Financial Innovation

3 December 2007 at 2:51 am 18 comments

| Steve Phelan |

In his recent NY Times op-ed, Paul Krugman railed against the evils of financial innovation:

How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts.

O.K., to be fair, some kinds of financial innovation are good. . . . But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk. . . . What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Folsom’s (1991) “Myth of the Robber Barons” contrasts “political entrepreneurs,” who basically engage in rent-seeking, from “market entrepreneurs,” who seek entrepreneurial rents and improve social welfare. (HT: Rafe Champion.) I’m wondering if we need a new category of entrepreneurs?

It is not clear that the current financial crisis was (necessarily) caused by subverting regulators nor would I describe it as benefiting social welfare. Instead, I see it as yet another form of agency cost. I tend to group financial engineers in the same category as trial lawyers and realtors — making a living off fees and commissions and prone to agency problems.

We know that agency costs will increase if performance is difficult to monitor. Are we aware if anyone in the literature has ever discussed that this might create an incentive for agents to make the system more complex? If so, could we term them “agent entrepreneurs”? It certainly seems to be the case that financial instruments are getting more complex — and arguably agency problems are increasing. Is there a link?

I just have a hard time believing that the “poor” agents simply have a hard time valuing assets given the complexity of the “system” (a system they have created). Should we just trust that they are trying very hard to work it all out?

P.S.: Perhaps someone would like to argue that financial innovation is simply a new take on “political entrepreneurship” or even a form of “market entrepreneurship”?

Entry filed under: Entrepreneurship, Former Guest Bloggers, Myths and Realities.

Pros and Cons of Academic Blogging Ratings Agencies

18 Comments Add your own

  • 1. Twofish  |  3 December 2007 at 1:05 pm

    The problem here is that a-proiori it’s not easy to figure out what are “good innovations” and “bad innovations.” The classic examples of “good innovations” which the regulators looked on very negatively when they were first introduced are money market funds and jumbo CD’s.

    Another problem is the belief that the “natural” state of affairs is this static market in which everyone is happy. What happened this summer would have been familar to people in the 19th century which suggests that some of the basic causes that created the problems aren’t due to financial innovation.

  • 2. Twofish  |  3 December 2007 at 1:23 pm

    It’s also not clear to me how Krugman plans on regulating financial innovation. The problem with some types of regulation is that you end up with the government assuming the risk of losses. If the security has been “approved” by a government regulator, then if something goes wrong they will go back to the regulator and demand to be compensated.

    There is a lot of regulation in financial services and the regulation seems to have worked thus far to keep a crash from becoming a massive disaster. One should note that thus far the big financial losses have been borne by hedge fund managers and bank shareholders.

  • 3. Twofish  |  3 December 2007 at 1:25 pm

    One other problem is that Wall Street banks just pay more than government regulators and pension managers, and so the people with the skills to know what makes sense and what doesn’t tend to end up on Wall Street. The obvious solution of paying government regulators enough money so that they can compete with Wall Street for talent runs into political problems.

  • 4. Steve Phelan  |  3 December 2007 at 2:23 pm

    Twofish, I agree that it is often difficult to tell whether an innovation is beneficial or harmful.

    However, “blind freddy” could tell:
    a) borrowers would not be able to pay reset ARMs
    b) house price growth was unsustainable
    c) subprime loans are not AAA

    I think the big losses are being felt by those who bought AAA-rated subprime laden bonds – this is not just hedge funds but regular pension and mutual funds both domestically and abroad.

    Banks had no incentive to screen borrowers because they just sold the high risk loans to Wall Street.

    Wall Street in turn repackaged the loans in exotic vehicles and resold them. This was greatly facilitated by AAA ratings – see this Financial Times story.

    The ratings agencies in turn received their commissions from the issuers so they had no incentive to give lower ratings.

    Many funds had rules that they could only buy AAA rated bonds – the fund managers couldn’t get enough of the higher yielding AAA bonds being issued – this in turn gave lenders like CountryWide the green light to issue more bad loans.

    So what to do? Would underpaid regulators have spotted this problem? Would they have been co-opted by the investment banks if they did (much like the ratings agencies have been co-opted)?

    It seems that John Q. Public is the dupe as usual – believing that investing in funds that only buy AAA instruments was a safe bet.

    For me the bottom line is to follow the money. If it seems too good to be true it probably IS too good to be true – particularly when agents with no skin in the game are the loudest advocates.

    I guess the interesting observation in my post is that rent-seeking behavior can adhere to private entities, such as ratings agencies, as much as to government.

  • 5. Twofish  |  4 December 2007 at 5:14 pm

    Phelan: I think the big losses are being felt by those who bought AAA-rated subprime laden bonds – this is not just hedge funds but regular pension and mutual funds both domestically and abroad.

    Pension and mutual fund managers are not babes in the woods and the reason they are allowed to invest in these securities is that they presumably know what they are doing.

    Phelan: It seems that John Q. Public is the dupe as usual – believing that investing in funds that only buy AAA instruments was a safe bet.

    One thing to point out is that public investors *haven’t* lost that much money from direct impact of the subprime mess. The main losers are bank shareholders, hedge funds, and to some degree subprime borrowers, but the borrowers were able to cash out mortgages.

    Phelan: For me the bottom line is to follow the money. If it seems too good to be true it probably IS too good to be true.

    The credit spread for a AAA CDO was much higher than a AAA corporate. If something is more expensive, you have to ask why. I don’t expect widows and orphans to ask too many questions so they need to be protected, but I do expect some questions from pension fund managers.

  • 6. spostrel  |  4 December 2007 at 6:08 pm

    I am unimpressed by the Phelan-hindsight approach. (It is not even clear that this critique is correct ex post, but let’s skip that for now.) It was also obvious to “blind freddy” that mailing credit cards out to people who hadn’t requested them was a bad idea, but it turned out that the credit card industry could never have gotten started otherwise. It was obvious to “blind freddy” that the innovation of life insurance was immoral and would lead to murders for profit, but it turned out that life insurance was pretty valuable to the market. See also: junk bonds, LBOs, hostile takeovers, money-market funds, stock options, and commodity exchanges. Each was “obviously” a bad idea to many critics when introduced.

  • 7. dhoopes  |  4 December 2007 at 6:21 pm

    Paul Krugman is a perfect example of the tenure system’s problems. Tenure at Princeton and an idiot.

  • 8. Steve Phelan  |  4 December 2007 at 7:32 pm

    Is it just me or is that thread getting a little heated?

    Twofish: Fund managers are agents, too. These agents are keen to post higher returns than their competitors because they are compensated as a proportion of funds invested. Hence, the temptation to invest in higher yielding AAA bonds.

    As to the losers, we really don’t know who is holding the risk. See here. We DO know that banks sell 93% or more of their subprime loans to the secondary markets. Also, bundling subprime loans to achieve AAA ratings doesn’t help to sell CDOs to hedge funds – it helps to sell them to entitites that are greedy for AAA-rated bonds with higher yields. The market watch story suggests that might be pension and mutual funds, particularly overseas funds.

  • 9. twofish  |  4 December 2007 at 10:57 pm

    Phelan: These agents are keen to post higher returns than their competitors because they are compensated as a proportion of funds invested. Hence, the temptation to invest in higher yielding AAA bonds.

    This is a problem if that is the way that fund managers are compensated, but there is no reason why fund managers have to be compensated in this way. Also the need to post higher returns than their competitors is not an inherent constraint in most pension funds.

    Phlean: Also, bundling subprime loans to achieve AAA ratings doesn’t help to sell CDOs to hedge funds – it helps to sell them to entitites that are greedy for AAA-rated bonds with higher yields. The market watch story suggests that might be pension and mutual funds, particularly overseas funds.

    Actually it does. If you carve out the AAA stuff to sell to pension funds than that leaves you with the truly scary risky stuff that gets sold to hedge funds.

    It’s very, very unlikely that much of this stuff would end up in US mutual funds since US securities regulations limits the things that mutual funds can hold and how they can hold them, and I think it is very unlikely that US mutual fund holders would be impacted directly by subprime (indirect affects are another matter), since any holdings of CDOs would have to be disclosed in the prospectus before the purchase and they have to disclose their holdings periodically.

    Pension funds are not subject to the same restrictions and they aren’t subject to the same restrictions since it is assumed that they would be run by people who know better.

    The big “oops” will come the in next two months. European banks report six months after an event rather than one quarter as to US banks, and one should expect some pretty nasty news.

  • 10. twofish  |  4 December 2007 at 11:05 pm

    spostrel: Each was “obviously” a bad idea to many critics when introduced.

    We need to distinguish financial innovation from the subprime mortgage situation, and the more I think about it, the more I think that “financial innovation” has gotten a bad rap.

    Selling mortgages to people with bad credit on the assumption that house prices would have increased indefinitely was a stupid idea, but I think that one could make a case, that given low interest rates, that people would have done it anyway even if there were no financial innovation.

    The argument that I’d like for people to think about is that without these complex instruments, the crash would have looked more like the S&L crash of the 1980’s. As it is, the direct costs of the damage has been borne mainly by investment banks and hedge funds with large amounts of capital. Without financial instruments which effectively focused the risk in those entities I think it could be argued that the cost would have been more widespread.

    Something to think about.

  • 12. Steve Phelan  |  5 December 2007 at 2:32 pm

    Twofish: I have learned a little more about the process after reading last week’s business week article on money-backed assurances. It seems that traditional funds were not heavily involved – it appears money market funds were the target of the AAA ratings.

  • 13. Twofish  |  5 December 2007 at 4:38 pm

    I think that it is more complicated than that.

    From what I’ve been able to piece together, money market funds didn’t buy any CDO’s directly. What happened was that people used issued high grade commercial paper to buy AAA CDO’s. The commercial paper paid low short term interest and received high long term interest from the CDO’s. Some of that commercial paper was then put into money market funds. The problem is that once people start getting scared of CDO’s, they started getting scared of asset backed commercial paper, and this started to hit things that had nothing to do with subprimes.

    Also, at each stage from subprime -> CDO -> commerical paper that there is usually an investment bank that issues guarantee of payment in case of default, and a lot of the hits have been banks saving reserves if this happens.

    So far no AAA CDO has defaulted, and there haven’t been any other dominos falling either. However the fear that the dominoes will fall have frozen markets.

  • 14. Twofish  |  5 December 2007 at 4:48 pm

    I’ve noticed in situations like this there is a intense desire to blame some person or group with the theory that if you make that person or group suffer, that everything will be alright.

    The possibility that things can go wrong even if everyone does reasonable things is hard for people to accept. One framework that may be useful when thinking about these things is airplane disaster investigations. Instead of saying thinks like “pilot error” stopping, the analysis goes further to ask how those errors take place and what can be done to stop them.

    I’m not opposed to effective regulation, but I am opposed to things like Sarbanes-Oxley that results in just another set of bureaucratic processes without any evidence that it actual improves things.

  • 15. Steve Phelan  |  6 December 2007 at 12:58 pm

    Twofish: “I’m not opposed to effective regulation, but I am opposed to things like Sarbanes-Oxley”

    Very interesting when linked with Professor Postrel’s comments that nothing can be known without the benefit of hindsight.

    You seem to be calling for a system-level analysis of error (which I like from my days in TQM/Six Sigma).

    Unlike Professor Postrel, I also believe that systems can be designed in advance – a belief I think that engineers share with strategists. Yes, there is always the possibility of unanticipated consequences but I think there is also a category of anticipated (negative) consequences that can be avoided in advance. Clearly, I think some of the subprime problems could have been anticipated.

    This does not mean I am opposed to innovation or market experimentation. I am a great believer in evolutionary thinking. I just think evolutionary search is more efficient as a “directed search” than a “blind search”.

    (Of course, this raises the question of who should be doing the directing of the system and what are their incentives – I guess I’m with Douglass North in believing that institutions evolve as well as markets – and that directed institutional evolution should be more efficient thatn blind institutional evolution).

  • 16. Twofish  |  6 December 2007 at 5:37 pm

    Phelan: Unlike Professor Postrel, I also believe that systems can be designed in advance – a belief I think that engineers share with strategists.

    I’m skeptical that social systems can be designed at all, which is one reason I’m a fan of Austrian economics. The difficulty with designing social systems is that people have some inherent unpredictibility, and it is difficult in social systems to make a clean separation between the designer and the designed. To give an example, if you are a strategist in a company, your actions will lead to events that will get you fired, promoted, or somewhere in between. So are you the designer or the designed? The designers are part of the system they are designing.

    For really big social systems, I don’t think that directed searches are that much more efficient than blind searches, and in fact may be much less efficient. One problem with directed searches is that the people doing the directions have their own biases and can be horribly wrong, and I don’t think that at the really big questions that experts in institutional design actually come up with better designs than blind watchmakers.

  • 17. srp  |  6 December 2007 at 7:42 pm

    I have no problem with attempting to use foresight–as a private matter for private investors and managers. It will always be imperfect, but the effort to anticipate contingencies is crucial to improving the odds of success.

    I object to coercive public policy attempting to use foresight about these private financial innovations to structure regulations. Setting aside the dangers of regulatory capture by vested interests fearful of new competition, the regulators have neither the incentives nor the competence to perform this task effectively. And after-the-fact interventions are usually driven more by a need to “do something” and affix blame than to develop rational policy for the future. Sarbanes-Oxley is just the latest manifestation. Remember Regulation Q?

  • 18. Mis sold Mortgage  |  13 July 2010 at 3:57 pm

    Although the financial regulations currently in place have so far prevented a recession from becoming a deep depression. It is true that hedge fund managers and bank shareholders are the main victims in terms of financial loss but it will inevitable filter down to us ‘Joe Public’.

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