Felix Salmon

Shleifer vs Milken on financial innovation

By Felix Salmon
April 15, 2010

Yesterday I went to a seminar at NYU where I heard Andrei Shleifer defend his paper on how financial innovation causes crises. At the same time, Mike Milken published an op-ed saying that financial innovation is a wonderful thing, and that what we really need to worry about is too much leverage and too little assiduous underwriting. “Over the long run,” he writes, “the best way to maximize profitability is not to increase leverage, but rather to analyze credit properly”.

This is true, but Shleifer’s point is that it becomes much harder to analyze credit properly if you’re constantly trying to analyze new products without any real-world past history. In the world of credit, innovation generally consists of taking risky stuff, waving some kind of diversification and/or overcollateralization magic wand, and ending up with something which is (a) meant to be safer, and (b) much more difficult to analyze on a fundamental basis: you end up having to use models instead. And models have a tendency to break.

The Milken Institute’s Glenn Yago, in the comments to my initial post on the Shleifer paper, lauds CLOs as wonderful innovations, in contrast to CDOs, on the grounds that they outperformed CDOs during the crisis. But that’s ex post — and the fact is that during the crisis the prices of CLOs dropped sharply, if they were traded at all, entirely in line with what Shleifer’s paper would predict. The point is, says Shleifer, that when people bought triple-A-rated CLOs, they wanted something completely riskless. As a result, the mere realization that there’s a possibility that they won’t get paid out in full is sufficient to see them collapse in price, given the way in which such instruments tend to have been oversupplied by the market.

“The amount of financial innovation is incredibly sensitive to how people think about risk,” said Shleifer. “That’s the point of the model.” In boom times, people think locally, don’t think about tail risk, and pile in to innovative financial products, which banks are happy to pump out in essentially unlimited quantities. In crunch times, people get much more cautious, don’t trust models any more, and flee to the safety of traditionally risk-free products like Treasuries.

This is all true pretty much regardless of the actual product in question. In this rebound, CLOs have obviously outperformed CDOs, since there’s real value in CLOs, while a lot of CDOs are simply going to zero and staying there.

The point is that when Milken says that “credit research should go far deeper than ratings” while at the same time lauding the innovation of collateralized loan and bond obligations, he’s trying to have his cake and eat it. You can do deep credit research on a plain-vanilla unsecured bond or loan. But when you start adding bells and whistles to it, and burying it within much larger and more complex securitization and passthrough structures, deep credit research becomes much, much harder — to the point at which, with CDO-squareds, it’s essentially impossible. At that point, you’re forced to rely on models and Monte Carlo simulations and the like.

In this crisis, model risk went, pretty much overnight, from something which no one spent much time worrying about to something which everybody was terrified of. And so good CLOs sold off alongside bad CDOs. And that exacerbated the crisis. That’s endemic to financial innovation: it’s a real bug in the system. And no one at Milken seems to be willing to admit it.

8 comments so far | RSS Comments RSS

The link to Shliefer’s paper is broken…

Posted by DACoffin | Report as abusive

There’s a big difference between models that didn’t work, models that were ignored, bad and insufficient data fed into models and managers that that overode risk metrics (think 3 Mile Island)that predicted defaults and illiquidity for products and banks that were known–ex-ante–to be seriously overleveraged. As we say around here, complexity is not innovation (especially if it is opaque and designed to obscure risk) and leverage is not credit–the fundamental analysis requisite for real innovation—i.e., products and services, processes, and organizational forms–that lower capital costs, create jobs, and fund entrepreneurial change. Let’s define financial innovation properly and not simply assume it’s every Rube Goldberg capital structure that tries to dodge disclosure. Then there are the agency costs of ratings agencies and that game which deserves and is getting serious attention by the firms themselves and regulators.

Posted by gyago | Report as abusive

I’d highly recommend as a corrective to the limitations of Vishny, et.al.’s model which most elegantly works for describing behavior independent of capital structure and temporal changes, the paper by Michalopolous, Laeven and Levine on Financial Innovation and Economic Growth (http://www.nber.org/papers/w15356).   In short, historical observations and empirical evidence show that economic growth stops unless there is more financial innovation, not less.

Also, there is additional work demonstrating how improvements in financial contracts, markets, and intermediaries reduces inequality as well.

See: “Finance and Inequality: Theory and Evidence” (with Asli Demirguc-Kunt) Annual Review of Financial Economics 1, Palo Alto, CA, December 2009, 287-318.

Hope that this is helpful in sorting out these complex and important issues.

If not, we always have the 50+ finance panels at our upcoming Global Conference: http://www.milkeninstitute.org which will delve into this debate in much greater depth.

Posted by gyago | Report as abusive

How on earth do either the despicable Schleifer or venal Milken get away with showing their faces in public? Only in America…

Dignifying seminars with either of them by your attendance rates close to scalping tickets to Paris Hilton and Angelyne debating the topic of virginity, only worse. Really.

Posted by HBC | Report as abusive

Felix –

You, at least partially, prove Milken’s point.

“In boom times, people think locally, don’t think about tail risk, and pile in to innovative financial products, which banks are happy to pump out in essentially unlimited quantities.”

If the products were properly underwritten during these boom times, the bubble wouldn’t get as big and the risk wouldn’t be as large. What would have happened if proper underwriting would have cut the knees out from under 100% LTV NINJA (No Income/No Asset confirmation) loans?

Proper underwriting, at a basic tenet, prevents stupid things from happening – regardless of the innovation.

Case in point – proper underwriting could (would??) have stepped in and identified the fundamental flaw in ratings agencies using only boom time historical data for projecting future returns.

In closing, if “financial innovation” brings us to the point where it’s, as you say, “impossible” to have a firm grip of the credit risk – who the heck is signing up to buy that??

Posted by rfreeborn | Report as abusive

Link to paper fixed

Posted by FelixSalmon | Report as abusive

I’m not sure it’s accurate to say that people will flee all “innovation” during a crisis. ETFs are a fairly recent innovation, but I don’t recall hearing anything about people fleeing them specifically during the last crisis (any more than they fled stocks in general). I think people were smart enough to realize that the particular innovation that was in trouble was structured credit. Were CLOs oversold during the crisis because of their structural similarities to ABS CDOs? Yes, they were. But anyone with the funds and confidence to buy CLOs during the worst of the crisis would have made a very nice profit. I think that CLOs will have a future, but only if they become simpler and more transparent. The basic concepts of diversification and tranching are not that hard to grasp. Diversification is already the principle of any mutual fund, and no one seems to question the rationale for those. By adding tranching, CLOs do add a layer of complexity, but it’s not really that hard to understand as a concept. The problem is that sometimes structurers make the CLOs more complicated than they need to be. I’d guess the future is probably going to be simpler structures with clear rules for assigning losses to tranches.

Posted by o_nate | Report as abusive

Felix, loans have strong covenants and bonds don’t. That’s the main difference.

Posted by DavidMerkel | Report as abusive

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