Shiller: Financial Infrastructure Must Improve - TheStreet

This column was written by Robert Shiller, author of the new book 'The Subprime Solution: How the Current Global Financial Crisis Happened and What to Do about It.'

There was very poor understanding of the housing and mortgage lending boom of 1997 to 2006 as it was happening. As home prices continued to escalate, national leaders issued virtually no warnings. Instead, many of them congratulated homeowners and the firms that put them into their investments. Because they did not understand the boom, they did not see the end coming.

Now that the end of the boom is a matter of history, it is widely accepted that something was wrong. Still, there is little understanding.

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Most financial experts didn't get it then, because they had the wrong model of the economy. They haven't changed their fundamental model, so they still don't get it. As a result, experts underestimate the extent of the damage. Moreover, survey evidence shows, most home buyers today just assume that the current subprime crisis is just a minor interruption in a continuing boom.

The problem is that the canonical model does not recognize that investor psychology drives markets. Investors are seen as reacting rationally to new information -- like

Fed

policy -- when, in fact, many have been acting consistently irrationally based on misunderstandings.

The boom years were driven by major investor misperceptions of the fundamentals of the housing and mortgage market. A real estate myth developed, that because of the relentless pressure of fundamentals, investments in real estate are guaranteed to provide high returns. Real estate was viewed as a magic money machine.

The rapid appreciation of home prices was seen as just the consequence of these fundamentals. This myth encouraged people to make highly aggressive and leveraged real estate investments, feeling that they could not go wrong, that there was no need to hedge their risks. The myth accounts for all manner of errors -- errors made by mortgage lenders, mortgage insurers, mortgage packagers, investors including banks and hedge funds, rating agencies and government regulators.

Part of the reason that the crisis drags on so long is that we part with our myths only slowly. The gradual changes in our beliefs have profound effects on the markets over time. Market prices are not so much moved by changes in government policy as they are with fundamental changes in public confidence and trust -- the social fabric.

Because our national leaders did not warn anyone of this crisis, and those homeowners whose homes are worth less than their mortgage are in trouble, we are naturally bitter. This is a problem that won't go away soon.

Congress has provided a Housing and Economic Recovery Act to bail out some homeowners, but many more are not going to be helped. This bitterness and loss of hope may adversely affect spending patterns.

The changes in popular assumptions about the future prices, about the outlook for the economy and sense of fair treatment, are fundamentally damaging to the economy, and to the outlook for various enterprises.

The response to this crisis should be, and hopefully will be, to develop our financial institutions better to prevent this kind of crisis from happening again.

There will continue to be angry recriminations against firms that offered smoke and mirrors, and who will be held responsible for our continuing ills. This will put pressure on those firms who can't offer a constructive response.

The crisis should result in major changes in our financial infrastructure. This will happen only over a period of years into the future. Many segments of the

financial services

industry will respond to criticism that they gave bad advice, or, in many cases, no advice. They will be responding to increasing regulatory pressure to clean up their act. But they will also be responding to public pressure towards a more rational economic system.

There should be pressures towards a democratization of finance, meaning developing the financial infrastructure to involve more people in high-level information acquisition. New financial institutions should be established. Some examples of these institutions would be continuous workout mortgages, home price

derivatives

and home equity insurance.

There will be opportunities for a different kind of firm if and when the kinds of responses that seem necessary to deal with this crisis are implemented. Firms that offer fundamental risk management services based on realistic assessments will eventually prevail.

Ultimately, we should move towards a better financial services sector that encourages faith in properly functioning risk management, rather than misplaced faith in speculative cycles.

TheStreet.com TV: Shiller: Homebuilders May Have Struck Bottom

Homebuilding stocks overshot to the upside before the housing bubble popped. Famed Yale economist Robert Shiller, author of

The Subprime Solution

, says the over-reaction to the downside may now be over.

To watch the video, click the player below:

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For John Fout's take on this book, read "BOOK REVIEW: Shiller's Subprime Solutions."

Robert J. Shiller is the Arthur M. Okun Professor of Economics at Yale University and is the author of 'Irrational Exuberance.' His repeat-sales home price indices, developed originally with Karl E. Case, are published as the Standard & Poor's/Case-Shiller Home Price Indices. The Chicago Mercantile Exchange maintains futures markets based on these indices.

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