Housing: Opportunities Created by a Bust

Throughout America's long housing boom, few observers were as consistently skeptical as Yale University economist Robert Shiller.

Shiller became famous when, in the spring of 2000, he published "Irrational Exuberance," in which he described the "wishful thinking on the part of investors" that some new dynamic had created a stock market that would consistently deliver 20 percent-plus returns. Sure enough, within weeks of the book hitting shelves, the fabled dot-com boom came to an end, leaving Shiller with a reputation for unusual prescience.

In 2004, with the housing market still booming, Shiller weighed in with an updated edition of "Irrational Exuberance" in which he took a hard look at why real estate, too, had become wildly overvalued. As the housing markets kept going up, Shiller became the go-to guy for anyone seeking to counterbalance the enthusiastic views offered up by real estate professionals.

So in November of 2006, Shiller found himself on a dais with Frank Nothaft, chief economist at Freddie Mac, one of the quasi-governmental bodies that buys home loans and bundles them into investments. As they discussed the risks to the economy as the housing market slowed, Shiller asked Nothaft if Freddie Mac had done any modeling to figure out how badly it might be hurt if housing prices started to slide. In fact, Nothaft said they had-and they'd even gone so far as to test what would happen if national home prices dropped as far as 13.4 percent. "What about the possibility of a drop that is bigger than that?" Shiller recalls asking him. Nothaft replied that a drop like that had never happened, at least not since the Great Depression.

Now, of course, it has-prices have dropped more than 15 percent nationally--and that's one reason the U.S. government stepped in last weekend, taking control of Freddie Mac and Fannie Mae to try to restore stability to the battered housing and mortgage finance markets.

Shiller describes his exchange with the Freddie Mac economist in a new book whose timing once again seems likely to be prescient. In "The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do about It," the economist briskly sketches out his views on both short-term and long-term strategies for dealing with a housing meltdown that's left millions of Americans a lot less wealthy-and an unfortunate number at risk for losing their homes. (A disclosure: Shiller has served as an occasional source for my reporting, and he kindly provided a blurb for my book on the real estate boom that was published earlier this year.)

In the first part of the book Shiller describes the forces that led so many people to become so irrationally exuberant about the rising value of their homes. He looks at the "social contagion" that spread as flawed logic convinced homeowners, lenders and regulators that housing prices would keep rising. "The very people responsible for oversight were caught up in the same high expectations … that the general public had [and] accepted the received wisdom that [the boom] could not end badly." Oops.

Shiller's new book arrived in bookstores before news broke of the Fannie/Freddie bailout. But he makes clear in general terms that despite many observers' mixed feelings about government intervention, some action like this seemed inevitable. It's not that the government should be acting to prop up home prices, he says. Rather, it's the risks created by the combination of a sharp consumer pullback and credit markets seizing up if big lenders or Fannie and Freddie themselves were to fail. "Bailouts of some sort are a necessary part of the subprime solution, to avoid an economic crisis that would destroy public confidence and lead to systemic failure," he writes.

The book's most compelling discussion centers on the long-term opportunities that lie in this crisis. Shiller describes how key parts of America's financial system--the Federal Reserve, the Securities and Exchange Commission, and the FDIC, to name only three--were created in the reforms after earlier bank crises or the Great Depression. Likewise, investors and executives saw a wave of reforms after Enron's collapse in 2001. Shiller suggests that political leaders should look at the current crisis as an opportunity to rethink the homebuying process and add new protections to keep homeowners from getting in over their heads during a future bubble.

For instance, Shiller proposes a government-subsidized system in which homebuyers would receive counseling from a financial adviser, who could help make sure they're not signing on to a mortgage they can't afford. He suggests another government-subsidized program that would lead to the creation of a gigantic new database with information on the finances of individual homeowners-one that goes far behind the current system of credit reporting--which could let lenders see if a borrower was getting in trouble with too much debt.

He suggests innovative new financial products could also help. He describes a system of "home equity insurance," that would let homeowners buy coverage against the risk that the value of their home would decline, the same way they currently insure against the risk of fire or flood. He also describes a nascent system that he's helped create to let investors trade futures contracts to bet against home prices, the same way stock investors can "sell short" to profit when a particular share of stock falls in value. "If we did have a liquid market in real estate futures by city, then any skeptic anywhere in the world could, through his or her actions in the marketplace, act to reduce a speculative bubble in a city, for such a bubble represents a profit opportunity for short-sellers," he says.

Some of Shiller's reform ideas are blindingly complicated. Many of them would be opposed by powerful industry lobbyists. And there's a strong argument that Washington is usually better equipped to deal with short-term crisis (like those posed by the potential failure of Freddie Mac and Fannie Mae) than it is to push through bigger, longer-lasting reforms to complex problems. (Consider health care costs or the looming Social Security shortfall). So it's not clear how many of these ideas might have a real shot at becoming a reality.

But with taxpayers now set to pick up a multi-billion dollar tab for the latest housing bailout-and with questions about the government's response to the bust likely to come up during the final weeks of the presidential campaign--it's worth injecting some of Shiller's far-reaching and imaginative solutions into this debate.

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