Shiller: Major Reforms Necessary to Prevent Another Financial Crisis

Wednesday, 15 Jan 2014 12:14 PM

By Dan Weil

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Significant reforms must be enacted, especially in the housing market, to avoid another financial crisis, says Nobel laureate economist Robert Shiller of Yale University. But he's not very enthusiastic that will happen.

Preventing another financial crisis is more difficult than most people realize, Shiller writes in an article for Project Syndicate.

"Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance, it also requires that politicians and their constituents have a shared understanding of these principles," he explains.

Editor’s Note:
5 Shocking Reasons the Dow Will Hit 60,000

"Today, unfortunately, such an understanding is missing. The solutions are too technical for most news reporting aimed at the general public."

People get excited about punishment of financial executives, Shiller notes. But, "they are far less enthusiastic about asking these people to expand or improve financial-risk management."

With special interest groups gravitating toward existing risk-management policies, "we are basically stuck with them, subject to minor tweaking," he writes.

The public wants action to prevent another crisis, Shiller argues. "But the political reality is that government officials lack sufficient knowledge and incentive to impose reforms that are effective but highly technical."

For example, the Dodd-Frank financial reform law includes a risk retention rule on mortgage securities, he notes. Mortgage securitizers generally must hold on to at least 5 percent of the securities that they create, so they still have a stake in the success of the mortgages.

But Paul Willen of the Boston Federal Reserve Bank argued in a recent paper that this rule is lacking, Shiller claims.

"Investors already know that people have a stronger incentive to manage risks better if they retain some interest in the risk," he states. "But investors also know that other factors may offset the advantages of risk retention in specific cases. In trying to balance such considerations, the government is in over its head."

The most important housing market reform would be one that curbs homeowners’ overleverage and lack of diversification, Shiller insists.

He likes the idea of "the government encouraging privately issued mortgages with pre-planned workouts, thereby insuring them against the calamity of ending up underwater after home prices fall."

That's true reform, Shiller says. "It would address the core problem that underlay the financial crisis. But there is no impetus for such a reform from existing interest groups or the news media."

A recent Wall Street Journal editorial recommends reform of the troubled Federal Housing Administration (FHA).

"In a better world, Congress would slowly work off the FHA's portfolio and get out of the housing subsidy business," the editorial says.

"Short of that, Rep. Jeb Hensarling, R-Texas, has a proposal to spin off FHA from the Department of Housing and Urban Development, make it a stand-alone agency, focus its mission on low-income and first-time home buyers, and subject it to the same accounting rules that private lenders have to meet. How about starting there?"

Editor’s Note: 5 Shocking Reasons the Dow Will Hit 60,000

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