Inside Story

Strange times

High-profile economist Robert Shiller doesn’t dig deeply enough into the causes of the sub-prime crisis, writes John Edwards

John Edwards 4 November 2008 2478 words

A downturn foretold: economist Robert J. Shiller. Benedikt von Loebell/World Economic Forum

The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do about It
Robert J. Shiller | Princeton University Press | $33.95

As Robert Shiller rightly argues in The Subprime Solution, today’s global financial catastrophe had its origins in the downturn in US house prices in 2006. While it had its origins there, however, it quickly became something else entirely – and this transmutation is not well captured in Shiller’s book. In the end his argument is like saying the first world war started because a Serbian shot an Austrian Archduke. It was the incident, not the cause. As a result the suggestions Shiller makes for avoiding future financial crises are unconvincing.

There is no argument with Shiller’s proposition that the financial tidal wave still coursing through the global economy started with the downturn in the US housing market, though the manner in which it started there is worth pondering. According to Shiller (and most other commentators) US house prices were in a bubble, which had been inflated partly by lower credit standards and the extension of lending to “sub-prime” borrowers. These are borrowers who had a history of difficulty in servicing their debts. Through 2004, 2005 and 2006 they accounted for a rising share of all new mortgages.

An important characteristic of sub-prime mortgages is that by definition they could not be bought or guaranteed by the government-supported institutions which guaranteed most US home loans, Fannie Mae and Freddie Mac. Another important and relevant characteristic of the US market is that many states limit the borrower’s obligation on the mortgaged property to that property alone. Once the value of the home falls below the value of the mortgage, the owner has an incentive to send the keys to the lender and move out. Sub-prime loans had very high loan to valuation ratios, so they were at risk from any sharp decline in house prices.

Finally, and this is also relevant to understanding what happened, more often than not sub-prime loans had an affordable introductory interest rate, which after a period of a year or two would convert to what was usually a penalty rate – unless the loan was renegotiated before the reset date. The incentive, intent and practice were that sub-prime loans would be renegotiated to a long term rate, with a lower loan-to-valuation ratio. So long as house prices rose, it was good business. But it all depended on house prices continuing to rise. Once they started to fall, which was inevitable sooner or later given the size and rapidity of the increase, there had to be a sharp increase in sub-prime mortgage delinquency. This became apparent through 2006 and into 2007.

But if a decline in US house prices and a rise in mortgage delinquency in a relatively small part of the market were the extent of the problem, the global financial crisis would not be anything like as serious as it now is. After all, sub-prime mortgages are only 15 per cent of all US mortgages, and even if we say 25 per cent are delinquent – around the agreed estimate today – that is only 4 per cent or so of US mortgages. Furthermore, some of the losses are recoverable when the repossessed property is sold. It is true that there is another class of mortgages – we call them low-doc and they are called “Alt A” in the United States – which are also not guaranteed and which have seen rising default rates. There is yet another class of unguaranteed loans called “jumbos,” which are too big to guarantee, though the default rate there is not particularly high. Even taking the estimated defaults in all unguaranteed loans, the total provisioning (which is higher than the actual loss, when recoveries are made) is roughly $600 billion. The Bank of England has estimated the likely actual loss after recovery at much less. The $600 billion estimate is a big number, but financial institutions have already written that amount off. More importantly, they have acquired a matching amount of additional capital.

If that was all there was to it, we would have moved on sometime around the end of 2007. It’s true that the decline in house prices in the United States would have continued and racked up further losses. In Australia or Britain that would mean banks and mortgage funds sustaining large and continuing losses. In the United States, however, most mortgages are guaranteed by the government-supported housing agencies. The losses in prime mortgages would have been almost entirely borne by Fannie Mae and Freddie Mac as the guaranteeing institutions for these loans. They would have been bailed out and taken over at enormous taxpayer expense (as they have been) but the world would have moved on.

The important point here is that the US home price bubble does not, as Shiller suggests, explain the seriousness of the global financial crisis. It only explains how it began, and not all of that. It was not so much the bubble itself as the innovation of providing an increasing proportion of unguaranteed mortgage loans to people who had a history of difficulty in meeting loan payments. (Incidentally, there was no legislated inducement or incentive to extend lending to sub-prime borrowers, as is now frequently alleged. It was not the outcome of warm-hearted but muddle-headed intervention by US liberals. This is startlingly apparent from the fact that the loans were not guaranteed. Hence the problem. The boom in sub-prime lending was a business calculation, which went very wrong.)

Shiller repeats the widespread claim that lending standards fell in 2005 and 2006. This has been contested, with other analysts suggesting there was no decline – though of course the standards were not severe in the first place. But you don’t need declining credit standards to explain what happened. All you need is high loan-to-value ratios in a particular part of the market (and they had to be high to be accessible to sub-prime borrowers), the option in many states of turning the property over to the lender with no further obligation – and declining house prices.

That is all you needed to start it, and all you need for a nasty shock to financial institutions. But it does not necessarily create a global financial catastrophe of the kind we now have. That is not a story about a bubble or house prices. It is about the way in which parts of the finance business worked, and Shiller does not come to grips with this. One reason he doesn’t is perhaps that he admires the technology of finance and is reluctant to hold it at fault. Indeed, his solutions typically involve yet more complicated financial instruments to insure against risk.

The transmission from mortgage delinquencies among poor US home owners to a global financial crisis was through a lethal gap in financial markets. Sub-prime loans were bundled together in their thousands into financial securities which could then be sliced up into different risk buckets and sold into the market. These are known as collateralised debt obligations or CDOs. They were (and in many cases still are, since they are not trading) held by financial institutions mainly in the United States and Europe, either directly on their balance sheets or indirectly in related entities funded by short term loans. By July of last year financial markets were well aware that the rate of delinquency in sub-prime lending was rising much faster than expected by the ratings agencies that assigned risk weightings to the various tranches of sub-prime debt. Often sub-prime debt was mingled with other debt, and it was impossible to separate it out. Buyers found it hard to value the CDOs, and were aware that the sellers, who often originated the security, knew more about it than they did. The buyers became reluctant to buy and over the whole globe the market in CDOs just stopped functioning.

It might be said that an ordinary share is also hard to value. It is no easier to forecast the stream of earnings for Qantas or BHP Billiton ten years into the future than to forecast the stream of earnings for a CDO. It ought in most circumstances be a lot easier. But share markets are deep, liquid and open. At any time of the day you can find out what the market thinks a Qantas share is worth. The market for CDOs is known in the trade as “over-the-counter”: they are traded transaction by transaction between institutions, and very often the characteristics of the instrument may be designed for a particular buyer. It is difficult to discover the price the market as a whole sets on CDOs at any one time. If the price is uncertain, the instrument becomes illiquid – it cannot be traded.

So CDOs stopped trading, and with them many forms of asset backed securities. Australian triple A mortgages for example, which then and now have very low default rates, could not be traded. Confronted with the need to take their structured investment vehicles, or SIVs, back on their own balance sheets and pay out the debt owing on them, major banks and other financial institutions became reluctant to lend to each other. Businesses found it difficult to issue debt, and instead turned to banks. This increased the lending requirements on banks at the same time that banks needed to pay out debt on their SIVs, and write off the diminished value of CDOs they held. Banks stopped lending to each other, conserving cash for their own needs. Lending growth slowed as bank capital declined. Central banks stepped in to lend cash to banks, and the banks were also able to raise capital by selling shares – often to government owned funds in Asia and the Middle East.

THIS TAKES THE story to the beginning of this year. It was calamitous enough then, but still within the realm of experience and policy. Then there were two further waves. The first was the serial collapse of New York investment banks. Investment banking used to be about advising businesses on mergers and acquisitions, arranging debt and equity issues, and broking in equities and debt securities. It was not a heavy balance sheet business. But for well over a decade major investment banks in London and New York have been making a bigger and bigger share of their profits from trading on their own account. They borrow from and lend to hedge funds, they buy debt, equities and other financial instruments, and they fund these investments by issuing debt themselves.

There are two generic trades at the bottom of all this. One is to lend a less risky asset in exchange for cash to a buy a more risky (but better paying) asset. Another is to borrow in highly liquid short term markets to buy assets which are less liquid and longer term (but better paying). Once lenders detected that US investment banks had suffered big losses in CDOs, they became reluctant to buy their debt. The investment banks could no longer fund their asset books, and the unwinding of their assets (now including not just the troubled CDOs but many other securities) caused further declines in financial asset prices and further losses, which accelerated the whole process.

The world was now in a thorough-going asset price deflation, in which hedge funds and other holders of speculative positions had to liquidate their holdings as quickly as they could to meet debt repayments. One result was that equity prices collapsed, though it was not in the first place an equity market problem and the price decline is much more than could be rationalised by a forthcoming global recession. The most recent stage of this unwinding came with the collapse of Lehman Brothers, which one way or another turned what was a panic among financial market traders into a panic in households, requiring government guarantees of bank liabilities to prevent complete destruction of the global financial system.

So there we are. The agreement among the rich economies that no major financial institution will now be permitted to fail has checked the subsidence of global finance. As I write share prices have steadied, and inter-bank lending rates have begun to decline. But we are in a very peculiar world – one where the US central bank lends money directly to US non-bank businesses by buying their debt, where the United States, Britain and some European governments are now direct shareholders in banks, where bank liabilities are for the most part guaranteed, where the US taxpayer is about to shoulder the burden of buying hundreds of billions of dollars in financial assets which are otherwise untradable, where those big stand-alone US investment banks no longer exist, and where the US government has had to fund a major debt insurer (AIG) and the two major mortgage guarantee businesses. We are looking at recession in the United States, Britain and Europe. I don’t now expect it, but it is entirely possible that some new episode of deleveraging, of the liquidation and deflation of financial assets, could be just around the corner. Third world debt perhaps, or commercial property. We have not yet seen what feedback impact unemployment and business bankruptcy will have back on to financial markets and businesses. I think we are getting towards the end of the worst of it, but I have thought so at various times before and been wrong.

Robert Shiller may well claim to have predicted this, but his remedies are quite insufficient for the immensity of the current problem or to prevent a recurrence. He suggests, for example, that people need better financial advice, and governments should subsidise this advice. But the biggest errors in this catastrophe were not made by the poor Americans who brought houses. They were made by the finance industry experts who provided the loans, by clever and well remunerated people in ratings agencies and banks, experienced regulators, hot shot fund managers. He suggests the encouragement of more insurance contracts, for household risks, national risks and so forth, notwithstanding the discovery during this current episode that private risk insurance is quite unreliable once we move beyond our normal experience of risk.

Shiller does advocate more disclosure about instruments like CDOs but has remarkably little to say about the need to replace over-the-counter markets for very big financial securities with exchanges, so that the market has continuous knowledge of prices and transactions. He does not have much to say about the need to improve regulation in the United States to mandate good rules on loan-to-valuation ratios, on transparency, and on permissible gearing. He does not have much to say about the need to change the Basle banking rules to make bank capital requirements counter-cyclical instead of pro-cyclical. Shiller may have foretold the housing downturn but this book is not (as it claims) either an account of how the global financial happened or what to do about it. •