Taking risk out of finance

Published December 6, 2008

THIS recession is terrifying because it`s assuming the character of an economic black hole. Property prices and economic activity slide, so that soon the problem becomes not the banks refusing to lend but the borrowers` worries. That creates a further downward spiral. The banks become even more cautious. Unless this cycle is broken, the economy is sucked away.
Standard economics and standard policy responses are useless because gloom creates its own rationality. A herd effect created the bubble. Now a herd effect is creating the opposite. A solution requires finding economics and policies that break the bearish psychology. Step forward Robert Shiller, a softly spoken and mildly eccentric Yale professor, who specialises in studying the psychology of booms and busts. Financial markets, left to themselves he says, reliably mismanage risk. They get carried away in booms. And in busts there`s a collective hysteria in which all we see is risk, uncertainty and loss. Letting `financial markets work`, as happened in Britain and America from the 1980s to today, has been disastrous. Instead, we need to devise interventions that help the markets manage risk better, which they will not do of their own accord. This, he thinks, is practical Keynesianism. I agree.

He was in London last week, promoting his new book The Subprime Solution and between events he met the UK finance minister, the Governor of the Bank of England, the Secretary of State for Business and Regulatory Reform and even — for a few minutes — the prime minister. One reason for taking him seriously is that he`s the only prominent economist who can claim to have predicted today`s bust.

But his solutions are so non-standard and outside conventional thinking, and his manner so self-deprecating and academic, that it takes a while to get the radicalism of his message. Minds seemed to wander last week — and it took me a good few meetings before I understood.

If we are going to get banks to lend and borrowers to borrow, argues Shiller, we have got to reduce decisively the risks they confront. He starts with the mortgage market and the collapse in house prices because they are at the centre of this crisis. Mortgages, he thinks, always unfairly contained too much risk for ordinary borrowers. Now they are a disaster. Who in their right mind would pledge hard-earned savings as a deposit for a house in a falling property market and, on top, take responsibility for repaying a big mortgage over 25 years when they may lose their job? It is far too much risk and reflects an unfair balance of power between borrower and lender. A left-of-centre government should insist that mortgages are redesigned so they contain far less risk for ordinary borrowers.

His radical `Shiller` mortgage has two components. The first is that repayments automatically adjust to the economic circumstances of the borrower over the life of the mortgage. Repayments rise in line with your growing income, but fall or stop if you lose your job.

At a stroke there are no more repossessions or fear of repossessions. In any case, banks hate repossessions because of the terrible PR and the irrationality of crystallising a loss on their mortgage books. For the borrower, a mortgage becomes less daunting.

The second component is that the borrower should be able to insure their down payment — and their housing equity — against loss. Shiller does not stop there. He thinks that the government should launch `livelihood insurance`, so that people can insure themselves against the risk of their wages being reduced. And he advocates a massive boost to the UK Citizens Advice Bureau network so there is an infrastructure of trusted advisers who can help citizens understand the case for better mortgages and insurance and take up the new financial packages.

These measures will help make the world safer for borrowers. The next step is to do the same for lenders.

I persuaded Robert Shiller to read the Crosby report on the British mortgage market released last week by the Treasury, along with the pre-budget report. In my view, it is one of the most alarming reports published by the Treasury in my working life.

James Crosby, deputy chair of the Financial Services Authority and former chief executive of HBOS, believes that without intervention in 2009, new net mortgage lending in Britain is very likely to fall below zero, spelling calamity for house prices and the wider economy.

Like Shiller, he thinks that essentially there is too much risk for the market. Every available penny of new savings has already been earmarked, leaving none left over for new mortgages. Lenders are shellshocked. Even if the banks were nationalised, they would face the same problem.

Crosby has a Shiller-style solution. The government must reduce the risks that are terrifying the mortgage markets. It should offer a GBP100bn guarantee so creating a GBP100bn flow of new credit to home buyers.

The UK finance minister, Alistair Darling, has promised to do something, but perhaps not this. Shiller, unsurprisingly, wholeheartedly backs Crosby. The two ideas together — Shiller mortgages and Crosby insurance — would break the gloom, take the risk out of the markets and bottom out the recession.

These principles could be extended to other areas of lending. The trouble is that it is not just ordinary borrowers who don`t understand finance. Neither do many bankers, committed to keeping their power and offering the same old mortgages where the borrower assumes all the risk. Nor do officials, who understand the pros and cons of measures like last week`s cut in Vat, but are outside their comfort zone when it comes to banks.

It can`t go on; the risk of a deep recession is too great. We need the state to take the risks out of finance.

— The Guardian, London

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