The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It | 
| Author: Robert J. Shiller
Publisher: Princeton University Press
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Rating:  21 reviews
Sales Rank: 2181
Media: Hardcover
Pages: 208
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Dimensions (in): 8.5 x 5.8 x 1
ISBN: 0691139296
Dewey Decimal Number: 332.722
EAN: 9780691139296
ASIN: 0691139296
Publication Date: August 24, 2008
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Product Description
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.
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| Customer Reviews: Read 16 more reviews...
 3 for Diagnosis 1 for Solutions. Read why. September 11, 2008
Gaetan Lion
45 out of 52 found this review helpful
Robert Shiller's track record was impressive at first. He wrote Market volatility in 1992 outlining how stock price volatility was due to psychological speculation as it was disconnected from economic fundamentals. He was right as the stock gyrations in 1987 and 1989 demonstrated. In 2000, he wrote the excellent Irrational Exuberance stating stock prices bubbled up and were bound for a crash. Within three months the NASDAQ did exactly that loosing more than half its value taking the rest of the market on a three year brutal downturn (dot.com Bubble). At this stage, we thought Shiller was blessed with superior insight. Then, he lost his edge by envisioning retail financial insurance products to protect against risks often not worth covering as introduced in his strange The New Financial Order: Risk in the 21st Century. This book recycles many of those confused concepts.
In "The Subprime Solution" Shiller diagnoses the cause of the Subprime crisis and also develops a set of short-term and long-term solutions to fix and prevent this crisis.
His diagnosis is OK. He attributes the overarching cause of the Subprime crisis to bubble psychology. This diagnosis is a repeat of "Irrational Exuberance" focused on residential real estate instead of stock markets. He ties a lot of symptoms such as the increasingly lenient underwriting, lenient Moody's MBS ratings, and investors appetite for MBS to bubble psychology. He thinks bankers, MBS investors, Moody's, hedge funds, homeowners, and condo flippers all thought they could throw caution to the wind since the value of the underlying collateral (home) would shore up all boats.
When Shiller comes up with recommendations he is not convincing. In the short-term he simply suggests we bail out everybody by reviving the Home Owners' Loan Corporation (HOLC) first established in 1933 but no longer in existence. The former HOLC accepted mortgages as collateral for loans to mortgage lenders so long as the mortgages had more lenient terms than the market. This recommendation has several flaws to it. First, it runs into moral hazard. It would bail out with taxpayer's money homeowners who never had the financial resources to buy a house and condo flippers who speculated with other people's money. Second, a good deal of those mortgages has been securitized into complex collaterized bond structures with many tranches sold to international investors. Those mortgages administered by bond trusts are not pledgeable to an HOLC organization.
Shiller's long term recommendations are ineffective. Here he repeats many of the retail insurance products he envisioned in "The New Financial Order." His first recommendation is nationwide government subsidized retail financial advice. Yet, all the financial advice prospective homeowners need is to ask themselves if they can afford the mortgage. If the borrower is not numerate, the creditor should operate in a regulatory environment to be forced to make a prudent decision on his behalf. Shiller recommends the adoption of a new economic currency that would be adjusted for inflation. He feels this would improve price information of homes. In a country with very moderate historical inflation such an economic unit adds much confusion without merit. Shiller also thinks that his creation (with the Chicago Board of Trade) of home price index futures will eliminate bubbles because international investors will short (sell futures) on cities whose home prices appear to have bubbled. But, such futures markets have not eliminated bubbles in stock and commodity prices. Why would they eliminate bubbles in residential real estate? Additionally, those home price index future markets have been in existence for already two years. And, they don't seem to get off the ground. Trading volume is not sufficient to provide valuable price information. Other strange recommendations include his "continuous-workout mortgage" whose term would be adjusted downward to reflect the current income of the specific occupation of the borrower. This entails a huge transfer of risk to the creditors which would result in much higher mortgage rates. Another recommendation is home equity insurance for the borrower. But, it is not the borrower that bears the risk on the collateral value, it is the creditor. This insurance would be of little value to the borrower. Another recommendation is livelihood insurance insuring one's income from the risk of one's specific occupation. This product is not readily feasible. It also understates how transferable many professional skills are and how liquid are labor markets are. In summary, his long term recommendations do not address the Subprime crisis.
I recommend a far better book on the subject: Charles R. Morris The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash. Also, Shiller feels cities are commodities with urban amenities easily replicable. For an excellent book that explains why this is not so, I recommend Richard Florida's Who's Your City?: How the Creative Economy Is Making Where to Live the Most Important Decision of Your Life
Shiller addresses everything except the actual fix. September 4, 2008
bob wilson (Bay Area, CA)
23 out of 36 found this review helpful
Mr. Shiller seems to be firing on half his cylinders in his approach towards solving the "housing crisis". Just like countless economists, he misses the mark completely on just what caused the so-called crisis to occur in the first place. For anyone with even a basic comprehension of simple economics, the reason is incredibly simple: Affordability.
The whole subprime machine was created out of the desire to continually inflate prices yet maintain sales by introducing 'clever' lending products for consumers who without such products would have long run out of the financial means to buy houses to start with. Had such loans and lending practices never been introduced, the bubble would have corrected much sooner, prices would not have climbed as high, affordability would not have become such a major problem in large metros ( almost 10x annual income in places like San Francisco) and lastly, we would likely have already recovered from such a correction. But instead, the fall has been far more painful and extended.
The solution is not to make attempts to create even more "democratic", or creative lending solutions. By doing so would merely deliver us back to a similar era of (In Mr. Shiller's words) Over exuberance.The simple answer to all of this is that we must allow the bubble to deflate. Yes, this means pain. It means a lot of people will lose homes that they had no business buying in the first place. It means prices will fall further. But it also means that once the dust settles, new home buyers will have a chance to buy in a more healthy, affordable environment. It means a return to more steady, reliable growth and appreciation. It also means more stability in the financial industry.
So no- I 100% disagree with Mr. Shiller on this. We as a nation should not be in the business of shoring up faulty business with the very tactics that placed it into its current negative position. Instead, we need a return to sound financial principals less reliant on shady economics. We need a return to actual affordability. Why this is so incredibly difficult for politicians, specialists, advisers, and economists to admit is beyond me.
Audacious in its proposals August 19, 2008
Dr. Lee D. Carlson (Saint Louis, Missouri USA)
20 out of 45 found this review helpful
The first thing that can be said about this book is that notion of a financial bubble is not really explicitly defined. Instead its author takes it as a given that there was a housing bubble and it aggravated the current "credit crisis". One could perhaps debate the author's contention is this regard, if one examined for example the relatively stable housing markets in many areas in the country at the present time. His emphasis in the book is not on the quantitative analysis of financial bubbles but rather in what measures can be taken to alleviate the effects of the housing bubble. The study of these effects has taken on major importance in the last year, and much has been written about them. This book, although short, is interesting at least from the standpoint of the audacity of the solutions that the author proposes.
One of the best features of the book is the author's discussion of the importance of technology for the financial community. He looks forward to the integration of behavioral finance in the mathematical modeling of the financial markets. This is just getting started, and those involved can look forward to some very interesting developments along these lines. It is always refreshing to see new paradigms being used at a practical level, and behavioral finance shows great promise in more accurate modeling of the financial markets.
As part of a long-term solution, the author proposes the "democratization" of the financial markets but his proposals in this context are somewhat annoying since he, as do most other writers, frequently refers to the "general public" in a manner that implies a complete disrespect for the members of this group. It is interesting that no matter what the topic or ideology, its advocates always refer to the "general public" as some sort of class or entity that they do not belong to, but that is clearly lacking in intelligence and in need of their assistance. It is though every interest group feels that those outside of its political and intellectual logosphere need "enlightenment" or guidance of some sort. The author for example makes the statement that "the public, of course, does not understand this basic economic fact" when discussing why their ignorance resulted in a massive speculative bubble. Addressing "the public" (whoever that is) in this way only exposes the author's elitism. It does not help at all in elucidating the need for the "democratization" of the financial markets.
And assuming that this need is a valid one, it would be interesting to see just what actually would be made available for this purpose. For example, anyone who has worked in mortgage modeling knows of the need for more accurate data on house prices. Would the author be willing to make the Case-Shiller index available to anyone who wants it, without any financial compensation to the firm that currently has proprietary rights to it? When reading the book, it would seem that only financial tools produced as the result of government funding would be available without charge to anyone that was interested in using them. An immediate question arises as to whether these public tools are better than the ones developed by private firms or institutions. If they are, and they are recognized as such, then financiers and investors will use them instead, eliminating the need for the private tools. If they are not, then the people who use them are getting sub-standard advice, and this will aggravate or cause another financial bubble, since clearly the author believes that bubbles are caused by information of poor quality or wildly optimistic estimates of future prices.
The author is in favor of governmental bailouts, citing actions taken in the great depression as evidence, and the need for financial "stablity" (the latter undefined in the book). But the ability of the governmental institutions to fix the problems that arose out of the great depression is not apparent when reading this book or indeed many others on the same subject. Yes, these institutions were put in place because of the great depression, but this reviewer is not aware of any evidence that they played an actual role in ending it. Just because they were invented with the intent of solving the financial problems of the great depression does not mean that they actually did. Other factors may have played the major role, these factors not being known, with the result of a false imputation of success to these governmental institutions. Indeed, there are a few ideological groups who claim that it was the gearing up for the Second World War that effectively ended the depression.
If government is to be more involved in matters of economics, maybe a good start would be to pass what might be called a "Financial Courage Act", which would be a massive educational program to instill in all citizens a recognition and appreciation of the extreme volatility of the financial markets of the twenty-first century. This would not be a propaganda campaign waged to protect Wall Street economic interests, but instead a long-term project that would educate everyone on why the financial markets take the form that they now do and thus alleviate some of the anxiety associated with rapid change. This reviewer cannot see anything intrinsically wrong with financial bubbles, and if we all understand them as just another aspect of our financial deal making we will not be emotionally overwhelmed when they do occur. When Roosevelt made his speech on the debilitating effects of fear, he was correct, and that speech might have been his greatest contribution to the economic turmoil of his time. The citizens of his generation had the courage to face up to their difficulties and move on, and so there is no reason why everyone at the present time cannot do the same.
 3.5 stars-Shiller can't deal with the risk versus uncertainty issue due to his support for SEU August 27, 2008
Michael Emmett Brady (Bellflower, California ,United States)
18 out of 36 found this review helpful
This could have been a major contribution to economic theory and history.Unfortunately,Shiller is unable to think outside the box of the basic neoclassical rational actor model of SEU(Subjective Expected Utility)theory ,and its extension in the form of the Tversky-Kahneman Prospect (Cumulative Prospect Theory )Theory that underlies the behavioral economics(finance)school of thought that has arisen since the late 1970's.Shiller makes it clear that he is an avid supporter of this school(Shiller,pp.117-120).SEU theory is actually a more advanced mathematical form of Jeremy Bentham's Benthamite Utilitarianism ,as expressed in his 1787 book, " Introduction to the Principles of Morals and Legislation".Bentham,the founder of neoclassical economics, asserted that all rational,and even some irrational, human decision makers are able to accurately calculate the outcomes of their actions .However,he failed to present a method describing how such calculations were made.Modern neoclassical economics filled this gap by combining the Ramsey-de Finetti-Savage subjective theory of probability,based on the premise that all probability calculations are precise,exact,accurate,unique,linear,additive,single number calculations, based on the addition and multiplication laws of the probability calculus,combined with the expected utility theory of Morgenstern and Von Neumann,which claimed that all utilities can be shown to also be exact,precise,linear,additive calculations.Neoclassical economist Herbert Gintis gives a good summary of the neoclassical SEU theory :"...the model can be shown to apply over any domain in which the agent has transitive preferences " so that " there is a probability pi subscript,0<=pi subscript<=1 such that the agent is indifferent between Ai subscript and a lottery that pays A1 subscript with probability pi subscript and pays An subscript with probability 1-pi subscript.Clearly,these assumptions are extremely plausible "(Gintis,2004,Politics,Philosophy,and Economics,3,p.40).Unfortunarely,this is not the case.Gintis has presented an abbreviated summary of Savage's sure thing postulate that both Keynes(A Treatise on Probability,1921,p.315,ft.2)and Ellsberg(Quarterly Journal of Economics,1961) showed required that the decision maker would have to be able to specify a complete information set in order to specify a single ,unique probability distribution.Keynes expressed this by the condition that the weight of the evidence,w,equalled 1.A weight of evidence between 0 and 1, 0were irrationally using heuristics and rules of thumb,instead of the mathematical addition and multiplication laws of the probability calculus, that a rational decision maker would use,rather than recognizing that the experimental subjects realized that their information base was incomplete so that w and rho were less than 1.In cases of uncertainty /ambiguity ,where w or rho are less than 1,it is irrational to attempt to use the mathematical laws of the probability calculus ,which only work if w or rho are equal to 1.This was exactly the same point made in 1931 by Keynes in his review of Ramsey's subjective theory of probability in the journal the New Statesman in 1931 .SEU theory can only deal with situations of risk(w=1,rho=1).It is not able to deal with situations of uncertainty /ambiguity/vagueness.
Shiller constantly refers to the need to better manage risk through the mathematical risk models used in " modern " finance theory .These risk models[VAR(Value at Risk),CAPM(Capital Asset Pricing Model),and the Black-Scholes Equation] all result in the use of some sort of normal probability distribution(joint normal,cumulative normal,bivariate normal,multivariate normal,log normal)using the mean and standard deviation(Variance-Covariance Matrix) to measure risk.Benoit Mandelbrot has demonstrated continuously for 50 years that none of the financial time series data supports the use of any type of normal distribution.The data supports the use of the Cauchy,Frechet,or power law distributions like the Pareto.Mandelbrot has correctly demonstrated that decision makers face the wild risk of the Cauchy and not the mild risk of the Normal.All 6 of the solutions proposed by Shiller on p.122, and discussed in depth on pp.123-169 of this book, can't deal with Keynesian uncertainty or Ellsbergian ambiguity or Mandelbrotian wild risk.The only way to deal with the uncertainty and lack of confidence ,created by the speculative and securitization behavior of the large Wall Street investment banks and the commercial banking system ,is a preventitive one-prevent the speculators from getting their hands on the bank loans that they need to leverage their debt position in the first place.This is the solution arrived at by both Keynes and Smith(See Smith,WN,1776,pp.260-340, especially pp. 339-340;Keynes,GT,1936,pp.321-327,338-353,and pp,374-377).It involves fixing the rate of interest at a low level permanently in the long run and applying a policy of credit restriction.There is only one reference to uncertainty in this book.Shiller puts uncertainty in italics on p.103:"Right after the 1929 crash,the forecasters,although they did not predict the depression that was to follow,expressed unusual uncertainty(uncertainty is in italics for emphasis)about the economic outlook.Romer believes that it was this uncertainty that led to the sharp contraction in consumer spending that ultimately caused the Depression ".(Shiller,p.103,2008).Unfortunately,none of his solutions,based on the standard neoclassical SEU risk models,that are taught universally in all economics and finance classes in universities and colleges throughout the world,including where Shiller teaches,can deal with the collapse in investor and consumer confidence because confidence is a function of Keynes's w,which is assumed to always equal 1 in the SEU theory.Keynes gave the correct solution on p.158 of the General Theory- " A collapse in the price of equities,which has had disasterous reactions on the marginal efficiency of capital may have been due to the weakening either of speculative confidence or of the state of credit.But wheras the weakening of either is enough to cause a collapse,recovery requires the revival of both(Keynes placed " both " in italics for emphasis).For whilst the weakening of credit is sufficient to bring about collapse,its strenthening,though a necessary condition of recovery,is not a sufficient condition."(Keynes,p.158,1936).None of Bernanke's current policies or of Shiller's 6 recommendations on risk management will have any impact on confidence whatsoever.
Shiller's position,in this book and the others he has written in the past,is that the problem is one of irrational exuberance combined with information cascades. "An information cascade occurs when those in a group disregard their own independently,individually collected information because they feel that everyone else simply couldn't be wrong ".(Shiller,p.47).Keynes had already shown that the reason this occurs is that each individual regards his w to be very low.This means that you are now dealing with uncertainty and not risk.Risk management techniques,no matter how mathematically advanced,will not be able to deal with this problem.
Shiller has correctly identified the problems of financial speculation and securitization.Unfortunately,his new risk management techniques would have no more of a chance of dealing with the wild risk of the Cauchy Distribution than an ice cube would have of not melting in the Sahara Desert.An ounce of Keynesian/Smithian prevention is worth more than a pound of risk management techniques build on the standard deviation of a normal probability distribution." Excessive Volatility" automatically means that you have to deal with uncertainty as opposed to risk.
The book should be purchased if you do not already have one of Shiller's other books in your library.Otherwise,it is more of the same.
The Troubles with Bubbles September 9, 2008
Omer Belsky (Haifa, Israel)
13 out of 23 found this review helpful
Subprime. How often did you use the word three years ago? Today it is all over the news. But what, exactly, is "The Subprime Crisis"? How serious is it? Who is responsible? And what shall be done to solve it?
If you are looking for answers for any of these questions, than, alas, "The Subprime Solution", which comes hyped by some great economic writers (like Gregory Clark, of A Farewell to Alms: A Brief Economic History of the World (Princeton Economic History of the Western World) fame) is not a book for you. Shiller's analysis of the crisis is unsatisfactory, and his solution either mundane or speculative - with serious problems which Shiller overlooks.
Shiller informs us, at great length and repeatedly, that we are facing an extreme crisis. He calls it a "historic turning point in our economy and our culture"(p.1) and repeatedly compares it to the economic reparations inflicted on Germany after the Great War, and to the Great Depression. Watch out for the Hoovervilles! Seriously, such comparisons are unhelpful and unnecessary. The Subprime crisis is grave enough without comparing it to the Great Depression (is the Great Depression some sort of economic answer to Godwin's Law, which states that on every discussion, Hitler must at some point appear? Can't we ever talk about an economic crisis without channeling the nineteen thirties?).
But I digress. From approximately 1998 until 2006, the price of houses in the US rose much above their historical value, without any justification in terms of economic situation, the costs of construction, etc, (p. 36). Why did the prices rise? Well, because everyone thought that they would - and the expectations became self fulfilling prophecies. In short, there was a bubble.
But the bubble, as bubbles do, burst. Many lenders, who have offered mortgages to people based on the assumption that house prices would continue to rise, now have a lot of bad debt. Borrowers, who believed the same thing, now find it difficult to pay back their loans, and thus face the prospects of losing their homes. This problem is exacerbated by all sorts of "new" mortgages, especially ones with adjustable interest rates. As interest rates rise, people who used to be able to pay mortgages are no longer able to do so.
But why was there a real estates bubble, and not a bubble of, say, Tulips (as in the Dutch Tulip mania of the 17th century)? If Shiller knows, he's not sharing. Nor is he telling us how big a problem it is. At the time of writing US unemployment rate is approximately 6%, GDP growth is down and inflation up, but the US does not seem to face either a contraction or hyperinflation, but only a recession. Recessions are part of economic life, and probably altogether unavoidable (which is not to say that US economic policies were ideal or even adequate).
Following his non description of the crisis, Shiller offers one short term solution, six long term ones, and a general call for more sophisticated housing markets.
The short term solution is a bailout. How large a bailout, and of what kind? Shiller mentions several proposals for a bailout, but he does not critically evaluate them. Nor is it entirely clear who he plans to bail out. Most of the time it seems the bailout will target borrowers, but Shiller also says that "it is essential that the... cost of bailouts... not be dumped into the laps of a small set of investors" (p. 108). There's a lot of talk of "getting the bailout right", and a lot of historical analogies (to the Great Depression, of course), but very little description of right and wrong bailouts.
The six long term solutions - as I said earlier - vary from the mundane to the speculative. The mundane: Improving financial databases and financial disclosures (is there anyone who will disagree?) The speculative: Shiller suggests "default options financial planning", what is now commonly known as Libertarian Paternalism - the government will offer a basic option, which people can cope out of (Nudge: Improving Decisions About Health, Wealth, and Happiness). This is of course a useless measure in mortgages, as the mortgage lender drafts the contract, in which you'll sign away your "default options". Shiller therefore slides into good old fashioned paternalism, requiring a notary to approve of mortgages (p. 134). "Libertarian Paternalism" I like; Regular paternalism, not so much. Typically, Shiller does not discuss the costs of his proposal (a Notary would be open to negligence suits by every defaulting borrower, and thus would require a hefty fee, needlessly impeding the transaction). Two further speculative suggestions are (1) a "Financial Watchdog" -equivalent to a Consumer Product Safety Commission, and (2) tax deductions for financial advice. Both suggestions exaggerate the knowledge of financial experts, who are no better at divination than the rest of us. The "Financial Watchdog" (1) runs a great risk of becoming politicized (think about what the Bush administration has done with the EPA), and of being relied upon too greatly. Shiller offers no evidence that tax credits for financial advice (2) are likely to be taken up by the small consumers whom the scheme targets, and to his credit, he admits as much. That he nonetheless dreams of a post-tax-deduction Utopia, where "technology will carry us forward into new dimensions of democratized financial sophistication that we cannot now imagine", is odd (p. 129).
The most interesting long term suggestion is to stop pricing things in currency, and to start using "inflation adjusted currency" or baskets. The government would publish a daily rate of exchange between the basket and the dollars. All prices would be denominated in "baskets". On pay day, one would look at the daily exchange rate between the "basket" and the dollar, and pay dollars based upon that rate. Apparently, such a system works well in Chile.
Again Shiller does not discuss the costs of such changes, and thus it is difficult to know if it is worth the fuss. First, teaching people to use a new measurement system is hard. If you are reading this in your native tongue, you are unlikely to use the metric system, because two hundred odd years after the French Revolution, it is still not widespread in the English Speaking World.
Furthermore, Inflation is not all bad, and so eliminating it is not an unalloyed blessing. There are two advantages to inflation. First, it allows prices (especially wages) to adjust downwards. Most people vehemently oppose pay cuts, but they are more willing to forego raises in difficult times. Second, a point made by Milton Friedman of all people, is that because people buy many different things but sell only a few things, they notice more a rise in their income than moderate rise in prices. Seeing your income going up is emotionally and psychologically satisfying (see Money Mischief: Episodes in Monetary History).
At the end of the book, Shiller argues for the development of sophisticated financial instruments for the housing markets. If (like at least one of the Amazon reviewers) you think speculation was the root of the crisis, you are unlikely to approve. As a fan of free markets, I'm open to the idea. But financial markets for houses would necessarily be very different than the markets for other products. To give just one obvious example, the product in most speculative markets are standardized (gold, dollars, US treasury bonds) - But every house is unique; With a little imagination, one can foresee all kinds of complications that this little fact may cause. Maybe these complications can be resolved, but Shiller's superficial account makes them seem far too easy.
"The Subprime Solution" is not as bad as most books I give 2 stars to; it is not entirely devoid of value. Nevertheless, its superficial account, melodramatic style and general lack of usefulness stop me from rating it any higher.
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