Neoclassical Finance and RealityLecture 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 2010-

2012 (Corelogic)

Real Consequences, Example: Continuing Care Retirement

Communities• CCRCs combine independent living, followed by

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

• 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 well-captured 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 1971-78

• 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

Obama’s Income-Based-Repayment (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 profits)

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