Shiller tries to defend subprime mortgages

By Felix Salmon
July 20, 2009

Robert Shiller thinks that creating a Consumer Financial Protection Agency “seems a good idea”, but is also a fan of financial innovation:

Our financial system has essentially exploded, with financial innovations like collateralized debt obligations, credit default swaps and subprime mortgages giving rise in the past few years to abuses that culminated in disasters in many sectors of the economy.

We need to invent our way out of these hazards…

The subprime mortgage is an example of a recent invention that offered benefits and risks… the higher rates compensated lenders for higher default rates. And the prepayment penalties made sure that people whose credit improved couldn’t just refinance somewhere else at a lower rate, thus leaving the lenders stuck with the rest, including those whose credit had worsened.

We need consumer products that people can use properly, and if this is what “plain vanilla” means, that’s a good thing. But we also need financial innovation.

This is the point at which I want to do my Jon-Stewart-rubbing-his-eyes act: Shiller really has just written a column defending “financial innovation” and using, as his sole example of a good financial innovation, the subprime mortgage.

Shiller seems to think that the best response to harmful financial innovations like CDOs is even more financial innovation, to reverse the damage initially caused. Wouldn’t it be better just to scale back the amount of financial innovation we had in the first place? Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years.

And Shiller’s defense of subprime mortgages is unbelievably weak. He never comes close to addressing the point that a huge proportion of subprime mortgages were sold to people who could have qualified for a prime mortgage; and his attempted defense of prepayment penalties is utterly bonkers. People prepaid subprime mortgages for three main reasons: (a) because their house had gone up in value and they wanted to do a cash-out refinance; (b) because they were selling their house; and (c) because interest rates had fallen since they took out their mortgage. The number of people who wanted to prepay a subprime mortgage because their credit had improved was negligible.

In fact, as Shiller knows but won’t admit, prepayment penalties were a profit center for subprime lenders — a way of squeezing money out of borrowers at the end of the relationship as well as at the beginning. If this is financial innovation, I want much less of it, thanks for asking. And while I agree that the CFPA “should be staffed by people who know finance and its intricacies”. I just don’t think they should start from the assumption that financial innovation is a good thing.

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26 comments so far

“Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years.”

Really? Do you want to make an actual argument, or are you just going to assume that it’s SO self-evident that you needn’t bother with the details. CDOs and CDO^2s weren’t the only financial innovations in the last decade, you know. (Or do you know?)

Posted by Mark | Report as abusive

Of course there were others. But can you think of a *good* one? I can’t.

Posted by Felix Salmon | Report as abusive

“The number of people who wanted to prepay a subprime mortgage because their credit had improved was negligible.”

I don’t wish to defend Shiller’s piece as a whole, but that’s not the point he was making. The point was that, without prepayment penalties, the pattern of refinancing would inevitably lead to dilution of the original pool, with a concentration of poorer than average quality borrowers remaining.

Now, we’ve seen a comparable thing happen anyway, with lower LTV borrowers refinancing out, and FICO scores being much less predictive of default than in the past.

Posted by Ginger Yellow | Report as abusive

How about cash vending machines?

Suggestion from somewhere in a thread on Dani Rodrik’s blog a few months ago about precisely this question – and where there is an link to an excellent(excellent according not just to me, but to Dani Rodrik, a _somewhat_ more substantial endorsement) discussion by Steve Waldman about good and bad financial invovation. eblog/2008/10/more-on-financial-innovati on.html

Posted by Sean Matthews | Report as abusive

Felix, you should go back and read Shiller’s book The Sub Prime Solution again. He argues that we should indeed have more financial innovation in order to deal with these things. One example is what if you had been able to short house prices through a futures market? Would the bubble have grown as large as it did if we could have?

The claim that financial innovation is a bad thing feels like a throw-away line that wasn’t really thought through. See Tyler Cowen’s response. If we aren’t going to roll back financial innovation all the way to the Middle Ages, what is the “magic” year that you propose we stop at?

Posted by Travis | Report as abusive

Financial innovation per se is not a bad thing- it’s just that it was taken too far. ARMs, CDOs and other products were positive developments that became abused by greedy and irresponsible institutions. We had a situation where a product is introduced and proves profitable for the innovator. But then you get multiple rounds of one-upsmanship by competitors that want to cash in on the innovation, and they end up going too far. The original product is useful and true innovation, but the subsequent mutations are just schemes to exploit the product.

However, how anyone can try to defend subprime mortgages is beyond me.

Yeah, weren’t joint-stock companies, coinage, etc. all financial innovation once?

Posted by jt | Report as abusive

I have to respectfully disagree with Shiller. His observation and calling of bubbles is 100% and backed up by analysis, but his policy prescriptions are often not just not the best, but plain bad. I think Shiller is mistaking the premise of subprime – lending to those with poor credit and/or low income – with how subprime came to be implemented in the bubble. There are many organizations that originated subprime loans but have not created the losses that the most egregious offenders did.

One of the most toxic subprime variants was the teaser rate, which goes with the prepayment penalty. That mix is done purely to bring quick fees. If the higher rate is how you offset default risk, why resort to teasers?

Posted by winstongator | Report as abusive

“If we aren’t going to roll back financial innovation all the way to the Middle Ages, what is the “magic” year that you propose we stop at?”

There need be no magic year – some bad products might have been introduced in year x and others in year y. But if you want a year-out-of-the-hat, how about 1960 ? (The hearts of half the readers of the comments have stopped, I’m sure, but that does seem to be about right.)

Posted by a | Report as abusive

“Really? Do you want to make an actual argument, or are you just going to assume that it’s SO self-evident that you needn’t bother with the details. CDOs and CDO^2s weren’t the only financial innovations in the last decade, you know. (Or do you know?)”

Well, do give us an example of a financial innovation in the last decade which you think is positive (and which does not derive its positive value by allowing regulatory or tax arbitrage). I can’t think of one, but I’ll be modest enough to admit I may be in error.

Posted by a | Report as abusive

“One example is what if you had been able to short house prices through a futures market?”

But this is insane. There were markets to make exactly these kinds of bets, and a select few made billions doing so. But is the suggestion here that the average homeowner should be expected to take advantage of such a market in order to adjust his/her risk profile? The average consumer has a life to lead, thank you very much. The only financial innovations that should be encouraged are those that are completely transparent and directly benefit the consumer. CDOs and the rest of the bullshit that’s been created exist only to enrich a class of financial middlemen and a tiny group of super-rich investors. Shiller and others seem to envision people being interested in learning how to do things like buy futures as an insurance against home price fluctuations. I’ve got better things to do. How about this instead: eliminate the financial vehicles/structures/”innovations” that make possible these extreme price fluctuations. Oh, how boring a world that would be! And how delightful …

Posted by Jeff | Report as abusive

Ed Gramlich, recently deceased former Fed governor (who warned Greenspan about the mortgage markets in a fairly timely way), wrote a similar piece about subprime lending for the KC Fed quarterly research publication — DF/4q07Gramlich.pdf

Posted by bdbd | Report as abusive

“Net-net, financial innovation is a bad thing: the downside, during times of crisis, is higher than the upside in more normal years”

Maybe for you, and the rest of the rubes. Some people are living like kings because of these innovations! And isn’t that what’s important?

Posted by Mysticdog | Report as abusive

I think it’s clear that the liability side of financial firms’ balance sheets is no place for market discipline. Best to give the Government guarantees in perpetuity, instead of the current system that puts in guarantees when it looks necessary, and then removes them when it looks unnecessary. Dishonest.

Second, put in incentives to make firms focus on credit risk, which is what they are meant to be doing in the first place. No securitization, all loans held on the originators books until they mature. This will get us back to the 1970s in mortgage markets, where the US enjoyed more housing starts than it did in 2005.

Third, actually impose capital requirements.

Apart from that, they can innovate as they please.

Posted by zanon | Report as abusive

Are you serious? Financial innovation is a GOOD thing. Period, end of story. The “Downside” is always caused by governments, not the private sector. If you don’t like the downside, then you should be arguing against government intervention into the private sector, especially the accounting rules, not arguing against financial innovation.

Human life depends on constant innovation. There is no such thing as “standing still” economically. You either go forward or backwards, and going backwards means moving toward death.

Posted by WM | Report as abusive

WM: Nice of a Republican spinmeister to drop by – now please try again using actual fact. The private market originated over 80% of those subprime (and Alt-A) loans between 02 and 07. The private market is solely to blame for the current crisis, not the .gov’s response to selfish morons.

Human life depends on USEFUL innovation. Madoff is about to find out what going backwards actually means.. the prisoners at his destination have made some fun public statements.

WM, I have an innovative investment opportunity – and this is the private market, so you can be sure I’m honest. I have a bridge in Florida that you can buy sight unseen. I also have a Nigerian compatriot who will be dealing with my finances. Untold riches for both of us!

Posted by Unsympathetic | Report as abusive

The first time I’ve read Mr. Salmon and very well done. I remained concerned that it seems like the top end of the Pyramid (Banks, etc) are getting bailed out but the People who need it still can’t get loans.

Posted by A.J. Franks | Report as abusive

Creativity and innovation are what made this country great. I tend to compare mortgage products to the gun control analogy, “Guns don’t kill people, people kill people”. The guns themselves don’t hurt people…its people acting irresponsibly that are the problem. Mortgage products don’t hurt people…it’s the irresponsible mortgage lenders that are the problem. Mortgage products aren’t “good or bad” they’re just different and serve different purposes.

Unfortunately, creative products produced unintended consequences…namely untrained mortgage lenders using sophisticated financial products. That doesn’t sound like a problem that can’t be fixed.

Posted by Jeff Wirsing | Report as abusive

Gee, Felix, you cannot think of any useful financial innovations in the past decade or so? Futures, options, ETFs, ABS, MBS, online trading, discount brokers, etc.? Or is your analysis so simplistic that you cannot differentiate between financial innovation and improper use of financial products? If so, you better stay away from sharp knives.

In defence of subprime mortgages? Okay, I will bite. How about self-employed people that cannot qualify for a regular mortgage? Or those that have the down payment, but not the FICO score? Such as those that are new the USA and have not built-up a credit rating? Or those between jobs?

Posted by MrBill, Eurasia | Report as abusive

How about interest rate swaptions (80s), tri-party repos (90s), ETFs (90s), weather derivatives (mid 90s), ECNs (late 90s), CBOE volatility index or VIX (90s), VIX futures and options (mid 2000s), CDARS – FDIC insured deposit network (2000s)?

These examples may not have all originated in the past decade, but they are pretty close and have certainly seen their most dramatic growth in popularity recently. Their relative merits may be debated but a very strong case could be made for them being ‘good’.

I think rather than debating whether financial innovation is good or bad, the more interesting question is who can tell good financial innovation from bad IN ADVANCE? Who has the wisdom and foresight to act as the gatekeeper to let the good innovations through? Like all areas of human innovation, including flight, medicine, engineering and even art, failure can be just as important as success.

When policies and regulations are put in place out of fear of the unknown to create a gatekeeper, society becomes stagnant and innovation (especially the good kind) is stifled. Call it what you like -creative destruction, trial and error or just plain experimentation- but this dynamism is the essence of capitalism, democracy and human ingenuity.

Posted by Grant | Report as abusive

I’m not sure mortgages with prepayment penalty clauses were often sold. The reason. Mortgages without them were about 60 basis points more expensive. And in a trillion dollar market, 60 basis points adds up to a lot more money for originators, securitizers and investment bank salesmen.

How about all the innovations of the good Dr. Bernanke and his partners, Mssrs. Paulson and Geithner? Several writers have commented that many of these rapid-fire innovations prevented a market melt-down, which most of us would consider a good.

I’ll cite one: the declaration in September ’08 that the FDIC would insure money-market funds, made in the face of a pending huge run on them — about $1.5 trillion, as I understand it — that developed in *one* day following the Reserve Fund debacle.

These funds were not officially bank deposits, but somehow had been allowed (for decades, not just under Greenspan’s Ayn Randism) to pretend as if, without the protection that Diamond & Dybvig said decades ago were necessary, albeit only probably sufficient, to prevent runs.

Ergo, here is an innovation that corrected a long-standing insecurity in our financial system. We could follow it up by requiring that ALL funds that promise a $1.00 NAV be treated as deposit-taking banks, moving from the panic-induced backstop to a sensible long-term framework.

Posted by Walt | Report as abusive

Don’t forget the greed for up front fees. None of this possible without complicit activity of the professional real estate appraiser…You want how much? Well ,sir, that seems to be the exact value of your place. Puhleeze

Posted by DanO | Report as abusive

Have a great thought that We need consumer products that people can use properly, and if this is what “plain vanilla” means, that’s a good thing. But we also need financial innovation.

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Posted by jennyping | Report as abusive

The foreclosure rate in the third quarter rose by almost 30 % as compared to that in the second quarter. Even though the government is trying to come up with feasible solution to the problems of distressed homeowners, with a good number of loans due to resent by mid of year 2008, the foreclosure rates are expected to remain high. Thus housing market is expected to remain slump throughout next year and even in early 2009.
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Posted by biju005 | Report as abusive
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