by Robert J Shiller (Princeton, £9.95)
Confessions of a Subprime Lender: An Insider's Tale of Greed, Fraud, and Ignorance
by Richard Bitner (John Wiley, £10.99)
When people who work for financial institutions, and who are paid (a lot) to understand markets, became aware of emerging problems in sub-prime mortgage lending in the US, the majority felt that it might have some impact but its overall significance was limited. Sub-prime lending is the advance of money to fund home purchases to people with a track record of struggling (and generally failing) to pay off debt. It was substantial, making up about 30 per cent of all lending for house purchase in the US between 2004 and 2006. And it had grown from virtually nothing in the late 1990s to a little under one quarter of all outstanding loans by 2007. But it seemed far-fetched that its problems could ripple devastatingly through the global financial system.
That, however, is exactly what happened. Two years on, we have just seen the effective nationalisation of two of the largest financial institutions the world has ever seen—Fannie Mae and Freddie Mac—as well as the collapse of US investment bank Lehman Brothers. Banks across Europe have suffered major losses related to sub-prime loans made in the US. Mortgage lending and the cost of home loans have been affected in the UK, as fear over risks on investments backed by mortgages has caused the flow of funds to lenders to slow and its cost to rise. In the US, with home prices having fallen sharply, losses on sub-prime lending are now on such a scale that they have caused a reappraisal of risk in home loans across many countries where, like in the US, prices had been driven up but are now falling. How could this happen on such a scale; and can it be prevented from happening again?
Robert Shiller and Richard Bitner have written two very different books that, in their own ways, set about answering those questions. Shiller is a renowned economist and a professor at Yale with an impressive track record of careful analysis of asset price movements. His past work led him to conclude—ahead of most others—that bubbles had not been eradicated from today's stock and housing markets; subsequent events have largely vindicated him. In contrast, Richard Bitner worked at the coal face of the mortgage market. He was (as his book's blurb has it) "in the trenches where this dirty work was going on." Yet what sets these works apart is not that one is by an academic and the other by someone describing where he worked. The divide is over human nature. Shiller is an optimist, believing that with better information and education this sort of thing can be avoided. Bitner is more pessimistic.
What they do agree on is that a key factor behind the problem was excessive optimism about returns on property. Shiller gives a very persuasive account of the most important aspect of this, the bubble mentality: the belief that house prices could not fall, and in all likelihood would continue rising significantly. This made all the players in the game carry on playing: from those who borrowed huge amounts to get into the market, even though their incomes made servicing the debt a problem, to those who bought securities backed by sub-prime mortgages.
It's a mentality we have seen in the UK. Until a year or so ago it was considered a bizarre and implausible view that house prices in Britain might fall heavily. The handful of economists who predicted falls of 20 per cent or more were ridiculed in much of the media as flat-earthers who claimed to see the end of the world on the horizon. But now prices are falling and, in the US, defaults on sub-prime lending have exploded. So what do we do?
Shiller is very clear, and generally persuasive, that in the very near term borrowers and many lenders need to be helped. That means helped by the government. He argues that "bailouts" are what the government should do after a disaster. The strategy of not providing support—to individual home owners and to some institutions (Freddie and Fannie again)—is deeply risky and unattractive. It would mean leaving some of the poorest Americans with no homes while running the risk of cutting off the stream of new lending that is essential to keep the housing market functioning. (A risk that the problems at Freddie and Fannie made very real, and much greater than in the UK.) And the US government has done a great deal: cutting interest rates and pumping hundreds of billions of dollars into the agencies who intermediate the majority of US mortgage lending.
But what to do when the smoke clears? Here, Shiller the optimist emerges. For him, helping people buy their homes is an unambiguous good. Shiller does not entertain the thought that some people are unlikely to ever be able to make payments on a mortgage and that home ownership may not be feasible (or desirable) for them. For him, a lack of information and understanding was the root of the problems.
For Bitner—who was dealing on a daily basis with brokers looking to get mortgages for those with patchy credit histories (and often a string of bad luck stories), the crucial point is the scale of misrepresentation involved in the sub-prime world. "Eventually," he estimates, "more than 70 per cent of all brokered loan applications submitted to us at Kellner were somehow deceptive." If this is even near the truth, it is remarkable; and if fraud on that scale did exist, it is very likely that a large number of potential US home buyers colluded with mortgage brokers in presenting a wildly optimistic (that is, false) position to potential mortgage funders.
Certainly, the mess now playing out suggests there were some shrewd calculations being made by some borrowers, who figured that the downside of not being able to make mortgage payments was not so bad. US mortgage borrowing in many cases is "non-recourse": handing back the home cancels the debt. This is never the case in the UK, when all mortgage borrowing is recourse lending, meaning that "putting the keys in the post" ("jingle mail") does not clear the debt.
Much of Bitner's book is taken up with documenting the role played by appraisers and rating agencies—as well as brokers—in perpetuating misrepresentation through the mortgage system. He also offers a brief cocktail of remedies, including proposals to make brokers, rating agencies and appraisers behave better. But one senses he has limited hope. Shiller, in contrast, believes that a major part of the problem was that buyers just did not have the right information to judge what was a good deal. He speculates: "What if, when they were buying their homes in the run up to the sub-prime crisis, low-income people had had access to good-quality, comprehensive financial advice, delivered to them one-to-one… by trusted advisors? The crisis might never have occurred."
Salesman: "This is your down payment, then here's your monthly, annnnnnnnnd there's your weekly."
Homer: "And that's it, right?"
Salesman: "Yup… oh, then after your final monthly payment there's the routine CBP, or Crippling Balloon Payment."
Homer: "But that's not for a while, right?"
Salesman: "Right!"
Homer: "Sweet!"
So how will this play out? House prices on both side of the Atlantic will be lower, which is not in itself a bad thing. Some people who a few years ago might have become home owners will not be able to, meaning the US owner occupation rate will be lower than it might have been. That in itself is not a disaster: there is no clear correlation between standards of living and home ownership. But Shiller thinks a lower owner-occupation rate would be a bad outcome, and to help avoid it he ends his book with a plea to politicians to help expand financial markets. Bitner ends differently. He thinks, sympathetically, about one of his customers who ended up handing his home back to the lender—a man he now sees as one "who never should've been given a loan in the first place."
Shiller's is certainly the more forward-looking work, outlining plans to deal with the mess in the short term and a blueprint for a better world. But I was left with the rather depressing thought that Bitner's book was more firmly rooted in the imperfect world we live in.
