Download The New Financial Order and the Current Financial Crisis

The New Financial Order and
the Current Financial Crisis
Robert J. Shiller
Professor of Economics, Yale University
Co-Founder and Chief Economist, MacroMarkets LLC
New Economic School, Moscow
March 14, 2008
New Financial Order
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Advances in mathematical finance
Advances in behavioral finance
Advances in information technology
Democratization of finance
Books
Discussing the need and history of financial
innovation in risk management
Macro Markets,
1993
The New Financial Order, 2003
New Markets in Progress
•
•
•
•
Home price markets
Oil price markets
Natural gas markets
Components of consumer price index
– Medical costs
– Education costs
• Personal income risks
• GDP
• Longevity
Current Financial Crisis
• International Stock market boom 1990s,
collapse 2000-2003
• International housing market boom Late
1990s-2000s
• Collapse of housing boom in US since
2006, following in other countries
• US Subprime crisis leads to freeze up of
financial markets, systemic effects
Spread of Crisis to Europe
• IKB Deutsche Industriebank AG, and
SachsenLB Bank in Germany
• Funds sponsored by BNP Paribas in
France
• Northern Rock Building Society in the
United Kingdom
The Crisis as Opportunity
• Example of stock market crash of 1929
• US Reaction in 1930s: financial progress:
creation of Securities and Exchange
Commission, Federal Deposit Insurance
Corporation, Fannie Mae, Homeowners Loan
Corporation, Federal Home Loan Bank System,
Federal Housing Administration
• European reaction: not so congenial to markets
• The current crisis should be dealt with with
financial progress again
450
1800
400
1600
350
1400
300
1200
250
1000
Price
200
800
150
600
Earnings
400
50
200
0
1860
100
0
1880
1900
1920
1940
Year
1960
1980
2000
2020
Real S&P Composite Earnings
2000
Real S&P Composite Stock Price Index
Real S&P500 Price and Earnings
January 1871 to February 2008
P/E10 and Nominal Long Rate
As of Today
50
20
2000
1981
Price-Earnings Ratio
40
16
1929
35
14
30
25
12
Price-Earnings Ratio
1901
1966
10
20
8
15
6
1921
10
5
0
1860
18
Long-Term Interest Rates
45
4
Long-Term Interest Rates
1880
1900
2
1920
1940
Year
1960
1980
2000
0
2020
Real Home Prices, Building Costs,
Population, Interest Rates
As of 2007-IV
1000
200
900
700
150
600
Home Prices
500
100
400
300
Building Costs
Population
50
200
Interest Rates
0
1880
1900
1920
1940
1960
Year
1980
2000
100
0
2020
Population in Millions
Index or Interest Rate
800
Comparing Real Home Prices in
Greater London and Greater
Boston 1983-2007
400
350
Real Price Index
300
250
Gr. London
200
150
Gr. Boston
100
50
0
1980
1985
1990
1995
Date
2000
2005
2010
Moscow Apartment Prices
1999-2008 $/Square Meter
Fig. 4 Real Home Prices Netherlands,
Norway, USA 1890 to 2004-5-7
Real Home Price Index, 1890=100
350
300
250
Netherlands
200
Norway
150
100
USA
50
0
1890
1910
1930
1950
Year
1970
1990
2010
Fig. 1 US Real Price, Rent and Building
Costs Quarterly 1987-I to 2007-II
180
Real Price
160
Index 1987-I=100
140
Real Rent
120
100
80
Real Building Costs
60
40
20
0
1985
1990
1995
2000
Date
2005
2010
Home Prices a Massive World
Speculative Bubble
• Gold rush mentality
• Stories of the rapidly growing “BRICs”
(Brazil, Russia, India, China) have the
whole world spooked
• Widespread anxieties about how to fit in to
the new capitalist world
• A popular view that property investments
are the best way to secure one’s future,
same phenomenon over much of world
The Behavioral Finance Revolution
Terms “Behavioral Finance” & “Efficient Markets”
in News Media from 1981 to 2006
0 .9
0 .8
0 .7
0 .6
" Effic ient M arkets"
0 .5
0 .4
0 .3
0 .2
" Behavio ral Financ e"
0 .1
0
19 75
19 8 0
19 8 5
19 9 0
19 9 5
2000
2005
2 0 10
Wishful Thinking Bias
• People exaggerate probability that their
team will win.
• People exaggerate probability that the
candidate they favor will win.
Attention Anomalies
• Attention is fundamental aspect of human
intelligence and its limits
• Social basis for attention
• Inability to account for one’s attention
• “No arbitrage assumption” of financial
theory: No ten-dollar bills lying around.
Does not require everyone is paying
attention.
Culture and Social Contagion
• Social cognition,
collective memory
• A global culture in
today’s world
S&P/Case-Shiller® Home Price MacroShares®
CME Housing Futures and Options
On May 22, 2006, The Chicago Mercantile Exchange launched the first successful futures and options market for
home prices. The contracts currently settle on 11 different S&P/Case-Shiller® Home Price Indices. The combined
cumulative notional value traded in the CME housing products (both futures and options) in the first year
exceeded $500mm, a period over which these products were limited to a maximum one-year term. On
September 17, 2007, the CME began listing longer-dated contracts (up to 5 years) to meet market demand for
greater product utility.
“Financial Engineering comes to
real estate at last, and the housing
market will never be the same.”
-Barron’s 5.15.06
C um ula tive C M E H o using Future s N o tio na l Tra d e d
(Sinc e Inc e p tio n, M a y 2 0 0 6 )
$350
$300
$200
$ 15 0
UPDATE THIS
$ 10 0
7/ 13/ 2007
7/ 03/ 2007
6/ 13/ 2007
6/ 22/ 2007
6/ 04/ 2007
5/ 14/ 2007
5/ 23/ 2007
5/ 03/ 2007
4/ 13/ 2007
4/ 24/ 2007
4/ 03/ 2007
3/ 14/ 2007
3/ 23/ 2007
3/ 05/ 2007
2/ 12/ 2007
2/ 22/ 2007
2/ 01/ 2007
1/ 11/ 2007
1/ 23/ 2007
12/ 19/ 2006
12/ 29/ 2006
12/ 08/ 2006
11/ 17/ 2006
11/ 29/ 2006
11/ 08/ 2006
10/ 19/ 2006
10/ 30/ 2006
9/ 29/ 2006
10/ 10/ 2006
9/ 11/ 2006
9/ 20/ 2006
8/ 21/ 2006
8/ 30/ 2006
8/ 10/ 2006
8/ 01/ 2006
7/ 21/ 2006
7/ 12/ 2006
6/ 21/ 2006
6/ 30/ 2006
6/ 12/ 2006
$0
6/ 01/ 2006
$50
5/ 22/ 2006
$ in M illio n s
$250
2/
6/ 200
12 6
/
6/ 200
30 6
/
7/ 200
21 6
/
8/ 200
10 6
/
8/ 200
30 6
/
9/ 200
20 6
10 /20
/1 06
0
10 /20
/3 0 6
0
11 /20
/1 0 6
7
12 /20
/0 0 6
8
12 /20
/2 0 6
9/
1/ 200
23 6
/
2/ 200
12 7
/
3/ 200
05 7
/
3/ 200
23 7
/
4/ 200
13 7
/
5/ 200
03 7
/
5/ 200
23 7
/
6/ 200
13 7
/
7/ 200
03 7
/
7/ 200
24 7
/
8/ 200
13 7
/
8/ 200
31 7
/
9/ 200
21 7
10 /20
/1 07
1
10 /20
/3 0 7
1
11 /20
/2 0 7
0/
20
07
5/
2
Problems Getting Market Started
Open Interest May 2006 to Nov
2007
$120,000,000
$100,000,000
$80,000,000
$60,000,000
$40,000,000
$20,000,000
$0
Home Price Futures
Percent Discount of CME Housing Futures from S&P/Case-Shiller HPI Levels – as of
January 3rd, 2008.
% d isc o unt v. S&P/ C a se - Shille r H o m e Pric e Ind e x
0%
Bo sto n
-5%
Chic ag o
Denver
- 10 %
LV
LA
- 15 %
M iam i
NY
-20%
SD
SF
-25%
W ash DC
Co m p - 10
-30%
-35%
Fe b - 0 8
M a y- 0 8
Aug - 0 8
N o v- 0 8
Fe b - 0 9
M a y- 0 9
N o v- 0 9
C M E Fu tu re s C o n tra c t Ex p ira tio n
M a y- 10
N o v- 10
N o v- 11
N o v- 12
Futures Price and Latest Home Price
Index
Daily, May 2006 – February 2008
S&P/Case-Shiller Composite- 10: Expected Change Within One Year, by Trading Day:
Through February 14, 2008
260
250
CME Composite-10 Futures
S&P/CSI Composite-10 Index
240
230
220
210
200
190
180
5/19/2006
8/1/2006
10/11/2006 12/21/2006
3/7/2007
5/17/07
7/30/07
10/09/2007 12/19/2007
*Data derived from the asking price of the long-dated CME futures contract and prevailing S&P/Case-Shiller Home Price Incex level on each trading day.
Efficient Portfolio Frontier
Effic ie n t P o r tfo lio F r o n tie r W ith a n d W ith o u t O il
Ex p e c t e d An n u a l R e t u r n
16 %
28% Up O il M ACRO s hares , 115% Sto c k s , - 44% B o nd s
15 %
W it h Oil
14 %
21% Up O il M ACRO s hares , 79% Sto c k s , 0% B o nd s
100% Sto c k s
13 %
W / O Oil
12 %
15% Up O il M ACRO s hares , 53% Sto c k s , 32% B o nd s
50% Sto c k s , 50% B o nd s
11%
9% Up O il M ACRO s hares , 27% Sto c k s , 64% B o nd s
25% Sto c k s , 75% B o nd s
10 %
100% B o nd s
9%
8%
5%
7%
9%
11%
13 %
15 %
S t a n d a r d D e v ia t io n o f An n u a l R e t u r n
17%
19 %
The MACROSHARES Structure
A Vision Becomes a Reality
On November 30th, 2006:
MacroMarkets LLC launched
MACROSHARES Oil Up and MACROSHARES Oil Down are listed on the
American Stock Exchange.
These securities track the performance (and inverse
performance) of West Texas Intermediate Crude Oil.
Ticker Symbols:
AMEX: UCR
AMEX: DCR
MACROSHARES
MACROSHARES
Oil Up
Oil Down
10/18/2007
10/4/2007
9/20/2007
9/6/2007
8/23/2007
8/9/2007
7/26/2007
7/12/2007
6/28/2007
6/14/2007
5/31/2007
CL1
5/17/2007
75
5/3/2007
CL12
4/19/2007
80
4/5/2007
CL60
3/22/2007
85
3/8/2007
UCR
2/22/2007
90
2/8/2007
1/25/2007
1/11/2007
12/28/2006
12/14/2006
11/30/2006
NYMEX Oil Futures Prices to 60 Months and UCR
Price Daily Nov 30 2006- Oct 28 2007
70
65
60
55
50
Spread Between Front-Month and 60-Month
Futures and Spread Between UCR and FrontMonth Futures, Daily Nov 30 2006-Oct 28, 2007
-10%
-15%
-20%
(CL60-CL1)/ CL1
(UCR-CL1)/CL1
9/30/2007
-5%
8/30/2007
0%
7/30/2007
0%
6/30/2007
5%
5/30/2007
5%
4/30/2007
10%
3/30/2007
10%
2/28/2007
15%
1/30/2007
15%
12/30/2006
20%
11/30/2006
20%
-5%
-10%
-15%
-20%
Pensions and the Risk of Outliving
One’s Wealth
 Life annuities are an excellent old idea, rarely embraced
by the public
 Wishful thinking bias, mental framing
 Public pension funds
 Private annuities
 Problem: annuity providers have to manage aggregate
longevity risk
U.S. Life Expectancy, 1900-2001
90
80
Ag e at D e ath
70
Fe m a le
60
M a le
50
40
30
20
10
0
18 8 0
19 0 0
19 2 0
19 4 0
19 6 0
19 8 0
2000
2020
Problems Inhibiting Longevity
Bonds
• EIB Bonds were nominal bonds, should be
real
• UK Issuers of life annuities were not
seriously enough interested in this small
issue to take fast action
• Those who would take other side are not
easily found, need to look at prices in an
established market
Efforts to Create Markets for
Longevity Risk

Swiss Re longevity bond, 2003

European Investment Bank-BNP Paribas longevity bond 2004


Swiss Re, takes on £1.7 billion of longevity from Friends Provident in UK
JP Morgan Launches International Longevity and Mortality Index –
LifeMetrics Index, March 2007
Goldman Sachs Launches Tradeable Index for Longevity and Mortality
Risks Dec. 2007

To date the longevity risk market is still struggling to gain a foothold
Personal Income Risk Markets
• Subprime crisis could have been averted
with income-linked (and real estate price
linked) mortgages
• Such retail products require the creation of
markets
GDP Linked Securities
• Governments could sell shares in their
GDP
• One “trill” is a trillionth of a nation’s GDP
• Precursors: Bulgaria GDP warrants, 1993,
Argentina GDP warrants, 2005
Summary
There is enormous potential for improvement in human
welfare from radical financial innovation in the area of
energy,, real estate, longevity and multiple risks we still
cannot immunize ourselves from today. The subprime
crisis is evidence of the need to improve our markets