In Defense of Financial Innovation

Financial innovation is taking quite a beating these days.  Only one man is brave enough to stand up for it. At least, I think he's a man. But that probably just goes to show how deeply I've internalized a heteronormative patriarchal cultural paradigm.

The point being that Economics of Contempt has some very, very interesting things to say about financial innovation, and why it doesn't make any more sense to be against financial innovation than any other sort:

It looks like it's time for everyone's favorite whipping boy, "financial innovation," to come in for another round of mockery in the blogosphere. Simon Johnson and James Kwak make all the familiar arguments about CDS and CDOs, neither of which they seem to understand in the slightest. Their discussion of CDOs is particularly specious:

The magic of a CDO, as explained in the research paper "The Economics of Structured Finance" by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in how CDOs can be used to manufacture "safe" bonds (according to credit rating agencies) out of risky ones. Investors as a group were willing to buy CDOs when they would not have been willing to buy all the assets that went into those CDOs. We don't have to decide who is to blame for this situation--structurers, credit rating agencies, or investors. The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made-because they destroyed value.

This is usually how CDOs are portrayed these days: they're obviously voodoo finance, because--get this!--they claimed to take a bunch of risky bonds and transform them into a super safe bond. What a ridiculous idea, right? Now do you see how useless financial innovation is?

Of course, this isn't a remotely accurate description of CDOs. Notice how they conveniently leave out the explanation of how CDOs transform risky bonds into a safe bond. They do this through subordination and various other credit enhancements. Say we have a CDO with a $100 face value, backed by a pool of BBB-rated mortgage-backed securities. The CDO sells three classes of bonds: an equity tranche, a mezzanine tranche, and a senior tranche. Investors in the equity tranche will take the first 10% of the losses; investors in the mezzanine tranche will take the next 15% of the losses; and investors in the senior tranche will take the rest of the losses. Investors in the senior tranche wouldn't suffer any losses unless and until the total losses on the CDO exceeded 25%, so we'd say that the senior tranche has a subordination level of 25%. When Johnson and Kwak say that CDOs "manufacture 'safe' bonds out of risky ones," the "safe" bonds they're referring to are the senior tranches. But as you can see, the idea that the senior tranche would be "safe" isn't at all ridiculous--after all, there's almost always some level of subordination that will make the senior tranche a safe investment.

The problem, in very broad terms, was that the lending standards on the underlying mortgages significantly deteriorated, while at the same time the rating agencies were handing out AA and AAA ratings to tranches with lower and lower subordination levels. I can't find a similar chart for CDOs, but this chart of CMBS subordination levels is instructive (the trend for CDO subordination levels was similar):


But of course, we get no discussion of low subordination levels--or even the idea of tranches--from Johnson and Kwak, who use the term "CDO" as some sort of trump card, the mere mention of which automatically ends any debate on financial innovation. This apparently passes for Serious Commentary nowadays.

There are certainly problems with financial innovation: it's hard to price, hard to regulate, and someone always gives into the temptation to take things too far.  But most of the financial instruments we use today were once dangerous financial innovation, with all the attendant problems.  It took us a long time to evolve regulatory standards and pricing frameworks for stocks and bonds that made them safe enough for home consumption . . . and nonetheless, we had the tech bubble, which was innovative only in the rationales cooked up to explain why valuations should depart so radically from historical norms.

I suppose there's an argument to be made that the pace of innovation is simply moving too fast, so that neither economic theory, nor the regulatory agencies can keep up with it.  But I'm not sure what you do with that insight.  Stop innovation altogether? It's hard to think how you actually do that without pretty much crippling your financial system, it won't keep bubbles from developing, and as Economics of Contempt goes on to illustrate, some financial innovation has turned out to be a very good thing.  We need to focus on developing the regulatory capacity to sort out the good innovations from the bad.

Of course, that's really difficult, particularly if you insist on paying your top-level financial regulators about what a secretary at Goldman Sachs makes.