WASHINGTON — Timed for this month's one-year anniversary of the housing-spawned crisis in financial markets, two new books from respected economists are offering provocative solutions to prevent similar meltdowns.
In "The Subprime Solution," Yale University economist Robert Shiller — the coiner of the famous phrase "irrational exuberance" to describe the financial-market boom of the '90s — says that the origin of today's housing problems is psychological.
"The crisis was not caused by the impact of a meteor or the explosion of a volcano. Rather it was caused by a failure to anticipate quite obvious risks — by 'irrational exuberance' at the prospects for profits, if one bought into the concept of an ever-expanding bubble," Shiller wrote. His other claim to fame is co-founding the Case/Shiller Index, which tracks home prices in major U.S. metropolitan markets.
Equally provocative is "Financial Shock," by Mark Zandi, the oft-quoted chief economist for Moody's Economy.com. His book is subtitled "A 360 Degree Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis."
After leading readers through the sordid history of the nation's housing meltdown, he offers 10 proposals to help prevent the next one. Some ideas already are being offered in part by the Treasury Department or Federal Reserve, things such as greater licensing and regulation of mortgage brokers and overhauling financial regulation to meet today's market realities. But others that make sense have received little attention.
Today's nationwide housing crisis began with bad adjustable-rate home loans made in 2005 and 2006 to borrowers with weak credit histories. Last August, the holders of fancy financial instruments worth hundreds of billions of dollars backed by these questionable mortgages began losing their shirts, as mortgage-holders couldn't make their payments. The housing problem snowballed into a financial markets problem, and later a U.S. and global economic problem.
In an interview, Shiller said he didn't expect the ugly year in credit and housing markets to get much better soon.
"I think it may persist a good deal longer, because it has to do with changing confidence in our markets and institutions. And those things don't fix themselves quickly," he said. "It's kind of a social epidemic. When confidence starts fading, it could be a feedback loop that goes on quite a while."
Like the financial bubble in technology stocks that exploded in 2000, real estate investors acted on unrealistic assumptions that prices could only go up. In the aftermath, Shiller's recommendation to policy makers is "Mend it, Don't End It." He advises regulatory modifications and greater financial disclosure from all players in the complex mortgage-banking process.
He proposes a creative "continuous-workout mortgage." A variation of this kind of mortgage was tried briefly in the late 1970s and '80s, when inflation was galloping and homeowners struggled with payments as their purchasing power eroded.
As envisioned by Shiller, a "continuous-workout mortgage" would adjust the loan terms on a monthly basis based on a borrower's ability to pay. This is already done after the fact by bankruptcy courts when a borrower is seeking protection from creditors.
"I think this is the kind of thing we will gradually see. Financial instruments will get more complicated because we have computers and databases" to calculate and manage risks better, he said.
The Yale economist also proposed new insurance products designed to guard against the loss of home equity. Taking a cue from disability insurance, which protects against lost income because of medical problems, Shiller proposes "livelihood" insurance, which would extend to economic risks from the loss of employment. Job loss is among the most frequent reasons for mortgage defaults.
One of Zandi's ideas is to create a federal foreclosure code, replacing the patchwork of state rules that make foreclosure proceedings anything but uniform. For example, many borrowers today have the right of redemption, which gives them the chance to repurchase their foreclosed homes for up to a year after they're auctioned. This creates uncertainty and helps drive down the prices that foreclosed homes fetch at auction.
Likewise, not all states consider foreclosure proceedings a judicial matter, and this leaves some borrowers with less protection against lender abuse.
Zandi proposes modeling a federal foreclosure code after the 2005 overhaul of bankruptcy laws. The code would create a one-year time frame for foreclosure proceedings, enough time for borrowers to work something out but not overly burdensome on lenders, who need to move the foreclosed properties off their books.
"The average time between first and last step ranges from between seven months in Virginia to 20 months in New York City," Zandi wrote.
Zandi lays blame for today's housing meltdown on the doorstep of the Federal Reserve. Former Fed Chairman Alan Greenspan held the view that it wasn't his job to identify asset bubbles such as tech stocks or housing, because markets self-correct.
"I think fundamentally that kind of logic is flawed. It is asymmetric," Zandi said in an interview. "If you are going to respond to the mess that is created when the bubble bursts, it does require you to respond when the bubble is forming."
Greenspan frequently has argued that it's impossible to tell when a market is becoming a bubble. How does one know where normal home-price appreciation ends and becomes a speculative bubble? However, Zandi said that making such judgments was the Fed's job.
"My view is that the Fed has to make a lot of very tough decisions: Is inflation too high? Is it accelerating? Are growth expectations weakening? I think it is in the same league" of intuitive policy decisions, Zandi said. "So you are kind of punting on policy decisions that you shouldn't be."
Zandi, an unpaid adviser to Republican presidential candidate John McCain, doesn't think that the Fed necessarily needs to raise interest rates to deflate a bubble.
"The response could be more regulatory oversight," he said. He said Greenspan's view that markets were self-correcting was "a good baseline" but insufficient. "I think we took that philosophy, in my view, to the extreme, and the sub-prime shock is in part the result of that. There is a role for good regulation, and in fact it is necessary at times."
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