When Robert Shiller collects his Nobel prize for economics in Stockholm on Dec. 8, he will undoubtedly be described as the guy who doesn’t believe in efficient markets. But the man who warned presciently of bubbles in stocks and housing is a huge believer in financial engineering. “Derivative” is not a dirty word to Shiller. Neither is “hybrid security” nor “negative amortization” (paying less than the interest you owe).
Shiller says financial engineering can be used not to fatten Wall Street wallets, but to shelter ordinary people from risks to which they are overexposed. The Case-Shiller Home Price Indices, for example, are part of an ambitious plan—still unrealized—to help people guard against the risk that home prices will decline in their neighborhood.
Although few of Shiller’s ideas have come to full fruition, just coming up with them puts him miles ahead of your average chalkboard academic. “Bob is a remarkable economist. He bridges the gap between theory and practice,” says Richard Sandor, chief executive officer of Environmental Financial Products (EFP), who is himself a pioneer in trading in interest rate futures and carbon-emission allowances.
Shiller, 67, a professor at Yale University since 1982, is lanky, soft-spoken, and self-effacing. In an interview three days before his trip to Sweden, he says his urge to innovate comes from his father, Benjamin, a son of Lithuanian immigrants who developed innovations for industrial ovens in the 1940s, ’50s, and ’60s, albeit without commercial success. “He was a real American,” Shiller says. “He believed in entrepreneurship. I guess I got some of my values from him.”
Shiller disagrees with one of his co-recipients, Eugene Fama of the University of Chicago, on how efficient markets are at incorporating available information into prices. (The third Nobelist, also at Chicago, is Lars Peter Hansen.) “I just want to be realistic about the world we live in,” Shiller says.
One of Shiller’s central themes is risk reduction. His 2003 book, The New Financial Order: Risk in the 21st Century, proposes financial products that would protect people from the risk of choosing the wrong profession, belonging to the wrong generation, or even living in the wrong country. For each he sketches out what a risk-mitigating financial instrument would look like. The concept behind the Case-Shiller Home Price Indices was to create futures markets for housing, narrowed if possible down to neighborhoods. People who bought a house could hedge their exposure by “shorting” futures on the index—that is, betting on their decline. If prices fell, the short would gain in value, reducing the homeowner’s net loss. Homeowners could also simply buy a policy from an insurance company that in turn used the futures market.
Things haven’t worked out as Shiller intended. On the upside, Fiserv (FISV) bought the firm that built the indexes in 2002 for “mid-tens of millions of dollars,” with the money split among all the employees, according to Allan Weiss, a co-founder. Shiller bought an island home off the Connecticut coast with his share. (CoreLogic (CLGX) bought the indexes from Fiserv this year.) But the outstanding futures contracts on the Chicago Mercantile Exchange (CME) cover less than $5 million in housing, not nearly enough to sustain hedging. “It should be huge,” Shiller says, a bit wistfully. “Hopefully, someday it will be.”
One reason housing futures haven’t caught on is the lack of a dealer network. In the stock and bond markets the best customers for futures contracts are dealers who need to offset the risks in their trading and investment portfolios, EFP’s Sandor says. Housing is a unique asset class: There are still no dealers buying and selling houses in large numbers for themselves and clients.
New markets, however worthwhile, are notoriously hard to get going because no one wants to get in first. The chicken-and-egg problem helps explain why Shiller also hasn’t gotten anywhere with other ideas—such as livelihood insurance and “intergenerational social security,” in which a generation that fared better would compensate one that did worse.
But Shiller, who is more energetic than his muted demeanor suggests, isn’t giving up. Nor are past collaborators such as Weiss, who’s working on another homeowner protection product linked to the indexes. “Bob’s work really inspired me to keep going and keep trying,” Weiss says. Karl Case, the retired Wellesley College professor who developed the indexes with Shiller, says his former collaborator “ate up the housing market like it was a T-bone steak.”
Shiller’s playing a long game. He notes that bonds indexed to protect against inflation were first issued by Massachusetts in 1780—then disappeared for centuries until reappearing as Treasury Inflation-Protected Securities (TIPS). There was no index of stock prices until the 1890s. Social Security, unemployment insurance, and the employment income tax credit all had to be designed and perfected. “There’s a whole swarm of people thinking about financial innovation,” Shiller says. “I’m just one small voice.”