Shiller’s Subprime Solution(s)

In my last post, I focused on what we still don’t know about the causes of the subprime crisis.

But here I’ll tell you about six solutions proposed by Robert Shiller in his book The Subprime Solution. (He has also recently published an op-ed in The Washington Post and an op-ed in The Wall Street Journal.)

Shiller separates the short-term need for a bailout from the need for long-term solutions. Much is being written now about short-term bailouts, and Shiller presciently has a chapter in his book on the inevitable need for cleaning up the past.

But this post responds to Shiller’s suggestions about what we should do prospectively to make sure this doesn’t happen again. For the long term, Shiller proposes “six major ways of improving the information infrastructure.” Three of his proposals are directly related to providing the system with more information (quoting, but reordering, from The Subprime Solution, P. 122):

1) promoting comprehensive financial advice;

2) improving disclosure of information regarding financial securities; and

3) creating large national databases of fine-grained financial data.

The other three proposals are, to my mind, substitutes for providing more information:

4) establishing a consumer-oriented financial watchdog;

5) adopting default conventions and standards that work well for most individuals; and

6) creating a new system of economic units of measurement.

I generally am more attracted to the three informational substitutes than to the first three proposals.

Shiller’s suggestion that government should subsidize unbiased financial advice for poor people is particularly weak. There isn’t good empiricism that shows that financial advice helps retail consumers make better decisions.

Many people are averse to thinking about their finances (even some of my colleagues at Yale Law School). And in this part of the book, Shiller too strongly embraces the notion that the subprime crisis was caused by consumers who would not have borrowed if they had been given better information.

He views borrowers through a complicated emotional lens, describing them alternatively as “complacent” (P. 6), prone to “excessive optimism” (P. 54), and “blandly accept[ing]” inappropriate terms (P. 133). But, as emphasized in my last post, I’m more open to the idea that some borrowers were making rational decisions about risks and rewards. Providing more information would not change these people’s decisions.

I am intrigued, however, by this suggestion of Shiller’s:

that every mortgage borrower have the assistance of a professional akin to a civil law notary. … In Germany, for example, the civil law notary is a trained legal professional who reads aloud and interprets the contract and provides legal advice to both parties before witnessing their signatures. (P. 134)

It might be worthwhile to test whether a point-of-purchase civil law notary would avoid some ill-advised borrowing.

Shiller also thinks that the ultimate buyers of the mortgages were making systematic errors. He wants improved disclosure about financial securities to help the ultimate mortgage buyers from making ill-advised purchases:

The subprime residential-mortgage backed securities were grossly misjudged because no one outside the rating agencies understood the information to correctly gauge the soundness of the mortgages on which they were based.

The stage was perfectly set for unscrupulous mortgage originators to lend to low-income people who were likely to default, and for mortgage securitizers to sell the soon-to-default mortgages to unsuspecting investors. (P. 136)

I’m skeptical about Shiller’s claim that the ultimate buyers lacked sufficient information or the sophistication to understand the data. Or even if they did, this is not an error they are likely to make again. Once bitten, twice shy.

They will demand, and originators will have incentives to offer, additional information. There might be a role for government in mandating standardized reporting so that comparisons can be more easily made; but I think it’s more likely that mortgage buyers simply underestimated the likelihood of a fall in real estate prices.

This is a failure of interpretation, not really a lack of data about the particular mortgages. (It’s also a reason that I’m skeptical of providing borrower advice. Apparently, Shiller would not have wanted Alan Greenspan and Paul Krugman to give financial advice because they underplayed the risk of a housing bubble. But where would the army of unbiased advisers come from in a world where, by assumption, we are caught in a bubble mentality?)

I’m similarly not persuaded that we need to create “large national databases of fine-grained financial data.”

To my mind, Shiller hasn’t made the case that failures in the current FICO-score system substantially contributed to the subprime crisis. His best justification for fine-grained data is, I think, to support his call for “continuous work-out mortgages” — mortgages whose repayment streams would be made contingent on information about both the state of the economy and the state of the borrower.

The problem with this proposal is that it is at war with the book’s embrace of transparency and simplicity. Automating the negotiating when housing prices fall makes a lot of sense, but I think you probably get 95 percent of the systemic benefit by making the payment simply contingent on this single price variable.

There is a certain disjunction between Shiller’s diagnosis of the problem and the solution. The problems are that:

1) we had a housing bubble that popped;

2) we had high systemic leverage at both the borrower level and the investment-bank level; and

3) we had asymmetric information about which financial intermediaries were exposed to the toxic debt.

Only the last of these is really an information problem, and providing more fine-grained information about borrower financial data doesn’t help solve the problem that we don’t know which institutions are exposed to bubble risk.

Shiller’s other three proposals might better respond to these problems. His embrace of Elizabeth Warren‘s Financial Product Safety Commission could be used to limit consumer leverage.

I’m attracted to the idea that we require 5 percent owner equity both at time of original sale and with regard to any subsequent refinancing; or government might allow a bit more flexibility by promoting less leveraged defaults.

Shiller appropriately “calls for the authoritative assertion of [a] new standard boilerplate for … mortgages,” and backs up the boilerplate by suggesting that the government only accept conforming mortgages as collateral for loans to mortgage lenders.

Viewed through the lens of the three problems (the bubble, the leverage, and the opaqueness), what are the best regulatory responses?

Deterring Bubbles: Economists don’t have a lot of proven tools to stop bubbles; but I like Shiller’s success in creating derivatives on city-level real estate prices. We might have fewer real estate bubbles if informed investors could more easily short the Los Angeles market.

Reducing Leverage: As mentioned above, we might require that homeowners maintain at least 5 percent equity at times of borrowing and refinancing. Systemically, there is also an advantage to requiring amortizing loans and discouraging second mortgages that pull out built-up data — because we’re macroeconomically safer when there is a distribution of home equity with 5 percent being the bottom.

We could also cap the amount of leverage allowable at financial institutions; but there are very real costs to constraining bank leverage, and we should proceed cautiously, or maybe not at all, on this dimension.

Reducing Opacity: This is, in some ways, the hardest. The problem of not knowing exposure to mortgage risk is serious in a world where mortgage pools are divided and subdivided again into esoteric products. In insurance markets, we tend to think that this atomization helps spread risk, but I don’t think there are good suggestions on how to get the opacity genie back in the bottle (or whether we should).

On the second page of his book, Shiller recalls that in 1919, John Maynard Keynes predicted that the punitive German reparations would result in disaster. Then, with one of the more chilling uses of the word “quite,” Shiller says: “A comparable disaster — albeit one not of quite the same magnitude — is brewing today.”

Shiller has been called a Cassandra, but he is Keynesian when it comes to his predictions and his diagnosis of the problem. His long-term informational solutions aren’t uniformly as convincing — but then again, I haven’t heard others that I like much better.


The real cause of the bubble is that so many people expected housing prices to climb steadily, 10-20% for years on end. With this expectation, it makes perfect sense to take out an interest-only loan. It also makes perfect sense to buy dangerous strips of mortgage-backed securities. The worst case scenario is that you refinance or sell the house at a small profit.

Better disclosure of terms would not have changed the basic situation. Buyers observed years of price rises, and saw other people making huge profits on their homes. When this is happening, having a civil clerk in the room is not going to kill very many deals.

The expectation of constant price rises is now gone, so the underlying problem is solved. Shiller has some good suggestions, but they mainly amount to ways to better lock up the barn door now that the horse has galloped off.


I'm convinced that the constant media blitz of economic horror stories is undermining the market as a whole. Stories are picked out of the air and sensationalized so much that the untrained 401K investor is scared into selling off and running for the hills. If the media isn't brought back to taking responsibility, there's no telling how bad things could get. Everybody knows that only bad news sells so the media is on a sales campaign of epic proportion. We need responsible reporting of facts and the media hasn't got a clue as to how to get there.


Thank you so much for this clear read!


"Don't make book, if you cannot cover bets!" -- Tom Lehrer

from "Be Prepared" a satirical song about Boy Scouts.

This seems to have been ignored by the players, the referees, and the cheering multitudes in the stands.

I agree with #24's hit points, and would add a point that seems obvious to me. Breaking up a mortgage into pieces to distribute the risk, INCREASES the risk, since a single player holding a bad mortgage can work it out with much more flexibility than multiple players holding different pieces with conflicting interests depending on the seniority of the pieces they hold.

Bobby G

@ Jan (#22),

I was speaking with some friends at lunch the other day about this: people really don't know much about the intricate going-ons within foreign governments. It's at once a little shocking to realize, but at the same time not really an odd concept. We in America, the average, newspaper-reading citizens, do not know really the minute, subtle differences that may separate the American government from, say, the British government, or the French, or even the Canadian. It wouldn't be a brash assumption, I would say, to assume that not many foreigners understand the true mechanics of the American government either. As individuals, there really is not much personal incentive to be well-informed about the intricacies of a foreign system.

You have a misunderstanding about some of the reasons behind our current financial woes that is shared by many Americans who *do* have an incentive (the weight of which could be linked to the present value of any and all misfortunes that will befall them due to this crisis) to stay on top of the ball. Mistakes were made by the high levels over the past decade, but not by the bank/Wall Street CEOs and executives (not the gamebreakers, at least). No, the mistakes were made by our government with the systemic removal of risk-management limitations applied to our taxpayer-secured financial friends including Fannie and Freddie (as I've mentioned a couple times now). I suppose there's no point explaining it here since it's briefly outlined above, and it seems you hadn't read that either... so I won't.

Ultimately though, I feel like the public has placed way too much blame on these executives of companies requesting help from the government. Sure these guys made mistakes, but quite frankly, there was government pressure to do so. On top of that, everyone in the industry was doing the same thing. Common business practice: do what your competitor does and you can't lose too badly (*cough* politicians *cough*). A lot of these firms are now asking for help because, well, the market found some small flaw, some minor disadvantage from the other firms, early, when the bubble was just being burst and there was a run on that bank, both literally and figuratively. Now with investor confidence shot to hell (although desperate to re-establish itself at the same time), we have our crisis.

Yes there were bad decisions made, but let's not get caught up with punishment, particularly where it isn't all due, and instead form solutions containing healthy economic incentives that hopefully will let us avoid such crises in the future.

I'll stand by my assertion that more regulation is not the best thing for the country. If you want to know my reasoning, read my comments above or in Mr. Ayres previous post.


Nicholas Love

Hmmm ... well it seems clear to me that some informational / regulation changes might help. Basic education too. But also that these by themselves absolutely will not prevent any future similar-or-greater-in-magnitude-but-different-in-nature crises.

Information is data acquired in response to a particular question about the past. How do we know we are asking the right questions? And how do we know what to do with the answer? We are emotionally confused because we don't really know what our lives are for, and this shows up particularly strongly in financial matters because of the connection between money and the ability to survive.

Bubbles are simply an expression of this confusion. And until the confusion is cleared up they will continue.

In the "death and taxes" certainty, it's time we started paying attention to the death side, and finding out what life is for.

Nicholas Love


David S.

For the past 13 months, every “crisis” in the banking sphere has descended from three basic flaws in the current regulatory structure:

-Over leverage. The failures of the Bear Stearns, Lehman Bros., Merrill Lynch and various hedge funds descend directly from their level of financial leverage. At the present levels of leverage, one mistake and you are dead. Back when these financial institutions were regulated to carry no more than 12:1 leverage, we didn't have banks blowing up every 13 weeks.

-Unregulated derivatives. This is what caused the trillion dollar insurance company, AIG, to be taken under by the Treasury Department. Financial service providers made billions writing insurance policies that were unregulated and carried no regulatory oversight that ensured they would be paid in the event they were triggered. No other category of insurance policies is unregulated in this manner. Warren Buffet refers to these instruments as “financial weapons of mass destruction.” The notional value of these numbers in the tens of trillions.

-Fictional Accounting. This is the precise reason that “short sellers” have pounced on the various financial institutions. The current accounting allows banks to intentionally produce fraudulent financial statements, regarding the value of various assets, they claim as part of their net worth. The short sellers understand that the value of these stocks are grossly under their current price and act accordingly. Banning short selling does not change the fact that these companies are priced well above their value. You NEVER see short sellers attempt this with healthy, truthful companies.

The solution is to pass a comprehensive regulatory reform bill that:

-Reduces leverage to safe levels. This needs to happen over the next two quarters. Company reports shall be required to show that financial leverage is within statutory limitations, or enforcement action will follow.

-Put Credit Default Swaps on a regulated exchange. This ensures the insured party can be paid and prevents the nightmare scenario of a chain-reaction of defaults across the system. The equity options markets are a good example of how this needs to be structured. No company may be allowed to write these derivatives without the capital backing necessary for performance.

-End fictitious accounting practices. Every company must mark all of their assets to current market value on their quarterly and annual statements. Each asset must have its own accounting as to its value. This way, full transparency is brought to the marketplace and investors know exactly what they are buying. This will end the practice of hiding unhealthy companies within the larger herd of structurally sound companies, as is the current practice in the US banking system. Capital will immediately flow to the healthy companies and the assets of the unhealthy companies will be taken into the market and deployed to their most efficient use. The current practice only serves to cast a pall of doubt over the entire sector until it fails en masse.

Note that these proposals end the current “crisis” within two quarters. These proposals do not cost the taxpayer one dime. They fix the problem, and most importantly, they eliminate the enormous moral hazard that is present in any derivation of the current Paulson/Bernanke proposal. They establish the framework for building a healthy, stable, and useful financial system in the United States. “Bailouts” and dark-of-night enforcement changes are obviated.

The Congress retains all of its financial oversight and regulatory powers. The Administration is consigned to its enforcement role, as the Founders had set forth.

For more information, please go to:


David S.

Information is at the heart of the current crisis. No one is willing to loan money to anyone because there is no trust that the the other guy can pay back the loan. You cannot trust balance sheets.

Jan Christiansen

Bobby G

I do view the American experience from a distance but distance can offer perspective. It seems to me that many of the American's commenting on these issues are too pre-occupied with domestic political fights to see the problem clearly.

I do not excuse the actions of the US administration - the fiscal and monetary policies of the last eight years have been reckless verging on criminal and your country is going to pay a high price for a long time and the world will be poorer for it.

However, the crisis in mortgage backed securities is not the result of government pressure to make home loans to sub-prime borrowers. No one could or did pressure investors to buy the mortgage backed securities, and no one could or did pressure investors to leverage their investments in those securities.

I do have long term confidence in the US economy. Last week I moved about 20% of my life savings into the US stock market.



The reason you need greater transparency is not to protect the relationship between lender and borrower, but to inform the markets of the true value of the assets of the lender.

If the market, outside investors, had known the true value of these instruments then the market could have and would have imposed much more discipline on the lenders. And the reaction would have been sooner and more dramatic then government regulators.

I think people inside these institutions had a much better understanding of what was going on inside these institutions then they have admitted. And they appear to have been very skilled at avoiding the numerous regulations in place.

Now I think playing these games will be subject to lawsuits. And with the government as stakeholders, will they be obligated to pay any damages. Lawyers must be licking their chops.

Bobby G

@ DanC (#4),

I agree with you: they lent to the uninformed borrowers because they didn't have an incentive not to. As someone else pointed out, there was a sort of indirect governmental pressure on Fannie and Freddie to buy higher-risk mortgages... the private sector risk assessment incentive was destroyed when the government said, "We got your back" and the government-applied risk limits were systematically being removed... essentially this tells the firm, "Hey, if there's a sliver of hope of making a profit on a mortgage, buy it!" Like I've said before, it's mis-managed regulation that was the problem here, not "deregulation." More regulation scares me.

@birtelcom (#5),

I'm not sure you can make that argument against information... perhaps it wasn't lack of information that was the problem (although I happen to think it is a likely part of it), but lack of comprehension of that information. What good is information if you don't understand it? This is a fundamental business problem: a business can get information about its customers, but if it can't do anything with it, that information is worthless to them. Is that information still important? Absolutely. The solution to that problem is for the business to increase profits by coming to understand and react to that information, not to cut costs by eliminating that information altogether. People need to get more information about their markets and then make informed decisions based on that info. Financial advice might be a workable aid to that end. Just because people play some games without being informed and sometimes win doesn't mean it was smarter to not be informed, it just means that they won and they probably don't understand why. People buying homes assuming prices would rise were uninformed: if they knew why the bubble was being created, maybe they could have rethought their decision and not suffered for it.

@ J (#8),

I like your quotes at the bottom there, but I don't understand how you can thus come to the conclusion you came to, "Once bitten, then bailed out, never shy again." This is the reason I reluctantly came to agree with the exective pay limitation... it creates an incentive for the businesses, at least the upper level management, to shy away from government regulation. Sure, gambling with other people's money (i.e. taxpayers) may be one thing, even if they are your ever-important customers, but gambling with your OWN life savings is a bit different. An overall healthy incentive was created then to make management not want to get bailed out.


Vincent Negre

At the root of the whole mess is a national policy issue : how do we house the poor ? Unless we tolerate shovels, the fact is that 10 % of the population probably will never be able to afford what we would describe as decent housing in America and Europe. The traditional answer was to subsidize rents on public housing. This was and is useful but has some perverse effects : bureaucratic injustice, ghettoisation, and the lack of pride in, and therefore care of, one's home that comes with ownership. This has been enough to excuse a political move to encourage mortgage-taking by people who cynics knew could not afford them, shoving the problem into the future and creating the bubble. But the whole issue remains : how do we decently house the poor ?


Case in point: Massachusetts no longer set auto insurance rates but 3/4 of the people haven't shopped. I did and found the rate reduction offered by my old insurer was $300 less than I could get elsewhere. Direct evidence that not even a small investment of time to save real $$ is enough to get people to act when it comes to finances.

In things like lending, you need to control from the top down because individuals will act as an aggregate whose behavior can be estimated given what's offered. If you're offered no money down or a teaser rate, it's not your fault as an individual if you take it but that's not really the issue: any lender has projections about market share and penetration based on their offers, which means they can manipulate the aggregate while no individual can.


the problem with requiring 5% equity is that equity is reeeallly susceptible to fraud and not-quite-but-almost fraud. 100% financing is mostly gone though and I doubt we'll be returning to it any time soon so it seems not worth the effort to regulate. I mean outside of the bubble mentality i think lenders will recognize that if the borrower has not personally invested any of their own money into something they have no incentive to keep paying.

Bobby G

Whew! Long blog post... much more gritty than the normal freakonomics post, but I think you have a lot of merit here.

I don't have time to write out my full response just yet, but I will say that information should not be downplayed... if information can be properly communicated with full transparency like Shiller proposes in his first three points, then it would truly be left to the comprehension of the borrower to determine economic efficiency. If, for example, borrowers had really known about the regulation changes on lenders and the reasons for those changes, perhaps those rational borrowing decisions would not have seemed so rational... when the bubble is explained, people can take steps to safeguard against a burst. I think you undervalue proper, complete, understood information in your post.

The latter three suggestions Shiller makes, particularly the watchdog, just strikes me as more regulation and more room for special interest obstruction/influence (the term "corruption" is being thrown about way too often these days). I think information would be preferable, increasing the profitability and thus value to society of people who could understand the information, allowing them to make better-informed risk assessments, and creating incentives to be educated and informed... two good things in my mind.

Perhaps such transparency is unlikely or even impossible, but it's just a pet peeve of mine when we dismiss basic economic principles. If we make a few changes, these principles could still work.

I'm looking forward to getting to the rest of the article later.



One cannot ignore the fact that many people in this country graduate from college with very little knowledge of economics and personal finance.

Personal finance is not taught in either high school or college, and although some high schools require a course in economics in order to graduate, many do not.

The result is a huge number of young adults who make poor economic and financial decisions due to lack of knowledge.

Ask a random 22-year old about compound interest, sunk costs, net present value, or opportunity cost, and you'd probably get a blank stare.


Shiller was prescient about the crisis, but some of his solutions are worthless. If education & information was the answer to human vice then you wouldn't see anyone smoking. Bubbles have happened since time immemorial. From tulips in the 17th century to houses today, once people become convinces prices can only go up there's no stopping them with information.

There ARE steps that can stop bubbles from inflating so wildly. Unfortunately Greenspan and others placed all their (and our country's) faith in the free market prevented them from working. Who in their right mind thinks the government has to turn away powerless when lenders decide to make loans to those who can't prove they can repay them?

Jan Christiansen

Here in Canada lawyers handle real estate transactions. Financial advice is not a standard part of what is provided. You had a bubble and even sophisticated people get caught up in bubbles. Adding a lawyer or notary to the mix will not fix the problem.

The housing problem the US has is not just in the subprime sector. If the banks had refused to buy the mortgage backed securities then the bubble would have been stopped in its tracks. Knowledgeable people knew as early as 2004 that you had a housing bubble. The mistakes were made at the top, not the bottom, of the economic food chain.

From my Canadian perspective it appears that the housing problem is just part of a larger US problem. Americans need to correct a whole series of imbalances and to do so would require an average 15% drop in your standard of living. Canada fixed its imbalances by dedicating all of the growth in productivity over a fifteen year period (1984-1999) to fixing those imbalances.



"Shiller's suggestion that government should subsidize unbiased financial advice for poor people is particularly weak. There isn't good empiricism that shows that financial advice helps retail consumers make better decisions. "

I'd love to see the psychological/economic source or study on this, it sounds fascinating, rather than your suppositions on such, completely discounting the power of information and words to effect consumer decisions.


As an aside, I have one issue I can not answer.

How is anything being done to fix the problem, address the issue of affordability? If a root cause is that home prices increased to a level that incomes can not support is there any way to stop the prices of homes from falling? And if home prices continue to fall, shouldn't we continue to see increases in defaults and a decreases in the value of assets. Can the government stand strong if all the homes in the United States decline by 10%