solid. He lives in the place, and to own it he has had no choice but to leverage himself and accept great risk. It is difficult for a person in such a situation to make a disinterested assessment of risk. He is affected by the psychology of his neighbors, who are similarly leveraged. Ask the New Yorker if he would own a house in Los Angeles, where he has no personal stake, and he is likely to say, “No way. Too many earthquakes and fires.” It would be desirable for the New Yorker to be able to register his unfavorable opinions about Los Angeles and take short positions in the LA housing market. Such would exert downward pressure on house prices in Los Angeles, and subject their prices to a more democratic bidding process. The introduction and widespread trading of new types of real estate derivatives, which would allow investors to take both long and short positions, can be expected to do a positive social good; they would lead to better price discovery in the real estate markets, and could ward off the formation of speculative bubbles.
In practice, most homeowners would not want to take any kind of speculative position, either long or short, on the housing market in other cities. However, Shiller argues that such speculative instruments could be repackaged as retail financial products that would allow the homeowner to hedge risks due to unpredictable fluctuations in price. Under such circumstances, the homeowner’s confidence in his investment would be rational and not subject to the psychological contagion of “new era” hype. Towards the end of the book, Shiller argues that being able to secure the price of one’s home against spastic variations could prevent the panic selling and “white flight” that has occurred in urban areas.
All these innovative, forward-looking ideas make The Subprime Solution an exciting work. It should be on the reading list of anyone who wishes to get a better understanding of the current crisis.
5 Stars Very interesting
Good and grounded analisys, well written, interesting perspective about the financial and real estate crises. Good sugestions for the outcomes and structural changes in the financial system and economy.
3 Stars Provocative analysis of the financial crisis
Robert Shiller, Professor of Economics at Yale University, has written an intriguing book about the financial crisis.
He writes of the US housing slump in the 1980s, “All this could have been prevented if people had simply adopted inflation-linked mortgages, but the public seemed unable to grasp the concept.” He seems to be blaming the public, for having imperfect information. But if markets only work when everyone has perfect information, then markets don’t work.
Excessive lending and speculation in housing created the house price boom of the early 2000s. Shiller blames `the contagion of market psychology’, a contagion without borders because of capitalism’s global nature. But the cause was not `market psychology’, but the globalised financial system which provided the opportunities and incentives for speculators. The system created the psychology, not vice versa.
Shiller proposes to revamp the financial system: improve the provision of financial information, extend the scope of financial markets to cover a wider array of economic risks, and create retail financial instruments to provide greater security to consumers. He defends the top executives in the financial sector and calls for extending and developing financial markets. But even more opportunities and incentives to speculate would lead to an even bigger crisis next time.
Yet he does make some sensible proposals, like improving insurance against unemployment and illness. He says that to restore confidence, capitalism must bail out the low-income victims of sub prime mortgage deals and support homeowners, to prevent mass evictions. He opposes bailouts to maintain high values in the housing market, stock market, land market or any other speculative market.
He points out that unfair land use restrictions benefit landowners by keeping land prices high, preventing new construction. We need cheaper land, so that we can build more homes.
But of course if capitalism could do all these good things, it wouldn’t be capitalism.
Related Websites -
Real Estate Stimulus Fail For two years I've preached that artificial means to prop up an inflated real estate market are not permanent solutions. Obama and his economic advisors (who are gradually jumping ship) thought otherwise. Can you guess where this is going? After flooding our economy with billions in home buyer tax credits...... - Review of Millionaire By Thirty Douglas Andrew’s book reads like a rejected first draft of Rich Dad, Poor Dad and right off the bat, it’s kitschy premise (ripped right from the above book) falls more than a little flat. In order to illustrate his points, the author relies on his sons and their imaginary......
-
Ben Stein Loves Real Estate I'm a big fan of Ben Stein's books.I also read his column, How Not To Ruin Your Life. This weeks issue is about letting the non-financially savy spouse in on what to do after you pass away. But best of all, he professes his love for real estate!We're currently somewhat...... -
Real Estate Investments - Good Idea or Bad Idea? Right now, if there was a market that had bad news written all over it, it would be real estate. The housing crisis has made investors jumpy, the economy appears to be tanking and home values are plummeting across the country. Would you believe that this is actually a good...... -
The Mortgage Crisis and Investments in Real Estate According to regional and state real estate analysts, the factors which previously fueled the housing boom of the last few years are easy to explain. The factors that fueled this boom in the real instate industry ranged significantly, including: - Interest rates that were historically low. - Flight-Risk Safety Investments......
You must log in to post a comment.