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Yale Economist Shiller Sees Future In Derivatives

Robert Shiller proposes derivatives that let homeowners protect themselves against the risk of falling prices.
Weapons of mass destruction. Upper-class slot machines. Two of the more memorable epithets attached to derivatives recently.

Complex financial derivatives, many based on mortgages, were blamed for fueling the current economic crisis.

So it might be surprising to hear a voice for more, not less, financial innovation as a way forward.

Robert Shiller is one such voice. He's the Yale professor who 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 crisis.

Shiller says financial innovation isn't to blame for the current mess. Rather, it was the errors made with certain kinds of derivatives, ones based on risky mortgages.

Explosion In Derivatives

Recent years saw an explosion in financial derivatives, a business worth trillions of dollars and involving ever-fancier new products, including those based on home loans.

Robert Shiller
There were collateralized debt obligations, or CDOs. Then there were derivatives based on CDOs: CDOs squared, or cubed.

But when the U.S. housing market deflated, losses linked to these complex instruments unleashed a chain of events that fueled the worst economic crisis in decades.

Shiller says mistakes are inevitable during any period of innovation.

"When they invented airplanes, there were a lot of crashes at first," Shiller told RFE/RL in an extensive interview. "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."

In Shiller's view, part of the problem was too little financial innovation for homeowners. That's because too many people put all their savings into one risky asset --- property. But homes are hard to sell in a market downturn, and it can be even harder to get back what you originally paid.

"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," he says.

Protection For Homeowners

Derivatives allow people to hedge against risks in the markets, or to speculate on the future direction of assets like commodities or stocks.

What Shiller proposes is derivatives that let homeowners protect themselves against the risk of falling prices.

"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' for the outlook for real-estate prices," Shiller says.

It's a little bit like having a party. Creating a market is like throwing a party.
So someone suspecting house prices were too high and due for a fall could enter into a "short" contract and bet that the market would drop.

If it did, his winnings would help offset the fall in value of his own home. That's the theory, at least.

Shiller has other ideas, too. Home equity insurance that would protect homeowners against losses from falling prices. Or mortgages designed so that interest payments would go down if the market collapsed.

He says derivatives markets based on home values could work elsewhere, not just in the United States.

But other experts are not so sure.

Dangers Of Speculation

Nicholas Motson is a lecturer in finance at CASS business school in London and a former derivatives trader. He says Shiller's idea is interesting but he worries about the danger of excess speculation. You only have to look at the oil market, he says.

"Commodity derivatives are probably the oldest established derivatives market out there. Yet look at what happened to the price of oil over the last two years," Motson says. "It's gone from $60 [a barrel] to $150 back down to $40. So moves can be exacerbated when you allow speculators into a market. So they [moves] may get pushed too far on the down side."

Another objection comes from Paul Wilmott, a London-based financial expert and author of books on derivatives.

"It can also encourage people to think there's less risk than there is," says Wilmott. "That's a classic example: 'OK, I've just bought a house and hedged it with some fancy derivatives.' But inevitably that derivative will not be aligned perfectly with your own house; there will be some mismatch."

But Shiller says a futures market could make the housing market less prone to bubbles forming. That's because "short-selling," or betting against the market, can push prices down.

In fact, Shiller's futures market based on home prices already exists. The contracts, traded on the Chicago Mercantile Exchange, are based on a housing price index designed by Shiller and another academic, Karl Case. But it's not yet caught on in a big way.

"It's a little bit like having a party. Creating a market is like throwing a party," Shiller says. "If a lot of people come everyone wants to come, but if no one comes then nobody else wants to come."