Bet against the bubble - how to head off a subprime crisis

Shiller goes on to point out that there are a few short-term things that we need to do: we have to stop the banking system imploding, certainly, but we also most certainly do not need to protect shareholders. Once you've bought into the capitalist idea that you're going to get the profits from putting your money with decent managers you need to accept the losses when they turn out to be not so good. Similarly we should help those in distress: buying a house which you can't afford at the top of the market is foolish, but not justification for a sentence of living under t' sweetpaper in middle of t' motorway.

Beyond that, though, he sees this not as a market failure but as the absence of a market. That is, a market that allows you to speculate or bet upon house prices falling. Thus, his long term solution is to build exactly such a market. Fortunately, he's already built one of the essential building blocks, an index which we can use to measure house prices in the major US cities. Known as the Case-Shiller indices (modest man our Professor) these are already used as the basis for a modest futures market. Very modest, actually: business is such that it covers some $15 billion worth of houses, a small fraction of the trillions of total house value in the US. As with all futures markets you can speculate (translation: bet) that prices will rise or that they will fall. This is the extra layer of speculation that he wants to add to the current housing market. So what good might come of this? More besuited plutocrats gambling away the lives of the poor perhaps? Perhaps not actually, there are two obvious and highly desirable outcomes from having such a market.

Laying off your bets

The first is the possibility of the transference of risk. If there's a deep and liquid futures market (and the almost inevitable options on top of that), and futures markets usually end up several times the size of the underlying 'real' market, then you as the holder of an asset in that real market can lay off the risk of a general fall in prices to those speculators. Via the soft commodities markets, a farmer can sell his crop at a pre-determined price before he even plants it via a future: the baker or the butcher can similarly fix the price of their requirements months or years into the future.

Airlines hedge their fuel requirements this way, Airbus hedges its dollar income this way, mining companies set the price of metals a year or more before they dig them up. The risk of price movements is passed to those speculators. Sure, if they get it right, they make good money. But remember that futures markets are a zero sum game. The amount won by those who get it right is exactly equal (by definition) to the amount lost by those who get it wrong. The value to the wider system is that these price risks have been transferred from, say, that farmer to those speculators. That's what those besuited plutocrats get their money for, holding that risk.

It might sound a little odd to think of an individual house owner offsetting the risk of a general decline in house values by taking out, say, an option in such a market. Indeed, for most such it probably wouldn't work, their needs are likely to be smaller than the average contract size. But farmers face a similar problem and the solution is that it's normally the grain elevators that do that passing on of the risk to the futures market. As Shiller points out, the existence of a deep market would lead to insurance companies (perhaps even the mortgage companies themselves) offering insurance policies which performed the same function, the passing along of the risk from individual to the market.

The second thing we'll get is that any future bubble simply wouldn't get as far as this one did. There were any number of people in 2005/2006 saying that these house price rises simply couldn't go on, that we were in an unsustainable bubble. But there was no way for such people to actually influence the market. You can bet on houses going up by buying one. But currently there's no good way to bet on their falling. You can't go short houses. But as we know from stories like Galton's Ox and Surowiecki's Wisdom of Crowds, you only end up with a realistic estimation if all of the crowd can have their say. In housing we could only hear, in the market itself, the voices of the bulls. The bears couldn't make themselves heard.

Imagine, though, what would have happened if there had been such a liquid futures market. The bears would have been able to put their money down and influence the price of said futures. The general hysteria that prices could only ever rise would have been confronted with an interesting new piece of data: not everyone agreed. Would this have meant that some poor sap wouldn't have bought a shoebox in Las Vegas for a million or two? No, but it would have meant that financiers would have been extremely hesitant to lend him the money to do so on an interest-only adjustable rate mortgage that depended upon ever rising prices to repay. That is, the simple point that some (many?) thought it was indeed a bubble and were prepared to put their money where their opinions were would have pricked the bubble that much earlier.

Saving us all some heartache and money into the bargain. I said up above that this solution would make some peoples' heads explode, that the solution to an excess of speculation is to create a market in yet more speculation. Yet in this case it is indeed true, this is a valid solution. For what we've been suffering from is not a market failure, rather from the absence of a market. In which case, the solution is to design the market needed to solve our problem. ®

Tim Worstall knows more about rare metals than most might think wise, and writes for himself at timworstall.com, and for The Business, among others. He is a Fellow of the Adam Smith Institute.