Can Financial Innovation Save us From Financial Innovation?
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.