Can Financial Innovation Save us From Financial Innovation?
posted by Nate Oman
Robert Shiller of “Irrational Exuberance” fame is coming in for some well-deserved kudos for calling the housing bubble a bubble back when it was still a bubble. If you haven’t heard it yet, I strongly suggest listening to the most recent episode of the EconTalk podcast where Russ Roberts interviews Shiller about the mortgage crisis. I was surprised to hear Schiller talk about solutions to the subprime mortgage problem, particularly in light of how I’ve seen Shiller cited as an authority by the financial-innovation-is-a-scam-for-the-benefit-of-Wall-Street variety pundit.
At least on the EconTalk podcast, Shiller was frankly willing to admit the virtues of subprime lending and refused to excoriate asset securitization. Indeed, he was celebratory about the benefits of bundling and selling mortgages. Rather, he advocated what he called a continuous work-out mortgage in which the payments are tied to the index of housing prices. (The creation of such a reliable index is actually a fairly recent phenomena and one for which Shiller deserves credit.) The effect of such a mortgage loan would be to shift much of the risk of shifting home prices from borrowers to lenders. It seems to me that the predictable result of such a move would be to increase interest rates and price a lot of folks out of the home market. Perhaps this is not such a bad idea if we think that housing bubbles represent some sort of recurrent economic risk requiring a systemic response.
This, however, is not what Shiller seems to want. Rather, he suggested that salvation lies in a thick housing futures market, something that does not currently exist. The creation of such a market would allow lenders to hedge against the risk that Shiller’s continuous work-out mortgage would assign to them. In the happy version of the story, the buyers get a house and the lenders get paid and all of the risk of asset prices is diversified away into global capital markets. Of course, Shiller’s proposed future market in housing is not a straight-out credit derivative like the credit-default swaps that brought down AIG (or at anyrate that brought in the feds), but they are awfully close. Rather than betting against borrower default one would be betting against a shift in asset prices that would effect the value of the payment stream from a borrower.
I’ve no idea if Shiller is right or not, but I did find it striking that in the midst of the excoriation of derivatives, the prophet of many a market basher sees financial innovation as the solution rather than the problem.
September 21, 2008 at 8:25 pm
Posted in: Contract Law & Beyond
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Responses (3)
Jon Garfunkel - September 23, 2008 at 12:18 am
Nate– I see that there is no ‘c’ in Shiller. I have a pet google I’m trying to train to spell. Google can spot the spelling error, but it indexes “continuous-workout mortgages” without the hyphen breaking up work-out (in case folks are looking for more info– a search on that phrase leads to a Times article from this weekend.; another link is to Frank’s post from last week).
I haven’t yet found any article critically analyzing the CWM. Surely Shiller has an answer for this– suppose that CWM had existed in 2000 as a substitute for the low-money-down loans. Incomes stayed flat for 2000-05, but housing went up 50%. How would that have worked favorable for borrowers? (I suppose it would have chilled the market somwhat… but so would responsible lending, no?)
FTR, Krugman has cited PIMCO’s Paul McCulley as one of the earliest to predict the housing bubble in 2001, figuring that the Fed would want to substitute the housing bubble for the stock bubble.
A.J. Sutter - September 23, 2008 at 11:34 am
On p. 151 of Shiller’s new book, “The Subprime Solution” (Princeton UP, August 2008), he quotes with approval Stewart Mayhew to this effect: “‘The empirical evidence suggests that the introduction of derivatives does not destabilize the underlying market — either there is no effect or there is a decline in volatility — and that the introduction of derivatives tends to improve the liquidity and informativeness of markets.’” The book doesn’t mention anything about credit default swaps.
According to Shiller, the sole cause of the subprime crisis was “the social contagion of boom thinking” (@41); lenders, the investors in the loans they sold off, and rating agencies also all believed there would be no bursting of the bubble, and Greenspan & other regulators didn’t “believe that there could ever be a housing crisis of the proprotions we are seeing today” (@50-51). Loose monetary policy was a “product” of the bubble, and not an exogenous cause (@ 48-49). The source (or at least, “disporportionate” source) of this contagion was subprime borrowers who “were consumed by the mere thought of somehow gaining a foothold in the housing market” (@50). I suppose they are also to blame for CDSs.
Low-cost, government-subsidized financial advice to low-income people is part of Shiller’s cure. Had people received “one-on-one, Suze Orman-style” advice from “trusted advisers[,] [t]he crisis might never have occurred” (@126). Surely “most” financial advisers “must have at least had some sense that the housing boom might not continue” (@127) — notwithstanding that even ratings agencies and Fed officials either didn’t believe this or didn’t recognize its implications.
His book also includes a big defense of “bailouts” — but for “preventing distress among people of modest means,” i.e. borrowers (@111). Yet in a 09/20 interview with Forbes, he said of the current bailouts, “[I]t sounds like they’re kind of doing what I proposed in my chapter [in The Subprime Solution] on bailouts.” See http://www.forbes.com/2008/09/20/shiller-buble-economy-biz-wall-cx_jz_0920shillerqa . Kind of, but not exactly — they’re bailing out different folks.
Yes, the guy predicted the bursting of two bubbles, but sorry if I’m not buying his solutions this time.
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