Comments on: How financial innovation causes crises A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: Uncle_Billy Tue, 13 Apr 2010 01:59:17 +0000 You trust his math? Or do you trust that he uses detail-oriented types to do his math for him? Or was this tongue-in-cheek?

“As a freshman at Harvard, Shleifer took Math 55 with Brad DeLong; he has said that the course made him realize he was not destined to be a mathematician, but the experience gave him a future co-author.”

“During the early 1990s, Andrei Shleifer was an advisor to Anatoly Chubais, the then vice-premier of Russia, and was one of the engineers of the Russian privatization. During that time, Harvard University was under a contract with the United States Agency for International Development, which paid Harvard and its employees to advise the Russian government. The results of privatization in Russia were criticized widely in Russia and western academic circles. Under Anatoly Chubais, privatization led to valuable Russian business assets being acquired at extremely cheap prices amid accusations of rigged auctions.
Shleifer was also tasked with establishing a stock market for Russia that would be a world-class capital market. That effort was also unsuccessful, and became mired in charges of corruption and self-dealing.[6]

Under the False Claims Act, the US government sued Harvard, Shleifer, Shleifer’s wife Nancy Zimmerman, Shleifer’s assistant Jonathan Hay, and Hay’s girlfriend (now his wife) Elizabeth Hebert, because these individuals bought Russian stocks and GKOs while they were working on the country’s privatization, which potentially contravened Harvard’s contract with USAID. In 2001, a federal judge dismissed all charges against Zimmerman and Hebert.[7] In June 2004, a federal judge ruled that Harvard had violated the contract but was not liable for treble damages, but that Shleifer and Hay might be held liable for treble damages (up to $105 million) if found guilty by a jury.[8]
In June 2005, Harvard and Shleifer announced that they had reached a tentative settlement with the US government. On August 3 of the same year, Harvard University, Shleifer and the Justice department reached an agreement under which the university paid $26.5 million to settle the five-year-old lawsuit. Shleifer was also responsible for paying $2 million dollars worth of damages, though he did not admit any wrong doing. A firm owned by his wife previously had paid $1.5 million in an out of court settlement.
Because Harvard University paid most of the damages and allowed Shleifer to retain his faculty position, the settlement provoked allegations of favoritism on the part of Harvard’s outgoing president Lawrence Summers, who is Shleifer’s close friend and mentor. Shleifer’s conduct was reviewed by Harvard’s internal ethics committee. In October 2006, at the close of that review, Shleifer released a statement making it clear that he remains on Harvard’s faculty. However, according to the Boston Globe, he has been stripped of his honorary title of Whipple V. N. Jones Professor of Economics” ifer

By: dWj Mon, 12 Apr 2010 12:10:05 +0000 These papers very rarely have actual mistakes in the math; Glenn’s points are in fact the reason to read the math rather than just the prose: the math makes the assumptions (more) explicit. In general, you can translate the prose into a fairly decent responsible understanding of the results, and usually the translation takes a form along the lines of “this is an illustration that the phenomenon illustrated can occur, to some extent, in various somewhat plausible circumstances, on top of all the other phenomena that are occurring.” I’m inclined here to recognize this as a potential cost to innovation that should be weighed against potential benefits.

In fact, this sort of phenomenon doesn’t even require “financial innovation”, really. Low-rated bonds weren’t invented in the eighties; it was just realized what a good investment they had been in the past. Canals in England in the 1790’s were very good investments. In both cases, high returns drew in market participants and increased supply, until the rates of return came down to reasonable levels — and then kept going. In both cases, people had started to neglect the ways in which things go wrong, and used recent history to assuage any concerns about risk. What financial innovation adds is that it exacerbates the extent to which relatively well-informed investors can fail to recognizes risks before they get hit. The rest of the boom-bust cycle is more general.

By: GingerYellow Mon, 12 Apr 2010 09:50:48 +0000 “By the end of 2009, 95% of CLO liabilities orginally rated AAA remained rated A or better; 90% of CDOs originally rated AAA were rated BB+ or worse. Why?”

To simplify, correlation assumptions. Even during the peak of the securitisation boom, rating agencies still stuck to relatively strict diversification criteria for the underlying loans in the CLO. By contrast, they assumed that RMBS tranches, even at the BB or BBB level, were inherently diversified – obviously, they weren’t. The cliff risk you saw in CDOs of RMBS wasn’t repeated anything like as widely in CLOs (with some exceptions such as market value CLOs and leveraged super seniors).

By: DonthelibertDem Mon, 12 Apr 2010 04:19:58 +0000 I didn’t get this:

“Lemma 3 In the absence of innovation, no risky claim is issued (a = 0) and pA < 1."

Isn't this an empirical question? In other words, couldn't the investors choose the product because it allows for less collateral? Which, in that case, would make them less safe, all things being equal.

The question then becomes did they sell these products on dubious grounds? My impression is that many of these innovations had previously existed, and were sold as tested, and not that investors were told we have theoretically safe investments that have never been tested.

By: gyago Mon, 12 Apr 2010 00:28:05 +0000 Here’s a question that would get this important discussion you’ve raised beyond financial luddism:

By the end of 2009, 95% of CLO liabilities orginally rated AAA remained rated A or better; 90% of CDOs originally rated AAA were rated BB+ or worse. Why?

By: gyago Sun, 11 Apr 2010 22:45:56 +0000 Seems like the blog and model fail to distinguish between financial liberalization (in markets and capital accounts) and innovations in products and services, processes, and organizational forms that enable financing. Also, no element in the model considers capital structure, overleverage, and impacts of regulatory arbitrage. This makes the model elegant theoretically, but empirically unable to distinguish between the good, bad and ugly of financial innovation—painting all with a No. 10 brush. For example, CLOs which lost no principal value, had suitable leverage and ability to access underlying collateral (oh yes, no differentiation of collateral is delineated in the model), leveraged loans and junk bonds (which have historically demonstrated their performance based on fundamentals and returns) are lumped with low quality CDOs buried with imprudent leverage, inability to access collateral, and concentration of risk that destroyed bank balance sheets. Not too sure how this helps us understand the incidence of crises derived from asset bubbles in the absence of financial innovation (e.g., Spain, Ireland).

By: Sprizouse Sun, 11 Apr 2010 21:38:35 +0000 Stop calling it “financial innovation” and start calling it “financial complexity”. Needless complexity was re-branded as innovation back in the 80s and that’s been a major source of our problems.

Complexity is easier to condemn, because we all understand that needless complexity is fabricated game to see who can outsmart who. But when it’s called “financial innovation” it makes it sound like some great public service has been done.