Felix Salmon

Good and bad financial innovation

By Felix Salmon
August 27, 2009

Simon Johnson and James Kwak have an important article on financial innovation in the latest issue of Democracy. The broad thrust of the article I agree with — as you might expect, given that after listening to my last debate on the subject, James Kwak came to the conclusion that “obviously I agree most with Salmon”. (Thanks, James!)

That said, there are significant chunks of the Johnson and Kwak article that I disagree with, and I feel that it’s probably long past time that the “financial innovation: good or bad?” debate allow itself to make some nicer distinctions than have generally been made until now. So with the clear proviso that I’m on the “financial innovation: bad” side of the broader debate, here’s where I take issue with Johnson and Kwak.

First, they address securitization:

Securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

Sure, nothing, on its own, produced the colossal boom and bust we’ve just lived through. But securitization is as much to blame as anything else, if not more so. Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway. And it made bond investors comfortable with the idea of buying structured products tested only by models, as opposed to actual analyzable liabilities of real-world entities. You can’t phone up the CFO of a special-purpose entity and ask him how things are going. And lending in general works when there’s a relationship between the borrower and the lender. Securitization severs that relationship, which is harmful.

I’d also take issue with the idea that anything which expands the pool of money available for lending is, ipso facto, a good thing. To the contrary, things which expand the pool of money available for lending can serve only to inflate credit bubbles. In general, lending shouldn’t be easy to come by; and it should in principle always be just as easy to issue equity as it is to issue debt. We’re nowhere near that point right now, and securitization only serves to drag us further away from it.

Johnson and Kwak then attack the credit default swap:

Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments.

The CDS, pace financial innovation, did not in and of itself underprice credit risk: it was simply a measure of credit risk. And indeed for most of the history of the CDS market, the basis on CDS was positive: as you’d intuitively expect, the cost of insuring a certain credit against default was higher than the spread on that credit’s bonds. You couldn’t lock in a risk-free return by simply buying a security and insuring it against default. So if the CDS market was underpricing risk, the bond market was underpricing risk even more. It was only after the credit market imploded that the negative-basis trade started becoming possible. So you can’t really blame a negative CDS basis for any part of the crisis.

Yes, it’s clear, in hindsight, that AIG, in particular, was underpricing credit risk. But that has nothing to do with the structure of the CDS market more generally. Instead, the problems with AIG surrounded the fact that it only ever sold credit protection, and never bought it; and that once it had sold protection, it used its triple-A credit rating to avoid having to put up any collateral against those positions or otherwise be forced to protect itself against loss. AIG in general, and AIG Financial Products in particular, did a lot of things wrong. But that’s not the fault of the CDS market.

Johnson and Kwak are right that regulators should be inherently suspicious of financial innovation; they’re possibly too polite to mention that this is largely because most financial innovation comprises, at its heart, some kind of regulatory arbitrage. (Securitization being no exception.) I agree also with the idea of standardizing CDS documentation, although it should be said that that is already happening to a large extent. I’m not at all sure, however, that standardized CDS will be much easier to regulate than the customized CDS of old. It’s not the customization which is the problem, it’s trying to get a grip on net positions, in a market which is constantly in flux. The way to solve that problem is to simply let the market continue down the road of the past six months, where CDS are increasingly being shunned as an asset class in favor of good old-fashioned bonds.

Johnson and Kwak then finish with a list of good financial innovations we might encourage: banking the underserved (a no-brainer), reforming health insurance (yes, but let’s not debate that here), and finally this:

We need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

This I’m much less sure about. You can be sure that no matter how good the financial education provided, the consumers of that education won’t end up being better educated about financial affairs than large and supposedly sophisticated investors, such as municipalities and pension funds. The problem with investors who made bad choices during the boom wasn’t that they were insufficiently educated: it was rather that they were educated too much. Financial education breeds overconfidence, and overconfidence was a much more important cause of the crisis than insufficient education was. If a strong CFPA prevents truly harmful products being sold to consumers, that’s the best we can hope for: a mass education program isn’t practicable and wouldn’t work even if it were implemented. The last thing I want is Robert Shiller being unleashed on the public, telling them that they can hedge the value of the equity in their houses by buying derivatives on house prices.

So thank you, Simon and James, for fighting the good fight. But this clearly isn’t the last word on the subject.

9 comments so far | RSS Comments RSS

Insufficient financial education does lead directly to one of the major issues of the moment: levels of financial sector compensation. If they were better educated about the likelihood of a successful outcome (or rather the lack thereof), consumers and corporate representatives would not pay nearly so much for financial advice and products, and the institutions and hedge funds would not be able to make the margins to pay their staff so much.

Posted by David | Report as abusive

There is another aspect in my opinion, Felix, regarding prevention from selling of harmful products to consumers. Banks nowadays are not looking for Bankers as employees, but for people who are able to sell every crap to consumers, cause they (the sellers) get paid for the total amount of the products they sell, not for consulting of the consumers, what is good, what is bad. I admit this has to do with the wrong remuneration in the finance sector. But it is not happening regardless of the so called „new products“ with alot alphas and betas in their labels which are overfloating the markets in the recent years.


“In general, lending shouldn’t be easy to come by; and it should in principle always be just as easy to issue equity as it is to issue debt.”

I understand why you say this (especially in light of the excesses of the past decade), but I think it’s important to consider the full implications. Thinking about individuals instead of corporates, a world of tight credit means a world where the poor are increasingly shut out of economic opportunities. The more we restrict credit, the more we restrict real growth opportunities. And for those who no longer can get a mortgage, car loan, credit card, small business loan, etc., “issuing equity” is not going to be the answer (equity in an individual’s future earnings?).

Remember in all your ranting against borrowing that some debt can be a catalyst for real growth, and expanding access to credit is often a really positive economic development. And to the extent that investors understand SIMPLE securitization structures (e.g. credit card pass-throughs) and want to take that risk, it increases the availability of credit and lowers the cost. More often than not, that’s a socially beneficial activity.

Posted by ab | Report as abusive

A couple of things to add:
1) We were doing negative-basis trades long before the credit market imploded. All you had to do was go to Ambac, MBIA, etc. and get them to ‘insure’ your AAA CDO for a few basis points.
2) Municipalities are the furthest things from sophisticated investors.

Posted by 3 | Report as abusive

Felix, securitization did not absolve lenders from sensible underwriting. The lenders abrogated responsibility – and also ignored the very real risks that they still carried even after selling loans to securitizations, like being on the hook for buying early defaulting and fraudulent loans back, at par, from securitization pools. That’s what killed so many subprime lenders so early in the crisis.

Securitization was just the tool. And not the only one. Option ARMs, after all, were loans that were kept on banks’ balance sheet.

I’m not saying securitization didn’t play a role. But blaming a financing tool rather than the people using/abusing it is just silly.

Posted by Murray | Report as abusive

“AIG in general, and AIG Financial Products in particular, did a lot of things wrong. But that’s not the fault of the CDS market.”

Not in the sense that the market mechanisms were faulty, perhaps. But it indicates the market participants were not acting as they should, in order for that market to function properly. At some point, should not participants have asked how AIG was always selling and never buying?

Posted by Ken | Report as abusive

“It was only after the credit market imploded that the negative-basis trade started becoming possible. ”

Huh? The boom years for negative basis trades, in Europe at least, were in 2005 and 2006.

Posted by Ginger Yellow | Report as abusive

Good innovations result in products that are easy to regulate. Everything that is so complex that it is almost impossible to regulate and enforce will be abused. Complex rules on complex facts gives you complexity squared, which is the sure way to lawless territory.

Posted by Gaute | Report as abusive

The flaws with CDSs are plain right in this blog entry.

Fact 1: AIG only ever sold, and never bought, credit protection.

Fact 2: AIG’s credit rating remained AAA until the bitter end.

Why was AIG able to do what they did for so long? Why hadn’t AIG lost its AAA long before? Because their CDS situation was incomprehensible, even to themselves.

Gaute, makes an excellent point about complexity. CDSs complexity comes from the fact that the probability of future defaults cannot possibly be known with any any reasonable precision.

Moreover the CDS market has demonstrated that it is a total joke. Last November, Berkshire’s five-year CDS spreads were at 475 BP.

The fact that there is a market and trading does not mean anything. Just look at AIG, FNM etc.

Posted by Daniel Hess | Report as abusive

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