The Man Who Called the Housing Crash Offers Advice

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"[Buying your own home] is the American dream," Robert Shiller told me during a recent interview.

Shiller is professor of economics and finance at Yale, and co-founder and chief economist of MacroMarkets LLC. "It goes back to Alexis de Tocqueville, who in the 1830s found that homeownership in the U.S. was higher than in Europe, and he made something of that -- that Americans aren't under anyone's thumb. There's no landlord above them. They're property owners. And he thought that this created a different spirit in America. Ever since that, I think Americans have been aware of these differences, and wanting to promote it."

The U.S. government wanted to promote that dream, too. But low interest rates, favorable home legislation and poor oversight, and a desire to make every American a homeowner led Washington and Wall Street down a destructive path. Perhaps no companies better illustrated the exuberance -- and now, the wreckage being pieced back together -- than Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) , which found themselves competing with the titans of Wall Street. (That ended badly.)

While the administration and Congress continue to work on financial reform, they are just beginning to take on the momentous task of fixing our nation's housing finance system. To gain insight on how the government should fix Fannie and Freddie, as well as its programs to cope with an ailing housing market, I spoke with Shiller. As co-creator of the S&P/Case Shiller Home Price Index, he is perhaps America's foremost authority on housing. Shiller is also the author of numerous books, most recently Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

What follows are edited excerpts from our conversation.

Jennifer Schonberger: What do you think of how the government is handling the housing downturn? Has it helped or hurt the situation?

Robert Shiller: Overall, I think the government has done well, because we had a depression scare.… But when you look at the housing market, it hasn't been a big success. Both Bush and Obama have had programs to try to stop this foreclosure problem, and yet foreclosures are still rising dramatically. President Obama had this HAMP program [Home Affordable Modification Program], which is supposed to help 3 million to 4 million homeowners, and it hasn't come anywhere close to that.

Schonberger: What about the administration's introduction of a short-sale program to stem foreclosures, or its adjustment to its mortgage-modification program to allow for principal write-down programs? Will these programs actually help borrowers, or just hurt banks?

Shiller: It's a good step. It's a question of whether the mortgage industry will respond. It's actually good that [Obama's] talking about principal reduction, because that is a problem because people are underwater with their mortgages -- even if you extend the payment, you're still going to see a lot of defaults and foreclosures. So he's onto the important problem, and that's a good thing. The question is we may see a double dip, in which case we may see home prices fall again. That would swamp out that program. Then I don't think this program is very massive -- it's not going to matter compared to the big picture.

Schonberger: So it may not be big enough?

Shiller: Yeah, that's the problem. But the problem is that it's hard to be big enough -- the government starts bailing everyone out. Now that's the problem.

Schonberger: If we do end up double dipping, or maybe activity slows, does the Fed go back and start buying mortgage-backed securities again, having actually stopped, or extend yet again the homebuyer tax credit?

Shiller: That's the interesting question. They're not going to propose doing that in advance, but they well might. But then this brings up almost the existential issue of, what is the government doing here? Are they going to be bailing people out forever? This is a theme I brought up in my 2008 book Subprime Solution, and I wish I was heard more. I said in that book that bailouts are necessary, but at the same time, there should be a serious proposal to change our institutions so that this doesn't happen again.

While we do have a financial reform bill in Congress, it doesn't really make an inspirational change -- not of the kind that I was talking about, or other people are talking about at this time. We have a lot more to do, and I wish it were happening faster because right now we're in sort of a funk with this "too big to fail" issue starting to cast a cloud over the economy, and no real plan to prevent this from happening again.

Schonberger: The government recently started to explore how to restructure Fannie Mae and Freddie Mac. How do you think we should restructure them?

Shiller: The next step has to be eventually to shrink this. They could have a reduced footprint in the world. Fannie and Freddie should [also] be more focused in what they subsidize.  …

I'm thinking about this. It may be part of my next book. One is that Fannie and Freddie should encourage better marketing instruments than a conventional mortgage. I talked about this in my book Subprime Solution. I propose what I call a continuous workout mortgage. There should be a pre-planned workout in the mortgage so that we don't reach this chaos where workouts are being applied arbitrarily with long lags, and given to people who complain at the expense of those who don't complain. So it should be priced into the mortgages and planned. And Fannie and Freddie would be agencies that could help with this transition. They decide on standards for mortgages that they'll securitize.

Another is that Fannie and Freddie might reduce their conforming loan limits, so that they're not just helping everyone buy a big house. They might be encouraged to manage their risk better so that they don't get in trouble again as they did.

The other thing that I've been trying to do that would be related, but which hasn't been a big success, is I've been trying to create better derivative markets for housing.

In 2006, after CME Group (Nasdaq: CME  ) [The Chicago Mercantile Exchange], we created a futures market for single-family homes. But it hasn't taken off. I'm wondering if somehow the government could somehow help create a market. They are interested in subsidizing or promoting more exchange-traded products and a clearinghouse for credit default swaps. So if the government is going to get involved in that, maybe they should get involved in trying to create markets for the big risks.

Schonberger: I recently spoke with Representative Paul Kanjorski, who thinks we should have lots of little Fannies and Freddies, so that if one fails, we can let it fail and not take the economy with it. What do you think of that?

Shiller: That's an interesting idea. It's been brought up in connection with the financial crisis, not just with regard to Fannie and Freddie, but also financial institutions.

Maybe we should split them up into smaller units. …That's an important theme, and I don't know the answer. The thing is it's a somewhat vague question, because even if you split financial institutions into many smaller ones, they could still fail as a group. It's been pointed that that in the Great Depression we had a massive banking crisis and that was a major factor in the Depression, but it was lots of little banks, it wasn't a big monopoly bank that failed …

Foolish recap
Shiller went on to say that the government may have a role in supporting housing, but it's not clear that subsidizing housing is the only way to improve our sense of democracy and citizenship. He says some countries like Switzerland have a very good sense of citizenship, democracy, and tolerance, but have low home ownership. "Yet we don't see the problems there we attribute to lack of homeownership -- crime and lack of ties to the community. So I think that there are other things that we might do to encourage a sense of belonging to our country."

Next week on Shiller's take on the state of the housing market.

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. The Motley Fool has a disclosure policy.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 16, 2010, at 3:32 PM, 5kidzrus wrote:

    "In the book "Good to Great", Fannie Mae was reported to have the goal of "democratizing home ownership" which was compared to Henry Ford's quote of "democratizing the automobile". The difference was that Ford did it by building a cheaper car, and Fannie Mae "tried" to do it by loaning money to people who couldn't pay it back. Maybe the solution isn't more creative financing, maybe the solution is a cheaper house.

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