Sorry, Doctor Shiller, not Everything can be Hedged
Many people don’t think through questions systematically. That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”
Ugh. And this from an esteemed professor at a significant university? And one with which I have sometimes agreed?
I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures. I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.
I use IBM as an example because it is so unlikely to go under. But who would be directly affected if IBM went under?
- Stockholders, both preferred and common
- Bondholders
- Banks that have loaned money
- Trade creditors
- Workers
Let’s talk about the bondholders. They could buy protection via credit default swaps [CDS] to hedge their potential losses. In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already. It’s not always true, depending on the specualtive nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.
But often the amount of CDS created exceeds the amount of debt covered. I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.
I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets. There is no risk transfer, but only a bet. My view is such gambling should be illegal, but I am in a minority on such points.
Now think about another asset: my house. Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes. So what is there to hedge here? I’m not sure, maybe future property taxes?
Aside from the county, and my insurance company, I’m not sure who has a real interest in my house. If I knew that there were many people betting on the value of my house, I might become concerned. What actions might people take against me in bad or good times?
But maybe no one would have interest in my house. It’s just one house, after all. Who would have a concentrated enough interest in it to wager on it?
Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average in your area. That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.
This is why I think that most real estate derivatives involve gambling. There is no significant natural exposure hedged. It is only a betting market.
And such it would be for most real assets. Few would want to create markets where the owner know more than they do, or, where there a few options for gaining control if things go bad.
At the end of the day, all of the assets of our world are owned 100%. Everything else is a side-bet. Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system. No tail chasing the dog. Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.
To Dr. Shiller, many markets are thin. The concept that everything can be hedged assumes deep markets everywhere, which is not the case. Time for you to step outside the university bubble and taste the real world. It’s not as hedgeable as you might imagine.
July 9th, 20097:44 am at
I think your views on real estate hedging being essentiall gambling are mistaken. Let me give you a couple of real examples.
We currently own my wife’s parents’ former home. We do not want to own it; we never wanted to own it, and it didn’t make any sense for my in-laws to own it either. We would have liked to sell it years ago, but that would have made them unhappy, so we didn’t. I think it would have been completely sensible, and not just gambling, to sell a future against the value of that house.
Now let’s take a prospective case. We own the house we live in, in a relatively expensive area of the country. We plan to live here until our daughter goes to college, at which point we intend to move somewhere substantially less expensive. I claim that hedging a portion of the value of our home would be a risk-reducing transaction that would be perfectly sensible to undertake.
I agree that people living in paid-up homes from which they do not intend to move don’t have much to hedge (except perhaps on behalf of their estates) , but that doesn’t seem like the only kind of people that exist.
July 9th, 20098:17 am at
David, you make an important point here. Shiller’s aspiration to provide hedging tools for homeowners is well-intentioned, but flawed.
The problem is something that that my lawyer pointed out to me years ago: an individual home is unique. There’s no exact substitute for my home or your home. It’s not like a security, where one stock or bond or barrel of oil is interchangeable with another.
Trying to hedge the price moves of my house with a security will always be an imperfect hedge, and it might even fail. In the Boston area, for example, the range of housing price changes over the last year spanned about -15% to +10%, depending on the town and neighborhood. In the aggregate (e.g. the S&P 500/Case-Shiller Boston index), prices were down, but some individual houses went up.
These hedging tools might make sense for a national homebuilder. Beyond that, I think Shiller’s hedging securities will largely be used by speculators and naive retail investors.
July 9th, 200911:51 am at
I’m in my early 20s. I plan to buy a house sometime in the next few years. I’m saving up a downpayment. Does it not make sense to store part of this payment in the housing up shares?
July 9th, 200912:33 pm at
It depends on what area of the country you are in — whether you should buy or rent. Areas of the country where the bubble blew biggest still have more deflation to do. Near market bottoms, transaction frequency is high but prices don’t move much.
As for Shiller’s product, it is probably not a good hedge in the short run — if you are planning on holding it to maturity, it might work, but remember, it works off of an index that tends to lag underlying price moves.
July 9th, 20093:43 pm at
matt wilbert:
It is a dangerous idea to hedge the value of the your house with a future. You will need to come up with the cash to meet the margin calls till the day you sell your home. Shiller’s hedging tools may work for the home builder, but unlikely for individual home owners. When oil was cheap, have you thought about longing oil futures to hedge your future consumption?
July 9th, 20094:42 pm at
The uniqueness of property argument is a canard as there is clearly some beta to prevailing prices. Logically speaking, it doesn’t matter that in any given case the hedge might not work.
I agree that speculation, particularly with credit default swaps, can be destabilizing, but you seem to be saying something more and relying on an arbitrary definition of gambling. You seem to be implying, for example, that all commodity futures transactions should only involve counter-hedgers. Or even that one should not buy non-dividend stocks in a secondary market (unless you’re buying enough to possibly steer the board and the actual business).
I have enjoyed your writing for years but I disagree with your conclusions as I understand them here.
July 10th, 20099:11 am at
David,
Doesn’t your real estate hedging logic extend to life insurance? Life insurers don’t have a natural exposure to your life, but through pooling are able to offer a product that allows you to hedge your idiosyncratic risk.
July 10th, 20099:33 am at
The concept that everything can be hedged assumes deep markets everywhere, which is not the case.
Exactly backwards: once we have “complete” markets, including an individual’s ability to buy, for example, insurance against average house prices in an area dropping sharply, THEN we can have hedgeability.
There’s a pretty good analogy to stocks: I as a stockholder, have never participated in an IPO, but the secondary market for stocks means that the IPO types can get out and move on to the Next Big Thing. In that sense, everyday stock investors are largely speculators, buying the stock in the hope that it will go up, but NOT changing the balance sheets of the firms they now own.
Please note that the Shiller products are structured as ETFs rather than futures in part to prevent margin calls from knocking out the unwitting. They really do look like well-thought-out mechanisms for hedging by those who most need the function.
July 10th, 20094:29 pm at
Margin calls on housing futures could be a problem, although probably not for me, but presumably you could borrow the money for the margin call if your housing equity were rising.
And yes, I try to offset my consumption-related short oil position by always having some long oil exposure, although not currently with futures.
July 10th, 200910:19 pm at
In the end, ownership is about the strategic selection of risks, calculated risks, where the likely rewards outweigh the risks. If the likely rewards don’t outweigh the risks then ownership (”investment”) is not a good choice. As Ben Graham put it, thorough analysis, security of principal and a reasonable return are the essential ingredients. Complexity bedevils analysis; hedging tends to involve concealment of risks to principal; financial intermediation (e.g. with a counterparty) requires sharing the expected return. The odds of mis-estimating risk become much higher.
On a more philosophical plane: I would hate to live in a world where everyone was “hedged” or “insured” and thought they had no risk, and yet would earn some kind of return. A world of prudent risk-takers, willing to put actual capital on the line because they’ve done their homework and willing to work to make their commitments work out, is better than a world of “hedged” risk-averse “free lunch” seekers who just want some counterparty to make everything all better for them if they turn out to be wrong.
There’s a moral hazard aspect to insurance — think about how popular the high-hazard “extreme” sports are, now that everyone feels entitled to having someone else pay for their wrecks. There’s also the problem that your average individual, regardless of means, is just not sufficiently sophisticated financially to make proper use of these “hedging” tools. We live in a nation where 90% of the population cannot do something as simple and obvious as paying off their credit cards in full each month! This applies all the way up to the highest levels of business and government — Representatives, Senators and even national presidential candidates are up to their eyeballs in debt that is clearly not in their financial interest. Should we really be turning the Wall Street marketing mafia loose with new “financial innovations”, on such ignorant prey?
My intuition tells me that it would be better for society if people who aren’t comfortable owning a particular asset were encouraged (”invisble hand” style) to stop owning it, NOT for them to maintain “ownership” but with “insurance”. Shiller and other advocates of hedging tools seem to be living in the pre-crash mentality, where financial complexity seemed like a good thing, and counterparty risks could be ignored. Such is not the case now. With the number of publicly filing businesses down about 1/3, and the number issuing “going concern” warnings rising dramatically, it’s flawed logic to assume that “insurance” (as a generic concept) is “guaranteed”. Would you sell a future on your home to the next AIG? The next Countrywide? The next Lehman Brothers? In the absence of financial transparency, particularly with respect to off-balance-sheet (and allegedly “hedged”) risk exposures, there’s no way to tell that your counterparty of choice won’t blow up in the next 10 years (or whatever time horizon). In such an environment, hedging makes little sense from a Graham-ian investment perspective, because upon thorough analysis the risks are quite likely too high.