The Subprime Solution
Posted on October 1, 2008 by Richard Beddard
Filed Under Editor's choice, Markets, Reading list |
The boss told me I should review this book last Wednesday. On Friday, he dangled a copy over my shoulder and reiterated his suggestion. On Monday, the US Market fell further in one day than on any day since 1987 as the US Government failed to bail out banks that had overdosed on subprime mortgages.
His timing was good. Bearing in mind how long it takes to write and publish a book, Robert Shiller’s timing is freakish. The Subprime Solution was published last month. It builds on the professor’s previous work including ‘Irrational Exuberance’, published on the eve of the stockmarket crash of 2000.
The book has three sections. The first discusses the cause of the housing bubble, that made it convenient for people to act as though house prices would rise forever and led to ill-considered borrowing and lax lending. The second presents a bailout as a necessary evil, the first step in securing the financial system. The third proposes a suite of financial institutions, measures, and products that would prevent future housing bubbles.
A medical metaphor runs throughout the book. Despite all the patsies put up by the press, from greedy bankers to the short-sellers that allegedly did them in, the real culprit is human nature. The housing mania was an epidemic, a psychological contagion that infected everybody. Not just the borrowers who took on the debt and those who financed it, but the regulators and politicians overseeing the financial system and the media commenting on it.
The bailout should be a kind of triage that prioritises the worst affected homeowners and supports the banks most willing to keep people in their homes by allowing defaulters to refinance.
After the epidemic, Shiller hopes the financial system will emerge stronger, as it did from the Great Depression of the 1930’s, but he’s worried, “The steps taken so far have been ad-hoc, and unlike the 1930’s nothing fundamental is being done.”
That sentiment pre-dated the Paulson bailout plan but judging by his ambivalence towards recent developments [video], Shiller’s opinion hasn’t changed.
He says people overestimate the financial rewards of home ownership and underestimate the risks, “A home represents a highly leveraged exposure to a single stationary plot of real estate – about the riskiest asset one can imagine,” he says, but the financial reward is negligible. Allowing for inflation and the fact that homes have increased in size, US house prices hadn’t risen in price for decades before the still-deflating bubble.
If we knew that, Shiller says we wouldn’t have speculated so wildly. His solution starts with education, and the first long-term index of house prices, which he created in 2004. He would price assets in index-linked currency units called ‘baskets’ to convince property investors that the huge dollar gains they may have made on homes they bought decades ago, are less attractive expressed in baskets. Outlandish? The Chileans already do it.
Some of his other ideas seem even more outlandish; labelling securities like foods, linking financial databases so companies can offer people individual risk management contracts based on their circumstances, and continuous workout mortgages where the rate of repayment varies according to the homeowner’s ability to pay. Instead of boom, bust and undignified bailout, the bailout is built into the mortgage.
New financial innovation, Shiller says, should make all these possible. We have the technology - like derivates, but the danger is people blame it for the current credit crisis. The reality is technology could have stopped the crisis, had it been used to help individuals manage the risk of home ownership.
The Subprime Solution is a lucid explanation of the financial crisis. Reading it forced me to reappraise myself as an investor, and, while the rest of us struggle to understand the momentous events buffeting capitalism, Shiller has outlined a more humane and equitable vision of the future.
A book that had done just one of those things would deserve a permanent place on my shelf of financial favourites.
I had lunch with an old friend today, a financial lobbyist who’s railed about the financial system for as long as I’ve known him, and worked on some of its better innovations. I pressed the book into his hand and made him promise to buy a copy, and read it*1.
I have to give mine back to the boss.
Footnotes:
- You can too in our bookshop.
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33 Responses to “The Subprime Solution”
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“Allowing defaulters to refinance” Some defaulters will be within reach of a refinancing solution. Others, so one gathers, will not. So “triage” surely means, in this case, sorting out the “hopers” from the “no-hopers”. But the real solution, surely, is to cap mortgages at, say 90% and for the government to withdraw depositor protection from banks which breach this. Events have shown, both for secured and unsecured debt, that some will borrow as much as they are offered, regardless of their ability to repay.
“the real culprit is human nature” Yes …..
Is this why the mortgage lenders are being so coy about the marital status of those in arrears with their mortgage payments?
To what extent is the fiasco connected with the recent and rapid rise in cohabitation and the similarly rapid rate of dissolution of cohabiting relationships?
Agree. The first step must be for the borrower to demonstrate that he/she is capable of saving a percentage of the price of the house that is to be purchased.
One of the puzzles which nobody seems to tackle very well is that the money has not in fact disappeared. Blaming bonus-hungry adolescent traders just do not wash.
The words that really rang true for me were “the fact that homes have increased in size”, because in reading them I was reminded of a friend in California whose niece had moved her family (I think including three children under the age of 10) out of the house for a matter of many months while the house was extended and the kitchen was remodelled. The niece is an intelligent and capable woman - she is a doctor, a physician, and her husband is a teacher. Both of them people you would go to for good advice, and get it.
In credit-risk terms, not a problem.
But I do think they got carried away. I think uprooting your family to mess around with Corian worktops is barmy. The big difference is that they could afford it.
But should we despise those people who could not in the end afford what they were led to desire?
If your mind starts filling with images of spendthrift council-house lager-louts with lousy tattoos, I think you may be missing the point. I live in a small street of twelve four-storey late-Victorian houses, in an area that has been on the rise for as long as I have lived here, which is pretty cushy for me. It is classic trading-up territory.
If there is one defining factor - your triage indicator - it is probably the car outside. My most agreeable and stable neighbours seem to own the cars that suit them; the ones who were fussy and then went away in a puff of smoke, pursued by bailiffs, had new cars that fitted some sort of profile of what you ought to have. Take it back in to kitchens, and I just hoot when I see people get into Aga-worship. If you really care about cooking, those things are fat heavy and useless unless all you are ever going to eat is stews, macaroni cheese, pies and cakes. Cooking over two smouldering logs works far far better. But they are gratifyingly expensive if you buy a new one; I paid £200 for mine, and it was not a great investment. Nice decorative item. But the world of new kitchens and bathrooms is where the money went.
Richard Byrne has a good point, if I understand him correctly. All these dud CDOs and toxic bonds - the money didn’t simply “disappear”. It ended up (almost all of it in the US economy) as commissions or in the pockets of property owners who sold out at the top of the market. But to the extent UK banks bought these CDO’s, it was a swap of “sound” money for junk bonds. Well done Wall St, I guess one has to say!
Why should prudent and fairly aware responsible citizens be forced to subsidise the greedy irresponsible buy to let lending which has solely been the cause of the extraordinary increase in house prices over the last few years. The only way I can see of preventing the overheating of this sort of greed again is to be able to tax some morgages. So should we tax borrowing???
M Redgrave
This socialist pinko government encouraged people who obviously couldn’t afford homes, to buy well beyond their means. There should be legislation to force a 90% mortgage cap and only allow lending of 3 times income or 2.5 times joint income(with proof) then house prices will follow average income. Simple. Legislation is the only way, if we don’t legislate banks will compete against each other and in the next cycle and we will end up again with banks offering NINJA loans etc.
Richard, your post made me laugh. I’m going to the Aga show room tomorrow with a view to buying one (seriously :-)). Couldn’t you have picked on something else? I’m now having second thoughts, and my wife will be furious if I voice them…
Aga; the ultimate english middle class folly; when questioned the only common positive answer I hear is that they keep the kitchen nice and cosy in the winter. The fact that you need another cooker so you can switch them off in the summer and they cost £8000 and they only have 2 rings one hot and one warm etc., etc.
Heresy I hear you say
Aga-ownership is one of the loonier religious sects if you ask me
Too easy credit and the idea that more than 40% of population can be owner occupier.
On a recent visit to Germany I watched a few buyers being rejected by the bank, as the bank scrutinized their application for a mortgage to buy a house.
These were respectably young couples, earning decent money and in the Uk and the States they certainly wouldn’t have had any difficulty raising the mortgage.
But not there where the banks like to see ca 25% of purchase price having been saved and the monthly mortgage fee being realistically affordable,— and this is what impressed me most: All the ‘extras’ and little luxuries that were being deducted from monthly income that eventually left not enough to pay the mortgage. As a result most applicants were refused a mortgage.
Rob, “There should be legislation to force a 90% mortgage cap and only allow lending of 3 times income or 2.5 times joint income (with proof)…”
‘Joint’, but for how long?
If you were a mortgage lender woud you treat married and cohabiting couples the same?
You don’t have to buy a book to know that most self-styled financial “experts” don’t have a clue what they’re doing.
Hi Richard,
Your article has certainly caused a stir after just one day!
One possible solution to asset price bubbles and/or asset price collapses would be to try to fix the efficient market model (EMT)! If any asset class starts to rise or fall at an unnatural rate, then trading in the asset class should be suspended. Instead of doing nothing (which is what normally happens when stock market trading is suspended) you would actively publish the current news which is causing the stir and try to collect some reasonable analysis of the information from ‘respected’ ‘experts’. Different asset classes would require different indicators to be published.
Once you are sure all the speculators have approximately the same information and understand the likely consequences on future returns, then you can ‘let rip’ again. Value investors (who try to understand their investments) would not be affected however speculators would have to stop pushing the price up or down once the likely earnings limit is reached or they would be betting against the crowd (which they hate!).
You would have to approach assets like houses in a different way as you can hardly suspend trading in houses. However, the fact that you have this analysis process in place, which kicks in once an asset starts to move outside of its historical norms, might be enough to calm people down. I am sure that Wall Street executives knew some of the consequences of their actions (although bringing their beloved American economy to its knees was probably not in their long term plans). However even they might rein in their firm’s activities if they start to bet against the consensus opinion of their peers.
Aga? Useless waste of money for snobs.
Go into any decent restaurant and ask the chef how he/she cooks; probably five gas rings and an oven.
Ask yourself; if Aga’s were that good, wouldn’t you see them in all the top restaurants?
Richard Byrne’s analogy referring to cars that suit their owners, says it all.
In this financial climate, keep your feet firmly on the ground. There maybe an earthquake just around the corner!
@ aga haters. I’m forwarding all your comments to my wife!
@ Robin. So as we nationalise analysis as well as the banks?! Actually your idea is not so far away from the proposal to enforce counter cyclical regulation - in other words compel banks to have much tougher capital ratios in boom times so they can relax them during crises. It’s the opposite way to way it works now. The problem is agreeing there’s a bubble before it bursts. Then it’s blimmin’ obvious. So far regulators have been just as useless as bankers in this regard!
Paul has raised an important point, and one which goes against what I have been saying.
If there is, as he says, an earthquake coming, I would definitely try to hide in an Aga. Say what you like, they are sturdy. If you want to come out of the rubble of your house in one smiling piece …
That is just my silly way of saying that there is a counter-argument, and it is still about the disappearance of money.
The transfer of money has been in the wrong directions. Setting aside all the nonsense I started about Agas (sorry) my underlying worry is that too much money has shifted toward illiquid assets - as a nation, we have in effect taken our incomes and locked them up in bigger, more elaborate homes. This is fine until you do need to pay for something that matters right now.
We have used our houses to store up our wealth - that is the truth behind anything like remortgaging or equity release schemes. We have been proud of the post-Thatcher levels of home ownership - all those tables of how more of us Brits owned our own homes than those foolish foreigners.
But Thatcher never ran a business. She married a guy who inherited one, which is not the same thing. Economics were a mystery to her, even before her Alzheimer’s. Don’t even mention her son.
The present crisis is not just about subprime. It is also about locking up too much money in the wrong things. How many companies go bust even though they own fixed assets which are huge? Bricks and mortar may have been a comfort to the Granny from Grantham (she did buy a Barratt house south of the river … ) but that sort of thinking is what led to the feeding frenzy of people like Jim Slater, who had only one idea, and that was to attack companies with dodgy liquidity but good assets.
The present flurry is very much like the asset-stripping bonanza. You buy up a big, maybe sloppily-run, company at a crazy bargain price, keep the good bits, and let the government worry about the bad bits and take all the heat.
Owning something is nice, it is comforting. But it may not be the best use of your money. Thatcher famously hated the idea of getting on a trains, because she disliked the notion of public transport. Every free citizen should have a car.
She had no concept that cars are fine, but if I want to get to central London more quickly, with less worry, and in fact at lower cost, the train works well, even if I shall never own a train.
I must come to the defence (at least in part) of the Iron Lady. Dennis Thatcher was a respected businessman, a director of Burmah or Castrol Oil (I forget which). As regards house-owning, Margaret Thatcher might be said to have “discovered” the Council House with the Jaguar out in front. She it was, who recognised that many who lived in Public Housing were actually perfectly well able to afford their own home. By encouraging them to buy, they became “stakeholders” and at the same time relieved the Local Authority of both capital and maintenance costs of providing housing. No-one, to my knowledge, has suggested reversing this policy. Simply it is that that sound concept has since been perverted, home ownership (laudable) conflated with buy-to-let (often speculatively). As for car use and ownership, Lady T. did perhaps get it wrong, but bear in mind that population growth and car ownership has rocketed way beyond any predictions made in her day.
You have merely swallowed some of the excuses, if I may say so. Thatcher is a detestable snob with a Grantham mind.
You say “home ownership(laudable)” because you share the assumption that these yobs will just trash their nice cheap houses. The stake-holder idea just assumes that left to themselves those dreadful people would buy a Jag and let the whole house fall into disrepair and wait for someone from the council to come round and mend it.
You lack a sense of history. The people who moved into council houses from much worse private lettings regarded it as a privilege. There is a parallel today when if a son or daughter goes to university, there is some comfort in knowing that he or she might be going into a hall of residence, rather than a privately-rented hell-hole where the landlord never takes care of anything, and will gouge every last penny in terms of deposits that will never be returned.
The council house system as it was before the Beast certainly had its faults, but it was broadly equitable. You might as well complain that the parents of a student in International Hall in Bloomsbury could perfectly well have afforded a flat in Knightsbridge, and they are just ripping us all off, whereas some jumped-up poor kid from the sticks shouldn’t even be allowed into Bloomsbury, not even in daylight.
And the idea of ownership is peculiarly Brit. You might be a surgeon in Stuttgart, a designer in Paris, a lecturer in Manhattan, and go through your whole life without owning your own home, but they just don’t think that is important.
We do not have troublesome population growth - forget that one. Why do you think there is so much worry that there might not be enough younger people of working age to look after us when we get old? We do have potentially troublesome population distribution. And this is not the old one about the nice little Cotswold village sub-post office closing its doors.
It is not hard to see how a car has become a requirement, not a luxury. One thing that always strikes me in New York is how very well little frail old people get by. They do their daily round of shopping within about a two-block radius, having small chats with people who know their names, picking up small items. I recently helped a friend to move her elderly mother to a smaller place, and the biggest question was “If she gives up her car, how will she buy food?” She is a sturdy walker, would have been absolutely fine in Manhattan, but at a loss in almost everywhere we inspected.
I won’t reply to all the above comments except to say this. Council House (and Housing Association) dwellers paid their rent (or had it paid for them) and when anything went wrong (heating/lighting/plumbing/doors/windows etc) just picked up the phone and Council & HA came along to fix it. Once they acquired the property themselves, these tasks fell to them, the burden on the taxpayer was correpondingly reduced. That’s when B&Q, Wickes etc started to get going. In short. money saved from the Public Purse, people acquiring new skills and making better use of their spare time than just going shopping or down to the boozer. Margaret Thatcher made some much-needed changes, she also made mistakes, but to refer to her as “Granny” or “The Beast”, not to mention her Alzheimer’s, degrades the discussion of this BB and serves only to tarnish the writer who uses such childish and emotive terms
I feel a Captain Mainwaring moment coming on -
“Silly boy!”
“people acquiring new skills and making better use of their spare time than just going shopping or down to the boozer.”
Just where do you think almost all the skilled carpenters, plumbers, electricians, joiners, cabinet-makers, painters and decorators, glaziers, plasterers, and all the rest who had gone through long apprenticships actually lived? In council houses.
B&Q and Wickes are for the unskilled - that’s why they are such clever profitable companies. Places for people who can’t tell a hawk from a handsaw to spend money on stuff they don’t know how to use.
(And I am cross with Thatcher, because she was a mean-minded, irresponsible, foolish and destructive person. It is not a Left/Right issue. If you can dismiss many millions of your fellow-citizens as unskilled, shopaholic drunkards, I can call Thatcher a Beast. And I was wrong - you say she was the Iron Lady, so it can’t be Alzheimer’s. It must be rust.)
Hi Richard,
I like your way of describing it ‘nationalise analysis’. Something needs to be done to put the finance industry on an equal footing with other industries. It is crazy that an entire industry, that only produces a relatively small and fixed amount of genuinely useful services, should be paid disproportionate compensation compared to other industries. It is like a disease which feeds into all the other industries (and here I am talking about executive compensation in general). Perhaps it is a case that capitalism is capable of working for everything except for Banks themselves!
To Robin Soole:
I had a long chat over the weekend with a friend on the West Coast, and she was telling me that her car had finally died of old age, she wanted a reasonable second-hand replacement, and so she went last week to talk to her credit union.
Over here, credit unions are generally for the poor, intended to keep people out of the hands of loan sharks. Over there they tend to appeal to fairly cautious, prudent members of the middle class - civil servants, academics. They use their banks for some things, their credit unions for others.
But what was being described to me was exactly what you have called “a relatively small and fixed amount of genuinely useful services”.
And when the topic of the banking crisis came up, the manager of the credit union put it so simply: “The way we do things is to take money in slowly and steadily, keep it safe, and pay it out again slowly and steadily”. Exactly the principle on which so many of our Trustee Savings Banks and building societies were founded.
The rush to privatisation, demutualisation,to getting a quick share windfall, lost us all of that. And we don’t have credit unions.
Well, I have to admit, my earthquake comment (along with the Aga) was meant to be a bit tongue in cheek with an element of truth, but the quake seems to have arrived rather sooner than I anticipated.
The question is; was today just a precursor rumble or have we now seen the main quake? Certainly there are chasms appearing all over the place. Are the tectonic plates of the financial world about to shift in an uncontrollable manner, that even the billions of tax payers funds committed by the various morons that comprise of governments throughout Europe (and the USA) have no hope of controlling? Are there yet more aftershocks to come?
These idiots never learn anything from the past. Greed rules: OK!
That aside, the major company’s that make up the FT100, (and even 350) are still in the main making good profits. Most are substantial enough to still be around this time next year. Some are now offering in the region of 10% yields, assuming they are not forced to cut dividends.
Clearly there is a huge lack of positive sentiment, but I can’t help thinking the heard mentality has really gone over the top.
Have I missed something? Am I being too simplistic?
The more I look at the present market, the more I believe there is absolutely no logic in what is happening.
Some interesting thought processes Paul but I think that what is happening now is logical it’s what created the precipice that we went over that was illogical.
Basically we now live in a world where what matters to most is price not value, Richard is correct - look no further than the AGA for a fine example of this trend.
We push the money around the block watching it grow without questioning what is really creating this percieved value. Don’t expect the city experts to point it out until after it collapses they are too busy riding their luck.
I think there is a degree of logic, but not a very comfortable one for the West.
Until so recently there was much talk of China - in effect, how relatively solid assets had moved from the US to China, and that the previous way of thinking, that the West consumed what China produced, must be revised now that China has evolved/created a huge internal market.
In the crudest terms, we thought they depended on us to buy their goods - we somehow assumed that we still had the upper hand. We even played around with how to make profit out of the expansion - ooh, the Chinese are buying lots of metal, let’s get into mining shares. You could ask the question - why weren’t we buying metal? Because we have few industries to use it.
We also made assumptions that we invented all the technology, they just built our gadgets for us, at ever-cheaper prices. Not just China - we have made fun of Japanese cars, then Malaysian cars, then Korean cars - Clarkson (who is fun) had a rant about Indian cars. But the money, and the stability, is not in making perfect goods, it is in making adequate, reliable goods in big numbers. And we simply forgot that fact.
The Swiss watch industry was nearly killed by simpler, in many ways better, technology. All those hobbing machines were redundant. They rationalised in two ways - you will find the same £45 mass-produced movement in watches costing anything from £250 to £2500. That’s the exploit-the-brand approach; but they also made Swatches.
The Swiss worked it out - just those two movements make millions. Lexus + Toyota.
Hi Richard Byrne,
This is exactly the kind of good services I am thinking of.
And an example of a bad service would be loan funded mergers. Here you have two companies that are propped up on the hard work of their employees who have some trust in the people at the top. You have a few executives at the top paying themselves extortionate amounts of money. You then have some loan sharks (sorry I meant investment houses and private equity groups), providing huge amounts of money on the pretext that a merger will be good when in reality they just want to get their 2% fee and divide it between themselves and the executives.
And another thing (sorry I can’t stop myself now )
Private equity merges is a great example of capitalism not working. Here you have a lot of potential customers (companies) and a lot of potential service providers (private equity groups etc) who, instead of competing for services, will benefit (personally) from the most expensive deals they can make, that is justified by their dodgy accounting practices.
People are now saying that ‘mark-to-market’ accounting has been partly responsible for the current market collapse. However just think how much worse it would have been if we allowed these insane practices to continue, hidden by their dodgy valuations!
Hello folks, for an alternative historical perspective I thought you mike like this: http://www.youtube.com/watch?v=WfvIstgOugc&NR=1
Beddard, I laughed out loud on a gloomy wet morning, eight minutes after getting an email putting a lower valuation on something I wanted to sell. A bit of superbly funny bad taste was just what was needed, and it worked.
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