“The Subprime Solution”: a must-read

I purchased this book on a whim a few weeks ago. My high hopes were satisfied as Shiller gave insightful explanations of how the subprime bubble occurred and offered innovative short-run and long-run suggestions for minimized the risk of another crisis.


Here are a few of his propositions:

  • Democratize finance. A major cause of the crisis was lack of educated financial action on the part of subprime borrowers. Subprime borrowers agreed to take out adjustable-rate mortgages despite the inherent risk of the instrument. Why? Because the idea that housing prices would increase indefinitely meant they were guaranteed to refinance later and qualify for a lower rate. 

    These borrowers had little access to proper financial advice because firms offering financial advisory tend to market their services to high-income individuals (after all, they charge fees as a percentage of the assets under management). Shiller advocates the institution of a government subsidy to help build a supply of financial advisors for lower-income individuals. In the absence of such advisors, the borrower’s only point of contact are mortgage originators and real estate brokers. Neither of these people’s incentives are aligned with the borrower’s since the broker gets paid as long as the house is sold and the originator can securitize the mortgage and sell it off. 

  • More derivatives! Create a market for derivatives with the Case-Shiller Home Price Index as the underlying. Maintaining a liquid market for options, futures, and forwards is an empirically proven way to decrease the volatility of the underlying asset. It also provides individual investors with a concrete way of gauging future home prices, as opposed to relying on rating agency models.
  • Home Equity Insurance. A drop home value is devastating. It could prevent the owner from refinancing to a lower mortgage rate, it could wipe out the homeowner’s equity, and event prevent them from relocating. The government should subsidize the creation of these insurance instruments to handle such housing risks. It would reduce the amount of underwater borrowers as well as subdue “panic-selling.” 

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