In a NYT op-ed weighing the benefits and limitations of financial innovation, Robert Shiller defends the subprime loan:
The subprime mortgage is an example of a recent invention that offered benefits and risks. These mortgages permitted people with bad credit histories to buy homes, without relying on guaranties from government agencies like the Federal Housing Administration. Compared with conventional mortgages, the subprime variety typically involved higher interest rates and stiff prepayment penalties.
To many critics, these features were proof of evil intent among lenders. But 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.
This made basic sense as financial engineering — an unsentimental effort to work around risks, selection biases, moral hazards and human foibles that could lead to disaster. This might have represented financial progress if it weren’t for some problems that the designers evidently didn’t anticipate. As subprime mortgages were introduced, a housing bubble developed.
Felix Salmon is incredulous:
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 defence 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 defence 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.
Our take: lending money to people with bad credit for the purpose of buying a house — a huge and expensive long-term commitment — seems like a bad idea. Shiller’s blithe dismissal of the downside (“oh, if only there hadn’t been a housing bubble”) is just too pat.
That being said, he’s not totally wrong in calling for more financial innovation, even on the mortgage front. Folks who pine for the good ol’ days of 30-year, fixed-rate mortgages are living in a dreamtime, where we all go work for the town paper mill, have two kids and retire with a pension and that’s that. With the average person switching jobs and moving much more than they used to, it’s time we found a way of home financing — maybe more appealing, long-term rental options — that fits with the new lifestyle. A regulatory body that thinks the plain vanilla mortgage is the end-all, be-all won’t do us many favours.
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