Sunday, October 12, 2008

Shiller: The Subprime Solution

As I mentioned before, books on the financial crisis have started to appear even though markets and the world economy may not have hit rock-bottom yet. Robert Shiller's The Subprime Solution, as its title suggests, does not claim to be a comprehensive guide to the financial meltdown, but an expose of where it all began, i.e. subprime lending. However, it even does not cover all aspects of the subprime meltdown such as the repackaging of the mortgages and the plunge in mortgage-backed securities in the early stages of the financial crisis. The book's span is limited to the surge and subsequent fall in home prices and its effect and subprime borrowers. However, this narrow focus turns out to be the book's major strength, as it allows Shiller delve into topics he has worked for the past 20 years and where his real expertise lies without getting off-track.

In the first part of the book, Shiller traces the roots of the crisis at the housing bubble driven by what he has called before irrational exuberance before offering solutions. While the ideas expressed here will not be new to those familiar with Shiller's previous work, his solutions, classified as short and long-run, are definitely worth a look. Whereas the short-term solutions focus on a bailout to mortgage borrowers, the longer-term solutions, which are the more thought-provoking, are organized around two main themes: Shiller first concentrates on institutions towards a more efficient information infrastructure such as a system for comprehensive financial advice for all (not just the wealthy), a new financial watchdog, default-option financial planning, improved financial disclosure & databases and new economic units of measurement to take into account rising prices and incomes. Then, he goes on to suggest new markets for risk management such as real estate derivatives markets, mortgages adjusting in response to an individual's ability to pay and changing economic conditions, insurance against a fall in her earning potential and home equity insurance.

While his suggestions of new markets, some of which have appeared in his earlier work, are indeed novel, it seemed to me that they would be difficult to implement in the current information infrastructure. For example, while real estate price indices (initiated by Shiller himself) do exist, better data and more educated individuals would be needed for the proposed markets to function properly. In this sense, his suggestions for a more efficient information infrastructure seem to be necessary conditions for his markets for risk management. I believe the book would have benefited more from the explicit exposition of this link between the two types of long-run solutions.

Shiller's unique style of using interesting anecdotes to illustrate his points, in the same vein as his earlier books such as Irrational Exuberance and The New Financial Order: Risk in the 21st Century, keeps the book interesting. Although he is an accomplished economist with many important contributions, anecdotes such as a luncheon with Turkish investors in Ozdere and origins of the term "bailout" enable him to convey his ideas much better than a literature survey would. In fact, such quotes were exactly what Shiller was looking for when I RAed for him during his early research on indexation.

As the World is focused on illiquid interbank markets and more importantly financial meltdown & global recession, Shiller's latest book enabled me to pause and look back to the subprime crisis of 2007 with a book that is both thought-provoking and enjoyable...

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