Shiller’s underwhelming innovations

By Felix Salmon
September 30, 2009
James Kwak has a great response to Robert Shiller's FT op-ed about financial innovation. But his line at the end about how "for the sake of argument, I am willing to concede that these are useful innovations that would make people better off" has been misconstrued, and it's worth pointing out that in fact they're not useful innovations that would make people better off.

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James Kwak has a great response to Robert Shiller’s FT op-ed about financial innovation. But his line at the end about how “for the sake of argument, I am willing to concede that these are useful innovations that would make people better off” has been misconstrued, and it’s worth pointing out that in fact they’re not useful innovations that would make people better off.

Why not? Mainly because, at heart, they’re all variations on the theme of doing-clever-things-with-as-yet-uninvented-derivatives. But that’s a theme which really shouldn’t have survived the financial crisis.

In 2003, Alan Greenspan famously said that ““what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” But, as it turned out, they weren’t. Lots of people wanted to transfer risk, and precious few were genuinely willing and able to take it on: even hedge funds generally prided themselves on being lower-risk than the stock market as a whole.

The result was a system where derivatives were used to hide risks, and shunt them off, unseen, into the tails. A system where hidden risks turned out to be much more dangerous than if they’d all been out in the open all along.

In each of Shiller’s examples, you start with a risk that an individual wants to lay off: the risk that home prices will fall, or that the market will plunge just before you retire, or that inflation or healthcare costs will kick in after you retire. And in each case, the individual tries to lay off that risk elsewhere.

Shiller simply takes it on faith, however, that a nice liquid market can and should spring up to provide two-way prices in such risks, solving lots of problems at a stroke; he doesn’t stop to consider that maybe the reason such markets haven’t sprung up is precisely that there’s no real demand from anybody wanting to take on those risks. In reality, Shiller should know that better than anyone: his much-vaunted house-price derivatives have gone nowhere, partly because no one ever really had any need or desire to go long.

Shiller’s first proposed innovation is an attempt to deal with the regrettable move, in recent years, towards a “popular reliance on housing as an investment”. Only except for suggesting the obvious — moving people away from the idea of housing as an investment, and towards good old-fashioned renting — he comes up with a complex mortgage with all manner of embedded options. As with any derivative, those options will be a zero-sum game, and you can be sure the homeowner is going to end up on the wrong side of it. But Shiller still seems to think it’s a good idea for homeowners to buy them, instead of simply getting a plain-vanilla, easily-comprehensible mortgage, with payments which are set over the life of the loan and which are entirely predictable.

Shiller’s second innovation is target-date mutual funds: I’m almost surprised that he didn’t suggest some kind of principal-protection scheme, involving derivatives, instead. (Maybe because that would have sounded too much like portfolio insurance, which caused the 1987 crash.) But target-date funds are widely misunderstood, and in 2008 some 2010 funds contrived to underperform the S&P 500. They’re a mess, and they’re expensive, and it’s not obvious that they do any good. So color me unconvinced on this front.

Finally, Shiller dreams of annuities which would pay out a set amount of money per month for life, after adjusting for inflation, and which on top would include all healthcare costs. Nice dream, Bob. But there’s a good reason such things don’t exist: no insurer wants to take on a large amount of those kind of risks, and nor would any self-respecting insurance regulator allow them to do so. There isn’t a long-dated derivatives market in future health-insurance costs, but if there were, very few people would have any reason to sell protection against those costs rising, at any price. Sure, a few hedge funds might dabble in the market. But they could never satisfy demand. And in any case, as with the mortgages, the buyer of the annuity would generally lose out, just because of the zero-sum nature of derivatives. Since the cost of the embedded options would be hidden in the price of the annuity, the insurer would have a license to charge through the nose for it, and the buyer of the annuity would never know.

Simplicity and transparency are good things, and Shiller’s innovations go the other way instead. That’s nothing to get excited about.


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I guess Shiller isn’t up on the OTS and how they “cut the red tape” s/ht_regulations_cut_081125.jpg

Posted by Sechel | Report as abusive

Not only do people not want to take those risks, the buyer of the ‘insurance’ does not want to compensate the party taking the risk adequately. If, say, a credit-default swap was priced magically, it would have been so expensive that the owner of the underlying security would not have bought the swap. Those swaps were underpriced which left parties like AIG without enough cash to cover the claims.

In 2005 why would someone have bought insurance against falling home values? At that time people believed home values only rose, which is why the loss provisions for default were near zero. People see the risk after it happens, and when they don’t think it’s a risk, they won’t buy insurance for it.

Posted by winstongator | Report as abusive

I started railing against innovation on Baseline when they had Elizabeth Warren guest post. She was comparing financial innovation to innovations in medicine. Barf.

Comment above:

“In 2005 why would someone have bought insurance against falling home values? At that time people believed home values only rose”

Speak for yourself. Some of us had seen real-estate cycles before and some of us didn’t forget it. Who are these standardized “people”? They don’t exist. Which is another part of the problem. Economists and media pontificators seem not to want to complicate things by having to know much about actual people. For instance, “fixed rate mortgages” are good for people because they can’t handle interest rate risk. Hello? Hello? Some of us grew up where the ONLY mortgages were floating rate. Some of us grow up with the idea that we can (and do) use multiple currencies. Some of us do have IO mortgages that WORK for us. Don’t talk about “people”, one size does not fit all in finance just as in clothing. Either that or I am not a member of the set “people”. It’s possible.

Posted by SP | Report as abusive


You’ve made 2 basic mistakes.

1. Confusing the complicated with widespread.

Fixed income and equities are asset classes where it is possible to have almost any type of derivative. In real estate, few derivatives are available. Real estate could benefit from more hedging products.

2. Confusing the current OTC market and its lack of transparency for possible transparency. Note that AIG was only 100B worth of money – not enough to have caused the economic crisis. Just because we were ripped off by Goldman in bailing out AIG doesn’t mean that these derivatives were the cause of the crisis.

Posted by Mike S | Report as abusive

You need to cut through some of the institutional nonsense to see that Shiller’s point about housing futures is a simple diversification story. Smith has a house in NY, Jones in CA. Both can reduce the idiosyncratic risk exposure by selling futures on their houses (or the local index) and buying into a fund that takes the long side. No need to “find” someone to take the long side, it’s ultimately just the homeowners themselves (albeit through an intermediary).

For this to make any sense you need to deal with moral hazard type issues (can’t let an owner sell futures on his own property without giving them perverse incentives) and basis risk issues (if you can only sell futures on, say, a regional index, it’s a very imperfect hedge).

Posted by thruth | Report as abusive

“In 2003, Alan Greenspan famously said that ““what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.””

I’ve said it before and I’ll say it again: the person most willing to take on risk is the one unaware he is doing so. He charges no risk premium. This is a competitive advantage which the market seeks out by Hayekian optimization.

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

Greenspan had it exactly backwards: those who shouldn’t be taking risk are precisely the ones who end up as a dumping ground for it.

P.S. Some people say things like “AIG must have known the risks they were taking”. AIG *managers* may well have known, but they weren’t the ones actually exposed to the risk. AIG *shareholders* didn’t know what risks they were exposed to or they would have sold in a New York minute (if they could find a greater fool). The modern financial industry is a mass of fraud, conflicts of interest, and breach of fiduciary duties from one end of the industry to the other.

Posted by chris | Report as abusive

“Finally, Shiller dreams of annuities which would pay out a set amount of money per month for life, after adjusting for inflation, and which on top would include all healthcare costs.”

I agree that the health care rider is an unlikely product. But inflation-adjusted annuities can and do exist, and are inherently useful to most people. It lets the average Joe transform his defined contribution plan into a defined benefit plan.

Posted by Richard | Report as abusive

It’s not just a matter of pricing such products appropriately, it’s a matter of making sure that the reserves actually get put away, and get put in things that don’t have the same damn risks as the ones you’re trying to hedge.

And of course what we’ve learned in the recent crisis (we have learned this, haven’t we?) is that zero-sum is the best outcome for a derivative. There are plenty of worse ones as well.

btw, plain-vanilla mortgages are hellishly complex: prepayment risk. This is very difficult to model, and very difficult to lay off. Apart perhaps from discount instruments and bullet bonds, there are no simple investment products. Although straight bonds are a lot simpler than mortgages.

Posted by Joe S. | Report as abusive

Per El Erian’s recent article all this bs needs to stop and soon before it’s to late. Its the level stupid, not the 2nd derivative.

Real estate for the MAJORITY…not speculators but the MAJORITY OF AMERICANS is their PRIMARY investment and its where they live ie: security. Residential real estate should always be viewed as a long term investment providing perhaps a return equal to inflation. Throwing off risk to another party ultimately invites speculation and creates price volatility in the underlying asset class and all the disasters that follow.

Was it not enough to see the 30 year mortgage rate stick to high levels while a perverse amount of capital ran to short term mortgage options that were thrown into cmo’s to hide the underlying risk, driving down the short rates and keeping the long rates artificially high??? Apparently not.

Watching this crisis unfold and how the worlds politicians, business men and woment and market particiapants deal with its challenges is like watching the insatiable apetite of the fat man in Monty Python’s movie ‘The Meaning of Life” which captures perfectly the current state of capitalism…we can only hope the outcome is not the same.

Posted by csodak | Report as abusive

Joe S…that is what duration projections are for.

Posted by csodak | Report as abusive

Complete markets would solve some information problems, and perhaps expose and burst some inconsistent assumptions; markets will never be complete, and the second best may not be the first best. I have some sympathy for Shiller’s views, and I expect if everyone in the market were as smart as Shiller they would work better than in the world we live in, but there’s something about this that kind of smacks of “Perfectability of Man”. The government is administered by humans, and empowering government technocrats to run the world tends not to work as well as might be hoped; letting market technocrats run the world is subject to the same failures. A system that assumes everyone is capable of understanding even fairly simple instruments like MBS tranches (or even just credit default swaps!) is built on a false assumption.

I think in fact that most everyone can understand these instruments provided they are given the equivalent education just as most everyone is capable of shooting a gun but I wouldn’t give someone who is either deranged or incompetent or a thief a gun. Market technocrats have proven to be deranged (Madoff, Sanford etc..), incompetent or thieves (any wall street exec/trader etc…)

Posted by csodak | Report as abusive

Just remember that congressman John Dingell wanted to shut down the commodity exchanges in the 80′s because he didn’t see any use for pork bellies. The innovation that followed, like portfolio insurance, bond and eurodollar futures might not exist today if everyone took your attitude toward financial innovation.

Spreads on the SPY are a penny wide due to these innovations and ECN’s that link to them.

Posted by jdor | Report as abusive

I’m not arguing that financial innovation is bad per se. I am claiming that instruments created through financial innovation can be healthy or unhealthy for the economy. It seems to me that it would make sense to create an independant body who determines the social benefit from the marketing of these instruments as well as the the ‘institutional character’ of the organizations marketing these products (the gun scenario applies here. this goes into corporate rights…a whole different animal).

Posted by csodak | Report as abusive

I am thinking there IS one way that selling a lifetime monthly annuity including health insurance could be very profitable for the financial institutions: what if they sold a bunch of them on the assumption that eventually the government will have to take over these costs, at which time the “health care” portion of your annuity became a freebie to the financial companies?

THEY have the power to get a public health care passed if it’s in their interests.

Posted by Tom Doak | Report as abusive

Hands down, Apple’s app store wins by a mile. It’s a huge selection of all sorts of apps vs a rather sad selection of a handful for Zune. Microsoft has plans, especially in the realm of games, but I’m not sure I’d want to bet on the future if this aspect is important to you. The iPod is a much better choice in that case.