Shiller Tries to Defend Subprime Mortgages

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.

Comments

[Davewmart:]

Never was a man more aptly named! Shill-er indeed!

Jul 20 06:59 AM

[Vox Rationalis:]

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

What nonsense. "Financial innovation" is far too broad a term to paint with such a wide brush.

Jul 20 09:31 AM

[Dave Shafer:]

Actually, pre-payment penalties allowed originators to hide the true cost of sub-prime mortgages. An originator could get 2 points for a 3 year pre-pay penalty and therefore hide 1-2% of the true interest cost from the consumer. However, with an experienced and honest originator you could offer a sub-prime mortgage to a customer at only 1% above prime rates using a pre-pay. Combine this with a fixed rate [instead of a variable rate] and you have a decent deal for a sub-prime customer. The point is that any financial product can be misused [and sub-prime was misused by the industry as a whole], but that the existence of sub-prime was not evil. Same could be said about Alt-A products too including pick-a-pay. Much blame can be placed on the mortgage companies for creating incentives to "cheat" the customer as well has hiring a sales force of uneducated buffoons who were raking in the $$$ at their customers expense. Bottom line it is not the product but the mortgage companies and their sales force at blame. [and the up stream investment banks and rating agencies that created the incentives from the beginning]

Jul 20 09:49 AM

[Unknown Pro...:]

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

This sounds suspiciously like Financial Ludditeism. I think you lack a sense of history. Would you prefer to go back to the financial system/products of the 1980s, 60s, or 40s?

Innovation is merely the creation of something new. New financial products survive when they serve a purpose. When not, they don't.

Jul 20 10:06 AM

[User 63094:]

There is NOTHING wrong with sub prime mortgages. There is a place for sub prime lending. I am NOT advocating stated income 100% LTV or the adjustable negative ams ,that is NOT sub prime lending that is lending on ACID. Higher rates for higher risk ..YES.

There is something wrong with banks leverage of 30:1 and Fannie 90:1. There is something wrong with banks knowingly selling toxic packages to their customers. There is something wrong with EXPLOSIVE growth in money supply and credit as orchestrated by the Fed Reserve.

BTW, Schiller is definitely one of the good guys. Perfect? No.... But he has more credibility than the blue suits in NY & DC.

Jul 20 12:22 PM

[question1:]

It's ironic that Felix chastises Professor Shiller for using subprime mortgages as his example that not all financial innovation is bad, using prepay penalties as his counter-example.

Prepay penalties were designed to protect against house flippers; they effectively acted as a vendor tax against those speculative borrowers out for a quick buck and lowered the cost of the true investor who may not have been able to get a prime mortage (first home buyers, for example). A disincentive against speculative borrowing which lowers costs for all borrowers; sounds like a pretty good innovation to me.

Jul 20 02:00 PM

[Bill Herbert:]

>>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”.<<

That would obviously not include muttonheads like Shiller and one J. Siegel, both of whom have spent way too long in academia, dreaming up ways to sink the real economy via "financial engineering" and "innovation."

These insidious mad scientists of academic finance suck money out of the government through huge "research" grants, then turn around and give cover to a bunch of parasitic thieves on WS through their academic studies and cockamamie theories of the economy, 'risk' and derivatives games.

The whole nonsensical train wreck that is the last thirty years of output from the likes of these Finance jokers should be banished from the markets, as all it has done is led to massive dislocations and enormous income disparities between those who actually contribute something real to the economy, and the predators who game the system and the laws to allow their illicit gains.

It is a shameful result of a profession run amok with greed and flighty thinking.

Jul 20 03:34 PM

[Fighting Yoda:]

Financial innovation itself is a good thing, provided it is used and implemented properly. That is where the problem lies – there will inevitably be greed and stupidity with any product, there will be some market participants who will be prudent and other’s will throw caution too the wind. Regulation or monitoring itself may not be the answer as – no one wants make the tough unpopular decisions – ‘take the punch bowl away’.

Overall financial innovation last 20/25 years has been a complete disaster – one crisis after another – Trillions and Trillions have been lost. Paul Volcker in speech a couple of months ago said- ‘the only good financial innovation has been the bank ATM”.

I am all for keeping things simple and honest.

Jul 20 07:33 PM

[E Nuff Sed:]

Financial innovation is like creative accounting, one step up from legalized robbery aka American capitalism.

Jul 21 12:50 AM