Felix Salmon

The final hour of Frontline’s Money, Power and Wall Street documentary will air on Tuesday; I’ll be participating in an online chat about the program with producers Martin Smith and Marcela Gaviria on Thursday at 1pm ET. I watched a preview this weekend, while also reading the World Economic Forum’s 92-page report on “Rethinking Financial Innovation”.

The two could hardly be more different. Frontline concentrates on international finance’s discontents, most of whom are convinced that no matter how assiduous financial-market regulation, the big banks will always find a way to extract enormous rents for themselves. The WEF, by contrast, is convinced that financial innovation is nearly always a good thing, and that a few tweaks to internal risk controls, and maybe a high-level council of graybeards thinking deeply about systemic risk, should suffice to protect us all from any downside it might have.

The WEF report is not an easy read. Literally: it’s printed in a light-grey sans-serif font on a white background. And for anybody hoping for an indication that the highest levels of the financial-services industry are taking the problems with financial innovation seriously, it’s particularly depressing. Taken as a whole, the report is a full-throated defense of financial innovation, says that substantially all financial innovations are good things, and downplays all possible downsides to the maximum possible extent.

The first words of the executive summary are “Financial innovation has a long history of success” — and that very much sets the tone for the rest of the report. Weirdly, the success of financial innovation is invariably asserted, rather than argued. For instance, on the left you can see the report’s list of financial innovations since the debit card. “Many of the historical examples of financial innovation listed in the timeline have at some point been misused and misapplied by market participants, and have contributed to significant financial system disruptions,” says the report. “Over time, however, most have been accepted as beneficial.” The passive voice is telling: nowhere are we informed who is accepting these things as beneficial, or what criteria they may be using.

Looking at this list, I can see three unambiguously good innovations: point-of-sale terminals, ACH, and CHIPS. All of them represent evolutionary improvements in the banking system’s payments and clearing architecture. With the rest, I certainly see a lot of innovations which resulted in banks and other private-sector finance players making lots of money. But was the publication of the Black-Scholes equation really a great thing for society as a whole? Are we better off now that we’ve moved from defined-benefit to defined-contribution pensions? Or, to take a slightly earlier innovation which the report dates to 1968, did the originate-to-distribute securitization model really help society as a whole?

It’s disappointing that over the course of its 92 pages, the WEF report never attempts to answer these questions. Instead, we just get lots of unsupported assertion, like the statement on page 40 that “most financial institution failures and insolvencies are not linked to financial innovations”. Well, I’m glad that’s cleared up. Eventually, we end up with a series of recommendations for regulators. The very first one? “Acknowledge the importance of innovation and its role in a competitive, free-market structure.”

From the point of view of someone who has been writing about the failures of various financial innovations for the past four years, there was very little in the Frontline documentary which was new to me. I would hope, similarly, that the documentary would also come as little surprise to any of the financial-services industry’s leaders. Reading this WEF report, however, I’m forced to conclude that they don’t actually have a clue how bad the 2008 crisis was; how closely the devastating global fractures coincided with various financial innovations; and how much it’s necessary to revisit all our priors in the wake of the worst financial crisis since the Great Depression.

The fact is that there’s almost nothing in the WEF report — beyond the simple fact of its existence — which demonstrates that anything at all has changed since 2008. The world’s most important bankers are desperately trying to convince themselves that they’re wonderful people doing God’s work, and that somehow the financial crisis was just one of those unpleasant hiccups along the way. Which it was, for the people who still have jobs at the top of the financial sector, paying millions of dollars a year.

All of which is to say that the WEF report suffers deeply from an unreliable-narrator problem: sometimes the people closest to an issue are the people who are the least trustworthy on that subject. The Frontline documentary might not talk about how it’s trying to “encourage dialogue among stakeholders” by providing “a taxonomy of potential negative outcomes”: that would be Swiss Re’s Stefan Lippe, a chief architect of the WEF report. But if you want to see what kind of damage the financial sector can wreak, you’ll be much better off with the TV show than with the WEF.

For all that financial innovation has got itself a pretty bad name recently, there’s no shortage of people with bright ideas as to how to address the euro crisis. Robert Barro is one. He thinks the euro should be phased out entirely, and has a plan for how to do just that:

Germany could create a parallel currency—a new D-Mark, pegged at 1.0 to the euro. The German government would guarantee that holders of German government bonds could convert euro securities to new-D-mark instruments on a one-to-one basis up to some designated date, perhaps two years in the future. Private German contracts expressed in euros would switch to new-D-mark claims over the same period. The transition would likely feature a period in which the euro and new D-mark circulate as parallel currencies.

Other countries could follow a path toward reintroduction of their own currencies over a two-year period. For example, Italy could have a new lira at 1.0 to the euro. If all the euro-zone countries followed this course, the vanishing of the euro currency in 2014 would come to resemble the disappearance of the 11 separate European moneys in 2001.

Is this workable? It all depends, I think, on the degree to which contracts could and would be switched over to German law during the two-year period of parallel currencies. While many people might be happy to see their euros converted to Deutschmarks at a rate of one to one, many fewer would be happy to see their euros converted to lire at the same rate. Which means that there would have to be some serious coercion — and a lot of court cases, too — before people holding euro contracts in Italy were forced to see those contracts redenominated in lire.

So while Barro is correct that this approach would help solve the sovereign debt problem, by allowing the likes of Italy to simply print new money to pay off their debts, it would also be a legal nightmare, as every contract turned into a fight between creditor and debtor over which currency it should become. The creditors, of course, would all want the contract to become Deutschmarkized, while the debtors would probably all want their debts to be converted to drachmas at that one-to-one rate. Given that the whole point of European monetary union was that it would become a single monetary union, trying to break it up into 17 component parts is certain to be a legal and logistical nightmare.

Would it be easier, then, to come up with a clever way of keeping the eurozone together? Because Jed Graham has one of those: he calls it Safeguard bonds, which is actually an acronym: Sovereign Approvable First-loss EFSF-Guaranteed Upfront Automatically Recallable Debt.

Graham’s idea is not that easy to understand, so I called him up and asked him to explain it to me. Basically, if countries signed up for a fiscal austerity program, they would be allowed to issue a certain quantity of Safeguard bonds, which would be guaranteed by the EFSF. Then, if at any point they broke free of their fiscal constraints, they would have to pay down 10% of the bonds, immediately, in cash. If you held €1,000 in Italian Safeguard bonds and the country ended up borrowing too much money one year, then Italy would automatically pay you €100 for 10% of your holding, and you’d be left with €100 in cash and €900 in Safeguard bonds; failure to do so would constitute an event of default.

The idea is that this would act as a real fiscal constraint: if a country were to avail itself of this facility, it would then be in a position where any fiscal slippage would be very expensive — because it would have to borrow at a very high rate to make the bond payment. Meanwhile, the EFSF-guaranteed bonds would trade at much lower yields, because of that EFSF guarantee, and because, under Graham’s plan, the ECB would step up and guarantee all Safeguard bonds in the event that EFSF monies ran out.

Because Safeguard bonds would be long-dated and very cheap, countries would have every incentive to use them to fund their current deficits — and thereby lock in fiscal constraint for the next 30 years.

It’s an intriguing idea, but technically extremely difficult to put together — these things are a bit like reverse CoCo bonds, in that they actually punish the issuer when the issuer gets into trouble. And, of course, as such they’re extremely pro-cyclical, if they ever get triggered. If a country suffers a nasty recession and sees its tax revenues fall a lot, the Safeguard bonds would get triggered and it would have to find a lot of extra cash just when it could least afford it.

I’m reminded of a clever idea that the World Bank had in the between 1999 and 2001, called the Rolling Reinstatable Guarantee. It was meant to be a way for the countries that used it — Thailand, Argentina, and Colombia — to reduce their borrowing costs by putting in place a World Bank guarantee which would cover the next coupon payment. In the event of a default, the World Bank would have to make the coupon payment, the country would have to pay the World Bank (because the Bank is a preferred creditor), and then the guarantee would get reinstated. Rinse and repeat.

When put to the test in the Argentine default, however, the mechanism didn’t work. And in general whenever people attempt to solve deep economic problems with the application of clever financial ideas, they fail. The eurozone might break apart, or it might stay together. But either way, financial innovations like these are not going to make much of a difference.

Time’s Stephen Gandel says that Loan Value Group’s Responsible Homeowner Reward program is one of “the 50 best inventions of 2010″:

Under LVG’s patented Responsible Homeowner Reward (RHR) program, banks promise to pay borrowers who continue to pay on time a lump sum — typically 10% of their original loan amount — when they sell or refinance their home. Miss more than one payment and the reward disappears. It’s still early (fewer than 5,000 people have been enrolled), but LVG says fewer than 10% of the borrowers in RHR have ended up defaulting, compared with a redefault rate of more than 20% for other loan-modification programs.

I like the program too, and am hopeful it will have lots of success. But what’s with that “patented”?

It turns out that RHR is technically an invention of 2009, not 2010, if you look at its patent application. Loan Value Group hasn’t actually been awarded the patent yet—Gandel was a little bit ahead of himself there—but LVG’s Frank Pallotta told me that applying for a patent on the idea “was the first thing we did” after setting up the company, and that the patent application preceded substantially all of the time and effort that LVG put in to building RHR.

Pallotta is an expert in mortgages, not in intellectual property, but he did say that he hadn’t personally ever come across a finance company applying for a patent on its idea before.

What’s more, it’s generally accepted that financial innovations can’t be patented: it’s an argument that Sebastian Mallaby regularly rolls out, for example, to defend and explain the secrecy of hedge funds. If you can’t apply for a patent, then the only way to stop people copying you is to operate in utmost secrecy.

But I’m not a fan of this development. For one thing, it’s unnecessary. The barriers to entry in this business are high: Pallotta says LVG has spent millions of dollars over the past few years building and marketing the program, as well as running it by a lot banks, servicers, investors, and regulators. And what’s more, LVG would probably benefit, at the margin, if and when its idea was ratified by the entrance into the market of other people doing pretty much the same thing.

More generally, I don’t want to see a world where people wanting to do positive things in the housing market are stymied by worries over patent suits. There is a worry that sleazy operators will put themselves forward as doing homeowners a favor when in fact they’re doing no such thing, but patent law is not the best way to stop such people. LVG had a good idea in 2009. But that doesn’t mean it should be able to patent the idea, and implicitly threaten anybody else thinking about entering the space with an expensive lawsuit.

Update: Mike Masnick points out 1998′s State Street decision, which was the point at which financial innovations started being patented.

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.

James Kwak has a great response to Robert Shiller’s FT op-ed about financial innovation. But his line at the end about how “for the sake of argument, I am willing to concede that these are useful innovations that would make people better off” has been misconstrued, and it’s worth pointing out that in fact they’re not useful innovations that would make people better off.

Why not? Mainly because, at heart, they’re all variations on the theme of doing-clever-things-with-as-yet-uninvented-derivatives. But that’s a theme which really shouldn’t have survived the financial crisis.

In 2003, Alan Greenspan famously said that ““what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” But, as it turned out, they weren’t. Lots of people wanted to transfer risk, and precious few were genuinely willing and able to take it on: even hedge funds generally prided themselves on being lower-risk than the stock market as a whole.

The result was a system where derivatives were used to hide risks, and shunt them off, unseen, into the tails. A system where hidden risks turned out to be much more dangerous than if they’d all been out in the open all along.

In each of Shiller’s examples, you start with a risk that an individual wants to lay off: the risk that home prices will fall, or that the market will plunge just before you retire, or that inflation or healthcare costs will kick in after you retire. And in each case, the individual tries to lay off that risk elsewhere.

Shiller simply takes it on faith, however, that a nice liquid market can and should spring up to provide two-way prices in such risks, solving lots of problems at a stroke; he doesn’t stop to consider that maybe the reason such markets haven’t sprung up is precisely that there’s no real demand from anybody wanting to take on those risks. In reality, Shiller should know that better than anyone: his much-vaunted house-price derivatives have gone nowhere, partly because no one ever really had any need or desire to go long.

Shiller’s first proposed innovation is an attempt to deal with the regrettable move, in recent years, towards a “popular reliance on housing as an investment”. Only except for suggesting the obvious — moving people away from the idea of housing as an investment, and towards good old-fashioned renting — he comes up with a complex mortgage with all manner of embedded options. As with any derivative, those options will be a zero-sum game, and you can be sure the homeowner is going to end up on the wrong side of it. But Shiller still seems to think it’s a good idea for homeowners to buy them, instead of simply getting a plain-vanilla, easily-comprehensible mortgage, with payments which are set over the life of the loan and which are entirely predictable.

Shiller’s second innovation is target-date mutual funds: I’m almost surprised that he didn’t suggest some kind of principal-protection scheme, involving derivatives, instead. (Maybe because that would have sounded too much like portfolio insurance, which caused the 1987 crash.) But target-date funds are widely misunderstood, and in 2008 some 2010 funds contrived to underperform the S&P 500. They’re a mess, and they’re expensive, and it’s not obvious that they do any good. So color me unconvinced on this front.

Finally, Shiller dreams of annuities which would pay out a set amount of money per month for life, after adjusting for inflation, and which on top would include all healthcare costs. Nice dream, Bob. But there’s a good reason such things don’t exist: no insurer wants to take on a large amount of those kind of risks, and nor would any self-respecting insurance regulator allow them to do so. There isn’t a long-dated derivatives market in future health-insurance costs, but if there were, very few people would have any reason to sell protection against those costs rising, at any price. Sure, a few hedge funds might dabble in the market. But they could never satisfy demand. And in any case, as with the mortgages, the buyer of the annuity would generally lose out, just because of the zero-sum nature of derivatives. Since the cost of the embedded options would be hidden in the price of the annuity, the insurer would have a license to charge through the nose for it, and the buyer of the annuity would never know.

Simplicity and transparency are good things, and Shiller’s innovations go the other way instead. That’s nothing to get excited about.

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.

I’m featured on yesterday’s Planet Money podcast, along with Mike Konczal and Tyler Cowen. I think they give me a fair amount of time to make my points, even though they cut the conversation down from well over an hour to just 25 minutes or so, including a lot of their own background and exegesis. In any case, if you prefer your Felix in audio format, here you are!