The New Financial Order and the Current Financial Crisis

1
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

2
New Financial Order

• Advances in mathematical finance
• Advances in behavioral finance
• Advances in information technology
• Democratization of finance

3
Books
Discussing the need and history of financial
innovation in risk management
The New Financial Order, 2003
Macro Markets, 1993
4
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

5
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

6
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

7
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

8
Real SP500 Price and EarningsJanuary 1871 to
February 2008
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P/E10 and Nominal Long Rate As of Today
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Real Home Prices, Building Costs, Population,
Interest RatesAs of 2007-IV
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Comparing Real Home Prices in Greater London and
Greater Boston 1983-2007
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Moscow Apartment Prices 1999-2008 /Square Meter
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Fig. 4 Real Home Prices Netherlands, Norway, USA
1890 to 2004-5-7
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Fig. 1 US Real Price, Rent and Building Costs
Quarterly 1987-I to 2007-II
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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 ones future, same phenomenon
  over much of world

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The Behavioral Finance Revolution
Terms Behavioral Finance Efficient Markets
in News Media from 1981 to 2006
17
Wishful Thinking Bias

• People exaggerate probability that their team
  will win.
• People exaggerate probability that the candidate
  they favor will win.

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Attention Anomalies

• Attention is fundamental aspect of human
  intelligence and its limits
• Social basis for attention
• Inability to account for ones attention
• No arbitrage assumption of financial theory No
  ten-dollar bills lying around. Does not require
  everyone is paying attention.

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Culture and Social Contagion

• Social cognition, collective memory
• A global culture in todays world

20
SP/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 SP/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.

UPDATE THIS
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Problems Getting Market StartedOpen Interest May
2006 to Nov 2007
22
Home Price Futures Percent Discount of CME
Housing Futures from SP/Case-Shiller HPI Levels
as of January 3rd, 2008.
23
Futures Price and Latest Home Price IndexDaily,
May 2006 February 2008
24
Efficient Portfolio Frontier
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The MACROSHARES Structure
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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 MACROSHARES Oil Up AMEX
DCR MACROSHARES Oil Down
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NYMEX Oil Futures Prices to 60 Months and UCR
Price Daily Nov 30 2006- Oct 28 2007
28
Spread Between Front-Month and 60-Month Futures
and Spread Between UCR and Front-Month Futures,
Daily Nov 30 2006-Oct 28, 2007
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Pensions and the Risk of Outliving Ones 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

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U.S. Life Expectancy, 1900-2001
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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

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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

33
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

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GDP Linked Securities

• Governments could sell shares in their GDP
• One trill is a trillionth of a nations GDP
• Precursors Bulgaria GDP warrants, 1993,
  Argentina GDP warrants, 2005

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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