BOOK REVIEW: Shiller's Subprime Solutions

Short-Term Solutions

Shiller argues for immediate action on the subprime crisis and a bailout - of sorts.

Shiller fears that not bailing out the victims could lead to rips in the social fabric, affecting our country for generations. Many of the increases in home ownership from 1997 to 2005 - about 11.5% -- "were largest in the West, for those under the age of 35, for those with below-median incomes, and for Hispanics and blacks." Many in this economic class failed to possess the knowledge necessary to avoid the pitfalls of home buying.

He says a bailout is needed to ensure we don't fall into another depression. Ever since the Great Depression, it has been the policy of the federal government to encourage home ownership. Now is not the time to end that policy. Shiller notes that the Depression worsened because of inaction:

"If any of the short-run solutions discussed here are to have a chance of success, our leaders must, in the first place, admit that a serious problem exists. It does not help matters if leaders continually assert that a turn-around is just around the corner. That was the strategy played by Herbert Hoover during the Great Depression..."

Ending the Depression spurred financial innovation -- not just the New Deal -- but important institutions that have been copied in country after country. These modifications strengthened the financial system, stopped bank runs, and increased participation in home ownership. Important reforms include: Fannie and Freddie (Home Loan Bank system similar to Federal Reserve recommended by the precursor to the National Association of Realtors), The Securities and Exchange Commission, Federal Insurance Deposit Commission, Appraisal Institute, Federal Housing Administration, and others. They remain in place today. Tracking home values using punch cards facilitated business development for IBM (IBM Quote) and Remington Rand Corporation (now Unysis (UIS Quote)).

Sadly, the present response to the housing crisis has been anemic. Even if one includes the risk taken on by programs at the Federal Reserve to facilitate lending to banks, the Bear Stearns sale (bailout) and the economic stimulus package, the effort only amounts to "one half of one percent of household assets." That's a drop in the bucket.

Banks and government have failed to recognize the extent of the problem. For example, Monday and Tuesday saw stock market investors wringing their hands over the future of financial stocks like Fannie Mae (FNM Quote), Freddie Mac (FRE Quote), and Lehman (LEH Quote).

Shiller concludes that everyone must share the burden of fixing the housing mess -- borrowers, lenders, investors and taxpayers. Reforms would be facilitated by the rebirth of the Home Owner's Loan Corporation (HOLC), which ceased to exist a few years ago. HOLC developed self-amortizing mortgages, rather than loans rolling over every five years with large payments due at the end. This stopped homeowners from facing foreclosure every five years from a balloon payment that was spread out over either a 15- or 30-year period.