Neoclassical Finance and Reality
Lecture 2: Why don’t sound financial
innovations get adopted?
Robert Shiller, Yale University
Princeton Bendheim Lectures in
Finance, October 9, 2013
Sluggishness of Financial
Innovation: Example, Home
Mortgages
• The recent financial crisis started with
conventional mortgage defaults – caused
by highly-leveraged conventional
mortgages with no risk management
• Most home mortgages haven’t changed
essentially since 1930s
• People are still leveraging up and not
diversifying, raising the possibility of
another bubble and a repeat crisis
Percent of Homeowners with
Mortgages with Negative Equity 20102012 (Corelogic)
Real Consequences, Example:
Continuing Care Retirement
Communities
• CCRCs combine independent living, followed by
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nursing home care, guaranteed for remainder of life
82% of CCRCs were nonprofit in 2009
640,000 Americans lived in CCRCs 2010, twice as
many as a decade earlier
Alternative: Subsidized HUD Section 202 Supportive
Housing for the Elderly Program had only 263,000 in
2006, must have income under half area median
income, two year waiting list
CCRCs are in crisis today because of the housing
bubble and faulty financing which contributed to it.
CCRC Crises
• Average CCRC age of entry 2009 was 81,
ideally entry age should be lower
• Median age of entry for Section 202, 70 years
• Average entry fee for a US CCRC 2010
$248,000
• Entry fee not likely correlated with home
prices
• Decline in occupancy rates with housing
crisis
• Probable further crises as baby boomers
approach their 80s
Occupancy Rates at
Independent Living Facilities
2006-2012
Opportunities and Obstacles to Innovation
Tied to Tension between Neoclassical and
Behavioral Finance
• Neoclassical finance suggests a
framework for mechanism design
• And yet blind adherence to neoclassical
finance principles will lead to failure
Financial Innovation and Financial
Progress, Google NGrams 1700-2008
Financial Innovation and
Academic Revolutions, Google
NGrams 1700-2008
Examples of Financial
Innovations I will Cover
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Fixed-rate self-amortizing mortgage
Inflation-indexed bonds
Price-level adjusted mortgages (PLAMs)
Shared appreciation mortgages (SAMs)
Continuous workout mortgages
Housing futures, options, swaps
Income-based-repayment (IBR) loans
Insurance products that address real risks better
GDP linked bonds
Theoretical Principles Illustrated
by These Examples
• CAPM is about risk sharing, but retail
public discussion of advantages of risk
sharing is still very rare
• Almost never are quantities described in
real terms
• Fear of manipulation leads to continuance
of traditional financial institutions
• Sales pitches aimed at naïve people
dominate discussion
Theoretical Principles Cont.
• Government plays a major role, usually
inadvertently hindering innovation,
occasionally hastening it
• Academic finance usually not interested in
realistic fundamental innovation, with
some exceptions
• Public attitudes towards risk not wellcaptured by current models
• Investors desire liquidity, never available
at the beginning with new products
Fixed-Rate Self-Amortizing
Mortgage
• First popularized in US by government for
farms with Federal Farm Loan Act of 1916,
with the 12 Federal Farm Credit Banks to
make the loans from 5 to 40 years long
• Created by government for homeowners in
1933 with the Home Owners Loan
Corporation and in 1934 with the Federal
Housing Administration, 15 years
• It is a behavioral finance innovation, since
it ties the borrower into a saving schedule
World’s First Inflation Indexed
Bond, Issued 1780, Maturing 1784
Inflation Indexed Bonds
Inflation-Indexed Debt as
Percent of Federal Debt Held by
Public 1790-2013
Price Level Adjusted Mortgages
Appear
Around
1980
• J. Huston McCulloch (“The Ban on
Indexed Bonds, 1933-77” AER 1980
shows legal evidence that courts thought
that the Joint Congressional Resolution of
June 5, 1933 effectively linked indexation
to gold clauses and thus made financial
indexation illegal
• Price level adjusted mortgage discussions
appeared soon after.
• Still corporate indexed bonds are rare and
municipal indexed bonds nonexistent
Price Level Adjusted Mortgages
(PLAMs) NGRAMS
Unsuccessful Efforts to Create
PLAMS in 1980s, amidst
Double
Digit
Inflation
• HUD program to promote them begun 1989
• Newspapers appeared skeptical. What if inflation
goes up a lot but home prices and incomes
don’t?
• Consumer Reports advised readers against any
nominal negative amortization mortgage (even if
real amortization was positive)
• Money illusion, popular theories about incomes
lagging behind inflation, played role
Shared Appreciation Mortgages
• Origin of idea hard to find, but Jerome H.
Grossman, Oppenheimer, got first media
attention for the idea in 1980
• Necessity: a time of very high inflation,
high nominal mortgage rates.
• Grossman said this was done just to make
mortgages affordable
SAMs: No Sharing in Nominal
Depreciation Losses
• With double digit inflation, in 1980, there
was plenty of scope to share in
depreciation losses in real terms
• If SAMS had taken off and were in place in
2007, and inflation remained double digit,
this would have prevented the crisis
• But Grossman never described such
advantages
• A sales-pitch-dominated discussion
Shared Appreciation Mortgage
NGRAMS
SAMs Tribulations
• Difficulties convincing investors of these
mortgages
• 1990s attempts by Bank of Scotland and
Barclays Bank found securtization difficult,
skeptical investors
• The UK home price bubble left mortgagors
unhappy, launched class-action lawsuit
• Dodd Frank Act in US called for a HUD
study of SAMs, but HUD has not done it.
Continuous Workout Mortgages
(Subprime Solution 2008)
• Workout of mortgage conditioned on
economic events is written into initial
mortgage contract
• Workout is continuous, happens every
month as economic indicators change
• In response to changes in home prices
and to changes in income and
employment
• Index-based, reduces moral hazard
CME Home Price Futures
Market
Income-Linked Personal Loans
• Yale Tuition Postponement Option 197178
• Yale Law School Career Options
Assistance Program 1988-today
• David Bowie bonds, David Pullman 1997
• Australian Higher Education Contribution
Scheme (HECS) is dominant form of
student loans in Australia today
MYRICHUNCLE.COM
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Obama’s Income-BasedRepayment (IBR) Student
Loans
Limit Payments to 10 Percent of Income: Borrowers choosing the income-based
repayment plan will pay no more than 10 percent of their income above a basic living
allowance, reduced from 15 percent under current law. The basic living allowance
varies with family size and is set at 150 percent of the poverty line, currently equaling
about $16,500 for a single individual and $33,000 for a family of four.
– More than 1 million borrowers would be eligible to reduce their monthly
payments.
– The payment will be reduced by more than $110 per month for a single borrower
who earns $30,000 a year and owes $20,000 in college loans, based on 2009
figures.
Forgive Any Remaining Debt after 20 Years, or after 10 Years for Those in
Public Service: Borrowers who take responsibility for their loans and make their
monthly payments will see their remaining balance forgiven after 20 years of
payments, reduced from 25 years in current law.
– Public service workers – such as teachers, nurses, and those in military service –
will see any remaining debt forgiven after 10 years
.
Howard Kunreuther Mark Pauly, Stacey
McMurrow, Insurance and Behavioral
Economics 2013
• Failure to insure
against big risks
• Lack of public
imagination about
possible rare risks
• Scarcity of long-term
casualty insurance,
insuring against the
risk or rising risks
Example of an Unforeseen Risk:
Global Warming, Google
NGRAMS Count
Home Equity Insurance
• Risks to values of homes greater than
risks by fire
• Oak Park Illinois, 1977
• Chicago Home Equity Assurance Program
1988
• Index-based insurance, Shiller and Weiss
1994
• Yale-Syracuse-NRC program, 2002
Catastrophe Bonds
• Transfer risk to the bondholder
• Typically, principal does not have to be repaid if
specified catastrophe occurs
• May 2006 Mexico placed US$160 million in
earthquake bonds through Deutsche Bank and
Swiss Re, Mexico’s first Cat bonds
• CAT bond issuance in 2005 was a record
US$1.99 billion in 2005, up from US$1.14 billion
in 2004 and US$1.73 billion in 2003
• CAT bond Issuance is still small
Proposal for GDP Shares or “Trills”
• With Mark Kamstra, York University
• Theory: Stanley Fischer JPE 1975,
Athanasoulis & Shiller AER 2002, Ball &
Mankiw JPE 2007
• Every country should issue GDP shares
• Each share pays one trillionth (hence
“Trills”) of GDP ($17 for U.S. now, about
$1.60 a year for Canada now) in local
currency
• Analogous to corporate stock (share of
These Risks Are Essentially Long
Term
• Compare Sri Lanka and Korea – forty
years ago had about same standard of
living
• Now, Korea has five times the standard of
living of Sri Lanka
• Why?
• Ethnic violence in Sri Lanka
• Samsung in Korea (Nokia in Finland and
Ericsson in Sweden)
Difference between GDP Shares
and GDP-Linked Bonds
• Borensztein-Mauro proposal IMF for GDP
linked bonds: dividends tied to GDP
growth rates
• GDP Shares are simpler
• Better price discovery
Difference between GDP Shares
and Inflation-Indexed Bonds
• Both are denominated in current dollars
• Both deal with inflation risk
• Only the GDP shares manage aggregate
income risk
• Pension funds, social security, more
naturally tied to GDP Shares
Purpose of Proposal for Advanced
Countries
• To hedge both national and government budget
risks
• To get advanced countries to set an example of
a such a market, create a liquid market
• Ultimate objective is that every country would
issue such bonds
• Investors would have an array of new choices
for investments
• The “market portfolio” would come into being:
market for all the GDPs of the world
MacroShares
• MacroMarkets LLC issued securities in pairs, up
and down, for oil prices, home prices, 2006-9,
ultimately to be for GDP or its analogues
• Up security pays dividend proportional to index
• Down security pays dividend that moves
inversely to index
• Retail product, was listed on New York Stock
Exchange, paid regular dividend
• Any imbalance can be evened out in futures
market
Our Difficulties Getting
MacroShares going
• Lawyers constrained our issuance to fit a
mold in existing SEC categories
• Could not have perpetuities
• Needed to refund money if stopped out,
which the oil security did in 2009
• Media seemed to be uncomprehending
that our oil securities did not track spot oil
price
Recap of Theory
• Neoclassical and behavioral finance both
play role
• Strong role of government in innovation
• Investors desire liquidity, never available
at the beginning with new products