Rational Exuberance

NEW YORK CITY -- Runaway bestseller “Irrational Exuberance” documented how technology breakthroughs inevitably result in stock market bubbles and catastrophe.

Its author, Yale Professor Robert Shiller has written another, “The New Financial Order”, which discusses how globalization and sweeping change threatens the “real assets” of people such as their incomes and value of their homes.

His prescription is to create imaginative financial hedging products, or insurances. And this April, his consulting firm, the Chicago Mercantile Exchange and investment banking partners plan to launch their first unorthodox “product” which will be designed to protect homeowners from losing any value on their homes.

"We want to launch the first real estate risk instrument. Real estate is bigger than the stock market, where hedging takes place, but single family homeowners have no way to hedge," he said in a recent interview. "A number of attempts have been made to provide this and they haven't worked, but it's going to come."

Essentially, homeowners will be able to eliminate any downside in value. This will be done through the use of futures: Homeowners or others will bet price drops will occur on average in 10 U.S. cities, thus allowing them to profit from losses which would, in turn, fully or partially offset their own drop in value.

"Imagine a broker being able to offer a homeowner a product which meant his house would never go down in value?" he said. “It will be very popular if the price is right.”

His book also explored other financial products that don’t exist yet, but should, such as insurance which would allow a worker to insure his or her future income stream against layoffs, downsizings, rationalizations or competition.

Professor Shiller’s work combines behavioural economics and risk management.
In this case, he has come up with profound ways to help mankind.
Income insurance and property protection insurance would give people enormous peace of mind, stabilize economies and shore up consumer confidence. It would create an economic boon.

He believes that financial markets will find ways to price these products and offer them to the public in a “win-win” fashion.

“We should be able to find a market for everything and we are only at the beginning of risk management in the world," he said. "What's changed is information technology which has allowed these products to be created. For instance, on-line auctioning is providing a market for people to take millions of risks each day. We want to provide a hedge that will change the world."

The home value protection product will fluctuate based on a Home Price Index that Shiller’s company, Macro Securities Research, devised 15 years ago.

He and the Exchange anticipate a huge market, but there are a number of obstacles to be overcome before the product can be offered to small, retail clients.

The sellers are plentiful and appetite for risk by institutional financiers is enormous even for the unorthodox. For instance, Swiss Re sold nearly US$800 million worth of "Lethal Epidemic Funds" to pension funds which would "benefit" if an epidemic wiped out many of their pensioners.

The Shiller group’s challenge is to determine how to price these products for both buyer and seller. But the fact is that there's a huge amount of capital out there looking for returns better than are now available in stocks and bonds.

"It all boils down to price," he said.
At the right price, there's plenty of players even willing to insure, and reinsure, the top three catastrophic risks currently in the world: North Atlantic hurricanes; an earthquake in California or one in Tokyo, said insurance executives.

Shiller’s product represents true breakthrough for humanity, an even greater benefit for our economies and psyches than our ancestors enjoyed.

Imagine what life was like before fire insurance was invented? It was nasty, brutish and bankrupt. House fires before insurance used to wipe out families and even cities. It still does in the developing world.

Now imagine life with protection against lower real estate prices for your home? Or protection against the bubble in your local real estate bursting, leaving you owing on a mortgage that's higher than the value of the underlying property?

Or, eventually, a way to protect your income until retirement age, whether you lose your job or not.
"There have been many attempts at this and like every innovation it takes time," said the shy Professor. "But we've learned from the mistakes of others, just as the Wright Brothers did. Lots of planes crashed before one actually flew. These will eventually fly and change the world."