Or, we can just yearn for the days of a 15% fixed-rate home loan with 20% down. The good old days of 3-6-3…

I’ve been working in the area where internet and markets converge these last 10 years (from a background as a director of a global energy exchange fwiw). I can see a new wave of financial products based upon a new approach to the legal and financial structures (“enterprise model”) we take for granted.

It’s what Gillian Tett of the FT calls a “Flight to Simplicity”

eg

http://www.policyinnovations.org/ideas/i nnovations/data/000085

http://www.slideshare.net/ChrisJCook/mon ey-30

Credit cards were a financial innovation. You could also say that “reward points” and frequent flyer miles were financial innovations. So were ARMs, CDS, options, ETF’s, mutual funds and dark pools.

Saying that financial innovation will lead us to ruin because (to use the example in the post) China has grown so much with an “old” financial system is ridiculous. We (in America) need financial innovation (as we need every kind of innovation) to keep growing. We have to rely on innovation because we don’t have the same resources of China. Our growth isn’t fueld by mass and population, it’s fueled by innovation.

Growth without (financial) innovation isn’t a good reason to give up on financial innovation. People made it by boat across oceans on ships, but we still invented the airplane.

You may not see these savings, but they are there in the form of online trading, ATMs, discount brokers, etc. But also capital markets have become more integrated and global. That is net:net a positive.

Financial information and live data that used to cost $35.000 per year twenty years ago are now either free via the Internet or sometimes with as little as a 15-minute delay. This has made capital markets much more democratic.

There is also nothing inherently wrong with spreading financial risks to those that can genuinely afford to take more risk in return for higher returns. However, regulation and supervision are key to making sure that risks are truly separated and reserve provisions are in place. Accounting rules and government regulations that do not clearly define risk and how to provision it are not proof that risk cannot be spread or reduced through hedging and mitigation. Pure insurance products are a good example of spreading risk.

On the other hand perverse tax incentives and implicit government guarantees that favor homeownership over renting, while distorting the housing market and encouraging would-be homeowners to buy more house than they can realistically afford, is not a market failure, but the failure of government intervention in the market. That is not the fault of financial innovation.

And, yes, I can’t handle complexity either. I like things simple and clear.

“In the 1960s, especially in the United States, financial markets exhibited unusually low volatility: the stock market rose steadily, interest rates were relatively stable, and exchange rates were fixed. Such a market environment provided investors and financial-services firms with little incentive to adopt new financial technology, especially technology designed to manage risk. However, the 1970s experienced several events that caused both structural changes and large increases in volatility. Among the more important events were: the shift from fixed to floating exchange rates with the fall of Bretton Woods and the devaluation of the dollar; the world oil-price shock with the creation of OPEC; double-digit inflation and interest rates in the United States; and the extraordinary real-return decline in the U.S. stock market from a peak of around 1050 on the Dow Jones Industrial Average in the beginning of 1973 to about 580 at the end of 1974.”

Things like interest-rate swaps, currency swaps, and the of the Chicago Board Options Exchange were created to address the uncertainty that was brought about with the collapse of the old financial order. Surely you agree that world has become more volatile since the 1970s and that scores of useful financial instruments were invented to deal with this uncertainty?

Without restructuring the cash flows from a mortgage, the maturity of the underlying pass-through (unstructured) security is hard to predict and potentially highly volatile, making them an awful tool for management of interest rate risk via immunization.

Prior to the advent of the CMO (late 80s??), there was no secondary mortgage market; loans were sold to GSEs and Ginnie, but they ended up being held on their books as there was little demand from institutional investors for unstructured pass-through securities due to the prepayment risk in the pools.

It’s also hard for me to see how these types of structures, without additional slicing and dicing into CDOs, could be the source of the kind of meltdown in the mortgage markets we have just witnessed. Prior to the emergence of the private placement market, the secondary mortgage market was a pretty boring place, filled not with speculators, but with staid institutional investors looking for ways to mitigate their interest-rate risk.

The advent of the CMO lowered the cost of mortgage borrowing by an estimated 50 to 75 bp (I forgot the citation, but can find it, if so desired) on 30-year loans and the default risk was held, and well managed, by the way, through stringent underwriting, by the GSEs.

Yes, modeling prepayment and valuing prepayment options involves lots of geekery, but that doesn’t necessarily imply that they’re weapons of mass destruction, either.

and many others. You should argue why these are bad to make your net-net argument.

For a serious article on this you can see Van Horne in the Journal of Finance in 1985, http://www.jstor.org/stable/pdfplus/2327 784.pdf.