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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