He was one of the few people to accurately predict the bursting of not one but two financial "bubbles." The dot-com collapse in technology stocks at the beginning of the decade, and the U.S. housing-market collapse that triggered the current economic crisis. So when Yale professor Robert Shiller comes up with suggestions for a way forward, they're likely worth hearing. One is about derivatives, the complex financial instruments -- many based on mortgages -- that were blamed for fueling the crisis. Shiller's prescription: not fewer derivatives, but more of them. RFE/RL's Kathleen Moore asked him why.
RFE/RL: To start, could you please help us understand derivatives' role in the current crisis? Was it the expansion, the burst of financial innovation that led to disaster? Was it that derivatives were so complex few people were able to properly evaluate their risks? Or was it the fault of certain types of derivatives, the mortgage-backed securities?
Robert Shiller: The financial crisis reflects some growing pains. Whenever you have innovation, mistakes will be made. For example, the mortgage-backed securities: Mistakes were made in overrating them, they didn't manage the agency problems well, of the issuers making loans that they weren't really confident of themselves.
These were errors made in the structure and management of these mortgage securities. But I think errors are inevitable and we shouldn't overreact to them. It's analogous to airplanes. When they invented airplanes, there were a lot of crashes at first. But they eventually ironed out these problems and now we all fly with confidence. We're not going to abolish airplanes, and we're not going to abolish these financial innovations either.
RFE/RL: So there was an explosion in mortgage-backed securities that helped fuel the housing bubble. But you would say at the same time there wasn't enough innovation in a way, there was no way through derivatives to help push down prices and "prick" the bubble before it got too inflated?
Shiller: That's right. The innovation we saw that contributed to the housing bubble was substantially in the subprime mortgages in the United States. But different kinds of innovation didn't happen, at least not soon enough or on a big enough scale.
I'd like to see people able to hedge housing risk and manage it and that there should be some kind of future or forward or securities market that gives "price discovery" (the way prices are determined through the market) for the outlook for real-estate prices and we don't have that, or hardly have that at all. So people were left in unstable positions, and we're seeing what happens now with people failing to manage their real-estate risk, many of them are in trouble.
RFE/RL: How would this work? Would this give homeowners the ability to "short" (bet against the value of) their own property, as I read it somewhere described -- or would they be betting on moves in the market as a whole to insure against the risk of falling house prices?
Shiller: You call it shorting one's own property; I'd call it diversification. That is, the only people who should take measures that move opposite to the market are people who are overexposed: They own too much housing. Unfortunately, a lot of people have been overexposed because they buy a house and that's all they have money for, and so their whole life savings are in a house and that's not smart.
We need institutions that will help people correct that. There are a number of ways this can be done. One is to have home-equity insurance, which is an insurance policy that protects them against home price declines. Another way is to have a mortgage, like I call in my book, "The Subprime Solution," a "continuous workout mortgage." It would be a mortgage whose interest payments would go down if the housing market collapses; in other words, it offers a workout to the mortgage which is already preplanned and built into the mortgage.
Future Of Futures
RFE/RL: About that market. Say you're a homeowner, you're nervous that prices are going to fall or fall further, you could take out a futures contract betting on that fall and that way, and if prices do fall you at least offset that loss in home value. Is that right?
Shiller: That's right. We work with the Chicago Mercantile Exchange to create futures markets, and they've been around for three years now. However, I think very few people are doing that -- very few people are hedging their home-price risk. I think a futures market is kind of a difficult thing for most people.
So we would like to see simpler institutions that would allow people to manage their risk. One is home-equity insurance; it could be part of a homeowners' insurance policy that ensures you against a major drop in the value of your home as measured by some index. Or it could be that people buy some security that moves opposite to home prices.
RFE/RL: As you mentioned, the Chicago Exchange already offers contracts based on house values. But it's limited. Why hasn't it caught on in a bigger way?
Shiller: First of all, less than 10 percent of the U.S. population even has a futures trading account, so they're not qualified or authorized to trade in futures. Futures are also difficult; even so, you could expect more volume because some people do trade in them.
I think it's always hard to get a new market started and people don't want to trade in a market unless it's liquid. It's a little bit like having a party. Creating a market is like throwing a party: If a lot of people come, everyone wants to come; but if no one comes, then nobody else wants to come. That's the problem we're in.
It's a problem of getting a market started. I'm hopeful we'll eventually see significant volume on this market, but it's not happening right now.
More Innovation
RFE/RL: It might be surprising to people who are hearing of the problems associated with some of the derivatives, the ones based on mortgages, that you say: Rather than restrict them, we need new kinds of derivatives, more financial innovation.
Shiller: I think that the real blame for this crisis is not that we're having financial innovation -- this kind of crisis is not new, we saw major depressions in the 19th century, close to 150 years ago; it's not particularly tied to this epic burst of financial innovation.
This crisis resembles, in many ways, the depression of the 1930s. [It's] not as bad, but it has many resemblances. So I think it's a mistake to blame it on financial innovation.
RFE/RL: Would these derivatives, securities based on home values, work only in the U.S. or could they work elsewhere, in the U.K., Europe, or Russia?
Shiller: Absolutely. The basic principles of risk management apply everywhere, and presumably [will apply] on other planets some day! There's logic to risk management. There's something called pooling of risks. If you pool a lot of risks, then the aggregate risk goes down. It's the same principle as insurance.
That's why one of the products I talk about, home-equity insurance, really is an insurance policy. Most people see the value of insurance. Unfortunately, insurance, like many other products, is also a complicated financial product; and we're seeing the troubles in the financial system [having an] impact on the insurance industry as well. It's a complicated world, and designing financial contracts, even insurance which is so widely accepted as a wise thing to buy -- even that is vulnerable and has to be designed carefully. We shouldn't take anything for granted; we should try to move ahead to more secure financial institutions and that's really the imperative that comes out of this crisis.
RFE/RL: The U.S. housing market still is falling -- from a peak in mid-2006, prices have gone down nearly 27 percent, according to your Case-Shiller home price index. Where are we now? How much further is there to fall?
Shiller: I don't forecast our indexes, but I can say that they have been falling quite dramatically. In many cities, they are practically down to their baseline level where they were before this whole boom started. The main question is whether they might overshoot and go even lower than the basic trend might suggest.
I don't know what might happen, but we have to recognize that home prices do show a lot of momentum; and once they go in one direction, they tend to go in that direction for a while. Recent movements have been sharply down. The real question for a homeowner is, What will the market be in five or 10 years? And those are still unknown.
We are in uncharted territory emerging from a housing bubble; and where we'll be in five years, [it] is risky to try to predict that. That's why we want to have risk-management institutions in place to manage that risk.
RFE/RL: How hopeful are you that a new market for real estate derivatives or contracts based on home values will really catch on and become fully established?
Shiller: It's hard to know. So far it's been difficult. There have been some remarkable successes in the U.K. with commercial real estate. We are launching on the New York Stock Exchange some single-family home securities (securities tied to house prices) we hope will be available to a broad spectrum of investors. We keep trying.
Ultimately I think it will take, because it's an important risk and people are focused on it much more than before. So I'm hopeful that we'll see some real progress.
RFE/RL: To start, could you please help us understand derivatives' role in the current crisis? Was it the expansion, the burst of financial innovation that led to disaster? Was it that derivatives were so complex few people were able to properly evaluate their risks? Or was it the fault of certain types of derivatives, the mortgage-backed securities?
Robert Shiller: The financial crisis reflects some growing pains. Whenever you have innovation, mistakes will be made. For example, the mortgage-backed securities: Mistakes were made in overrating them, they didn't manage the agency problems well, of the issuers making loans that they weren't really confident of themselves.
These were errors made in the structure and management of these mortgage securities. But I think errors are inevitable and we shouldn't overreact to them. It's analogous to airplanes. When they invented airplanes, there were a lot of crashes at first. But they eventually ironed out these problems and now we all fly with confidence. We're not going to abolish airplanes, and we're not going to abolish these financial innovations either.
RFE/RL: So there was an explosion in mortgage-backed securities that helped fuel the housing bubble. But you would say at the same time there wasn't enough innovation in a way, there was no way through derivatives to help push down prices and "prick" the bubble before it got too inflated?
Shiller: That's right. The innovation we saw that contributed to the housing bubble was substantially in the subprime mortgages in the United States. But different kinds of innovation didn't happen, at least not soon enough or on a big enough scale.
I'd like to see people able to hedge housing risk and manage it and that there should be some kind of future or forward or securities market that gives "price discovery" (the way prices are determined through the market) for the outlook for real-estate prices and we don't have that, or hardly have that at all. So people were left in unstable positions, and we're seeing what happens now with people failing to manage their real-estate risk, many of them are in trouble.
RFE/RL: How would this work? Would this give homeowners the ability to "short" (bet against the value of) their own property, as I read it somewhere described -- or would they be betting on moves in the market as a whole to insure against the risk of falling house prices?
Shiller: You call it shorting one's own property; I'd call it diversification. That is, the only people who should take measures that move opposite to the market are people who are overexposed: They own too much housing. Unfortunately, a lot of people have been overexposed because they buy a house and that's all they have money for, and so their whole life savings are in a house and that's not smart.
We need institutions that will help people correct that. There are a number of ways this can be done. One is to have home-equity insurance, which is an insurance policy that protects them against home price declines. Another way is to have a mortgage, like I call in my book, "The Subprime Solution," a "continuous workout mortgage." It would be a mortgage whose interest payments would go down if the housing market collapses; in other words, it offers a workout to the mortgage which is already preplanned and built into the mortgage.
Future Of Futures
RFE/RL: About that market. Say you're a homeowner, you're nervous that prices are going to fall or fall further, you could take out a futures contract betting on that fall and that way, and if prices do fall you at least offset that loss in home value. Is that right?
Shiller: That's right. We work with the Chicago Mercantile Exchange to create futures markets, and they've been around for three years now. However, I think very few people are doing that -- very few people are hedging their home-price risk. I think a futures market is kind of a difficult thing for most people.
So we would like to see simpler institutions that would allow people to manage their risk. One is home-equity insurance; it could be part of a homeowners' insurance policy that ensures you against a major drop in the value of your home as measured by some index. Or it could be that people buy some security that moves opposite to home prices.
RFE/RL: As you mentioned, the Chicago Exchange already offers contracts based on house values. But it's limited. Why hasn't it caught on in a bigger way?
Shiller: First of all, less than 10 percent of the U.S. population even has a futures trading account, so they're not qualified or authorized to trade in futures. Futures are also difficult; even so, you could expect more volume because some people do trade in them.
I think it's always hard to get a new market started and people don't want to trade in a market unless it's liquid. It's a little bit like having a party. Creating a market is like throwing a party: If a lot of people come, everyone wants to come; but if no one comes, then nobody else wants to come. That's the problem we're in.
It's a problem of getting a market started. I'm hopeful we'll eventually see significant volume on this market, but it's not happening right now.
More Innovation
RFE/RL: It might be surprising to people who are hearing of the problems associated with some of the derivatives, the ones based on mortgages, that you say: Rather than restrict them, we need new kinds of derivatives, more financial innovation.
Shiller: I think that the real blame for this crisis is not that we're having financial innovation -- this kind of crisis is not new, we saw major depressions in the 19th century, close to 150 years ago; it's not particularly tied to this epic burst of financial innovation.
This crisis resembles, in many ways, the depression of the 1930s. [It's] not as bad, but it has many resemblances. So I think it's a mistake to blame it on financial innovation.
RFE/RL: Would these derivatives, securities based on home values, work only in the U.S. or could they work elsewhere, in the U.K., Europe, or Russia?
Shiller: Absolutely. The basic principles of risk management apply everywhere, and presumably [will apply] on other planets some day! There's logic to risk management. There's something called pooling of risks. If you pool a lot of risks, then the aggregate risk goes down. It's the same principle as insurance.
That's why one of the products I talk about, home-equity insurance, really is an insurance policy. Most people see the value of insurance. Unfortunately, insurance, like many other products, is also a complicated financial product; and we're seeing the troubles in the financial system [having an] impact on the insurance industry as well. It's a complicated world, and designing financial contracts, even insurance which is so widely accepted as a wise thing to buy -- even that is vulnerable and has to be designed carefully. We shouldn't take anything for granted; we should try to move ahead to more secure financial institutions and that's really the imperative that comes out of this crisis.
RFE/RL: The U.S. housing market still is falling -- from a peak in mid-2006, prices have gone down nearly 27 percent, according to your Case-Shiller home price index. Where are we now? How much further is there to fall?
Shiller: I don't forecast our indexes, but I can say that they have been falling quite dramatically. In many cities, they are practically down to their baseline level where they were before this whole boom started. The main question is whether they might overshoot and go even lower than the basic trend might suggest.
I don't know what might happen, but we have to recognize that home prices do show a lot of momentum; and once they go in one direction, they tend to go in that direction for a while. Recent movements have been sharply down. The real question for a homeowner is, What will the market be in five or 10 years? And those are still unknown.
We are in uncharted territory emerging from a housing bubble; and where we'll be in five years, [it] is risky to try to predict that. That's why we want to have risk-management institutions in place to manage that risk.
RFE/RL: How hopeful are you that a new market for real estate derivatives or contracts based on home values will really catch on and become fully established?
Shiller: It's hard to know. So far it's been difficult. There have been some remarkable successes in the U.K. with commercial real estate. We are launching on the New York Stock Exchange some single-family home securities (securities tied to house prices) we hope will be available to a broad spectrum of investors. We keep trying.
Ultimately I think it will take, because it's an important risk and people are focused on it much more than before. So I'm hopeful that we'll see some real progress.
