Financial innovation is hard to kill

December 28, 2009

(Refiles on October 19, 2010 to add disclaimer for author’s personal investment. Neil Unmack bought Lloyds CoCos shortly before he wrote this article.)

NeilUnmack _160_px.jpgThe bad news of 2009 gave markets a chance to turn over a new leaf on the vexed topic of financial innovation. The credit boom was marked – and marred – by a surfeit of clever products that proved toxic when the good times stopped. In the aftermath, investors said they wanted a return to simplicity and conservatism.

But financial innovation never really died. In May, Credit Suisse offered a longevity swap, which lets companies lay off some of the risk that pensioners will live longer than expected. Then there was the contingent convertible bond issued by Lloyds Banking Group in November. These so-called “CoCos” are debt which automatically turns into equity when banks get into trouble.

These innovations are more benign than bamboozling. There’s scope for more good new stuff. The Holy Grail for 2010 will be a CoCo that is clear enough to appeal to mainstream investors. A liquid market in such protective securities would help make banking safer but not too much less profitable.

Corporate lending could also do with some creativity. Companies which are too small or risky to tap the bond market are finding it tough to borrow from banks. A product which allows non-bank investors to take controlled credit risks on loans could help everyone.

Sadly, if good innovation flourishes, its evil twin will be hard to keep down. When investors are willing to experiment with complicated products, engineers will be happy to promise more return for less – apparent – risk through the miracle of financial chemistry.

Already the search for yield, rampant during the good times, has returned, and with it the acceptance of innovative products. In December, the Italian telecom group Wind was able to launch the first payment-in-kind note in two years.

Credit spreads have already narrowed substantially; the Markit iTraxx crossover index of mostly high yield credits has more than halved from its peak of over 1,100 basis points to less than 480. If bond yields stay low and liquidity stays high, collateralized debt obligations, heavily subordinated corporate debt and other structured products will be back. Investors should, but probably won’t, be as wary as they ought to be.

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