Financial Innovation, Again

By James Kwak

I’ve had Robert Litan’s recent paper defending most financial innovation (the web page doesn’t tell you much; you need to grab the PDF) on my to-do list for a while now. I wasn’t looking forward to writing about it, since I’m a bit tired of the subject, and I don’t think I have much more to say. So thankfully Mike Konczal beat me to it, in a two-part series. Part I is really brilliant, and has not one but two insights. The first (to simplify) is that we generally think of innovation in products as making them simply better on all dimensions. We don’t realize that, with most new financial products, we are just getting to a new point on the risk-reward spectrum that wasn’t there before. Now, it might be good for the economy as a whole for that new point to exist. But as consumers, we don’t realize that the good properties of a new financial product are almost invariably counterbalanced by some bad properties.

The second insight is that real, good financial innovation does not look like a new product; it looks like a new way of dealing with an existing product. Konczal’s example is TRACE, a recent system for increasing transparency in the market for corporate bonds (you’ll have to read his post for a more complete description). The effect has largely been to make pricing more transparent and reduce spreads, which is good for investors. More broadly, as Felix Salmon said somewhere (probably many times), financial innovation should show up as lower prices for all the bread-and-butter financial products–equity and debt underwriting, interest rate swaps, etc.–not has higher profit margins for dealers.

Konczal’s Part II asks some more general questions about Litan’s results. I have some different questions.

Litan grades each innovation on three dimensions:

“The table illustrates that financial innovations are appropriately measured or ‘scored’ on three dimensions, of which the net impact on productivity or total output is only one. Financial innovations also have distributional impacts – for example, by expanding access to certain products (loans and investments) – and can affect convenience of the users of financial products and services.”

Litan calls these access, convenience, and productivity/GDP. And here are his scores:

But I don’t really understand these categories, especially the first two. Take “access.” On its face, it seems hard to imagine how a new financial product could reduce “access,” whatever that word means here. So you would expect the kind of grade inflation you see in Litan’s chart. Sure, I see how ATMs make it easier to access your money. I see how index funds make it easier for retail investors to “access” smart investment strategies. But what about CDOs? Litan says that they made it easier for people to access mortgages:

“While it worked, the CDO thus was instrumental in expanding access to mortgage financing to a large class of people who previously could not buy a home. We know now, of course, that many of these subprime borrowers never should have been offered these loans, especially with little or no down payment and with little or no documentation of their incomes (or lack thereof). But some portion of those who received subprime or Alt-A mortgage financing – we won’t know the exact share until the foreclosure crisis has run its course – clearly benefited from it. Thus, on my access and convenience measure, I am inclined to give the CDO a qualified, temporary ++.”

I agree with Litan that CDOs increased access in this sense.  But I don’t think it was a good thing to give people access to mortgages they couldn’t afford. Litan tries to capture this criticism by giving CDOs a — for productivity/GDP. But I don’t think that captures it. I think this increase in access was bad. So if the Access column is supposed to carry a normative judgment, then it should be negative here. Alternatively, I am willing to accept the ++ in the Access column (to mean that CDOs increased access) only if we agree that access itself is neither good nor bad; sometimes it’s good, sometimes it’s bad. But then all those plus signs under Access should no longer be read as benefits of financial innovation, but simply as descriptions (and near-tautological descriptions at that) of one effect of financial innovation.

Something similar goes for “convenience.” What financial innovation would reduce convenience? That’s why you see lots of plus signs. But is convenience unequivocally good? The convenience provided by credit cards, home equity loans, and (indirectly) asset-backed securities and CDOs sure made it easier to overborrow and lose your house. Is convenience always good? I think it’s generally good, but there’s a second edge to that sword that isn’t captured simply in the productivity column.

The weirdness of this chart is underlined by SIVs. Here’s Litan:

“Clearly, given this history, it is impossible to score the SIVs’ contribution to GDP as anything but –. Indeed, by helping banks to circumvent their capital adequacy requirements, SIVs enabled the banks to excessively leverage what capital they did have, which greatly magnified the economic impact of subprime mortgage losses after housing prices quit climbing and began to fall.

“On a positive note, by adding liquidity to the mortgage securities market, the SIVs temporarily enhanced access to mortgages by subprime borrowers and made it more convenient for them to do so. But even a temporary ++ score on these dimensions cannot come close to making up for the financial damage they helped cause.”

So Litan thinks SIVs were bad. I agree. But a casual reader looking across the SIV row will see four plus signs and only two negative signs. Maybe that’s the casual reader’s fault; but I think it’s partly Litan’s fault for creating a misleading chart.

That said, I think most of the details in the paper are good. (Although I don’t agree that venture capital is a financial innovation–for exactly the reasons Litan puts in his paper.) My main concern on that level is that Litan doesn’t always place much weight on the negative side effects. For example:

“As for their contribution to GDP, interest rate and currency swaps reduce the transactions costs of having to sell and buy the underlying loans or bonds. In addition, foreign currency swaps, in particular, facilitate cross-border financial flows, and thus, like futures and options, accelerate globalization and the benefits it brings. My judgment, therefore, is that these arrangements should be scored somewhere between a + and ++ for their contribution to GDP.”

As we now know, currency swaps also help governments hide their debt. And we’ve known for a long time that companies use both interest rate and currency swaps to massage their earnings. That’s a bad thing. Admittedly, it’s hard to quantify. But it should be in there somewhere.

38 responses to “Financial Innovation, Again

  1. “I wasn’t looking forward to writing about it, since I’m a bit tired of the subject, and I don’t think I have much more to say.”

    Sympathies. Laying zombies is tiresome work. I’ve been arguing with glibertarians for decades and still they come on. Even the wreck of their policies does not seem to have dissuaded the most determined.

  2. When solid evidence of failed ideology is sitting in front of someone, and they’re still espousing its merits and ignoring its flaws, you’re not going to slay the zombie. It’s staying alive on faith, and faith by definition does not need rational proof, nor will it heed disproof.

  3. How many times must we fell the same strawman?

  4. Mathematicians or physicists should come up with an irrefutable theorem that shows that a beneficial financial innovation is impossible.

    It would be like creating something out of nothing. It would violate some law of conservation.

  5. What’s the utility in still disproving garbage which has already been endlessly disproven? By now it’s been demonstrated that rationally disproving something only tends to confirm the lie in the minds of those temperamentally inclined to believe it in the first place.

    Thus, going to inordinate lengths to prove that Saddam had no link to 9/11 was found to confirm that belief in those predisposed to it. They found that if a liar said “Saddam caused 9/11″, and then an obsessive rationalist “Saddam did not cause 9/11, and here’s an elaborate proof”, many simply had the meme “Saddam-9/11″ reinforced but failed to enduringly register the “was not linked”.

    The right political response is to refuse to repeat the lie, but counterattack by saying, “You’re a liar, here’s the real truth”, and substitute an aggressive new statement.

    That was always common sense. Why shouldn’t people be suspicious of those who are endlessly patient in refuting nonsense? I know that’s the kind of things wonks like to do among themselves, but in the broader political realm, my suspicion has always been that “liberals” deep down want to believe in a lot of the things they claim to oppose, and their elaborate rationalisms are a way of trying to overcome their own self-doubt, or even to try to find the flaw in their own case.

    How often do I find myself thinking of the Dreyfus Affair these days, in many contexts…like in cases like thise, the way so many liberal Dreyfusards (and the mainstream press) kept trying to rationally explain the proofs of Dreyfus’ innocence, failing to recognize that that was irrelevant; they were in a political knife fight.

    The same is true for financial “innovation” or “trickle-down” today. Both are clearly Big Lies, proven false beyond not only a reasonable doubt but any doubt. Here the “debate” is on the same level as that on evolution. It’s the same kind of culture war, and has to be fought in the same way.

    As one of the Dreyfusards, Anatole France, said, “If I’m accused of stealing the Towers of Notre Dame, all I can do is flee the country.”

    Or fight on the same level. But clearly, rationally arguing that one could not have stolen the Towers would be pointless. And elaborate needle-searching trying to tease out the “uses” and “abuses” of these kinds of financial products only abets the ideology that even after all that’s happened, we should still be asking whether we should allow these things to exist at all.

  6. “The effect has largely been to make pricing more transparent and reduce spreads, which is good for investors.”

    “Reducing the spread” means that somebody who is not as savvy as Warren Buffet or Bill Gross is now willing to bid more than Warren Buffet or Bill Gross for a debt security. In other words, assuming that Warren Buffet and Bill Gross represent near peak market efficiency, this system will cause you to become overconfident and overbid against them and lose money in the long run, just like CDOs and all the other financial innovations.

    I have nothing against bond price reporting, but the notion that innovations will level the playing field is inherently deceptive.

    There is no fair and efficient way to mobilize the capital of people who can’t afford to lose their investments.

  7. I thought that financial innovation was good for the individual investor but bad for the economy as a whole. I thought that this was the lesson to learn from the recent crisis.

  8. I read through his paper a while ago with many of the same reactions. It’s useful to catalog the major financial innovations that have taken place, but the analysis is pretty superficial. The analysis might look a lot different if the author tried to quantify the benefits of these instruments. There has been some research lately discussing how private equity funds misreport returns, for example. It would also be interesting to compare the benefits of some of these instruments (increased market access and lower cost of capital) to the cost of effectively regulating them.

  9. The chart would be more informative if he removed the “access” criterion and added “transparency”.

  10. Innovation in this context should always be bracketed by quotes.

  11. I also find this table vague to the point of uselessness.

    Even the GDP column, which at least references a quantifiable measure, fails to distinguish between short- and long-term GDP growth. So it means nothing.

    The important question, it seems, is whether financial innovations contribute significantly to what financial intermediaries are supposed to do so well: allocation of resources to productive uses.

    A more interesting analysis, perhaps, that would more directly answer that question, would ask whether a given innovation contributes to long-term growth in wealth, as measured by the capital base.

  12. More thoughts.

    1. This paper, in its vagueness, does essentially nothing to answer Volcker’s challenge re: financial innovation.

    2. Fama and French demonstrated long ago that it takes very few players to make a market “efficient.” (i.e. to the point where you can’t tell if the price is “right,” or whether resources are being allocated efficiently.)

    It’s quite possible that the same is true of financial vehicles. You don’t need very many of them. Stocks, bonds, shorts, and futures are perhaps all that’s needed to create an efficient allocation of resources. The rest would then just be a casino, with no resulting increase in the capital base, and a serious downside in systemic risk.

  13. Mr Kwak wrote:

    “The second insight is that real, good financial innovation does not look like a new product; it looks like a new way of dealing with an existing product.”

    “Some economists argue that financial innovation has little to no productivity benefit: Paul Volcker states that “there is little correlation between sophistication of a banking system and productivity growth,”[2] that there is no “neutral evidence that financial innovation has led to economic growth”,[3] and that financial innovation was a cause of the financial crisis of 2007–2010,[4] while Paul Krugman states that “the rapid growth in finance since 1980 has largely been a matter of rent-seeking, rather than true productivity.”[5]

    http://en.wikipedia.org/wiki/Financial_innovation

    Mr. Einstein said:

    “The definition of insanity is doing the same thing over and over again and expecting different results”.

    Mr. Volker said:

    “I wish somebody would give me some shred of evidence linking financial innovation with a benefit to the economy.”
    Mr. Volcker’s favorite financial innovation of the past 25 years? The ATM. “It really helps people, it’s useful.”

  14. Hayek and Mises undertood that freedom depends upon limited government and honest money. Our current situation is the consequence of ninety-six years of dishonest money, and ninety-four years of essentially unlimited government in the service of monopoly capital.

    Financial innovation amounts to systematic fraud on honest savers. It is now impossible to identify value in financial markets, because every financial statement conceals exponentially more than it reveals. All we can expect is more bubbles, crashes, looting, ad nauseum.

    That noise you hear is chickens coming home to roost. Those jobs everyone is demanding are likely to involve spying on your neighbor, patrolling the streets to quell civil disobediance, rounding up the homeless, organizing the parades. Don’t think it can’t get any worse, because the statists are barely getting started.

  15. Well, there’s no there there. Just from looking at the table this guy created, it’s a qualitative assessment of “financial innovations” and not a very good one at that. Convenience for who? Convenience for the seller or the buyer or the thief? Another way to look at convenience is via the risk associated with it. The “assessment” is missing the risk involved in these products. All products involve risks. There’s a risk of loss when you drive your car (1 in 28,000 of death) for example. But risk is conveniently left out of the product assessment. What is the risk of losing your savings in an indexed stock mutual fund? The stock market in 2008 practically zeroed the ten year yields for most indexed stock mutual funds. One might have come out better putting their savings in a CD, since the only losses would be from inflation. Then there’s other risks of loss that are less tangible. Take online banking for example. If you use a Windows PC to do your online banking and you get infected with a trojan malware program, the convenience of online banking with a Windows PC just cost you your bank account. Retail customers may get reimbursed in full, but business customers’ accounts are not reimbursed for theft. I haven’t even touched on the risk of loss of homeowners’savings under threat of foreclosure by mortgage servicers who try to siphon off as much money from the desperate homeowners they can even though they know the house will still be foreclosed on. So, what good is a financial product assessment without cost-benefit or risk-benefit analysis so that people can tell whether their money is safe, moderately safe, or completely lost? Buying a house is not supposed to be a risky endeavour. Many people were told that 401(s) were safe retirement vehicles back in the 1990′s. At what point do people feel like they were conned by an entire industry? The bastards not only take your shelter on the commercial lending side, but they took a 40% slice of your retirement savings as well on the investment side. Yeah, the repeal of Glass-Steagall was a “good” deal – for the bankers lining their own pockets.

  16. When slavery was permitted, you would always find people justifying it on account of differences between races or whatever. Today somebody arguing for slavery would just be regarded as deranged.

    Same with financial innovation. Just ban it. If no one’s making money out of it, no one will try defending it.

  17. “Under free trade, the trader is the master and the producer the slave.”

    US President William McKinley

  18. What is happening is that people are abandoning these ideas. What is left are the hard core. Unfortunately, that includes many people who our “democratic” governments see fit to listen to. It’s going to be years before we reach a new consensus.

  19. Over time, people are persuaded, and especially younger people are persuaded. But the arguments must be made until they are accepted.

  20. Thanks Beth :-)

  21. A different form of financial innovation.

  22. Was not Mr. Litan one of the prime cheerleaders for the demise of Glass-Steagall and private securitization? His CATO paper recounts the joys of how Greenspan’s Federal Reserve promoted deregulation via its rulemaking powers.
    http://www.cato.org/pubs/journal/cj7n3/cj7n3-12.pdf
    There is also this lovely blueprint for the 21st Century with a preface by Robert Rubin:
    http://books.google.com/books?id=akvwL8hqZSQC&printsec=frontcover&source=gbs_navlinks_s#v=onepage&q=&f=false

    Methinks his interests are too vested, as is his “analysis.”

  23. CBS from the West

    Couldn’t agree more.

    Over many months there have been lots of comments on this blog discussing whether those who took out mortgages they can’t afford are scammers, merely irresponsible, or just victims of those pushing these instruments. There is no easy answer to that question. But getting back to transparency and “boring” banking would make the whole point moot.

    I’d be willing to bet that over the decades, few if any homebuyers ever understood their mortgages. I know only a handful of people who can remotely explain how the monthly payment is related to principal amount, term, and interest rates.

    But back before financial innovation, it didn’t matter. When you went to shop for a home you could look at the people and cars in the neighborhood and get a pretty clear idea if you were in that economic league. You didn’t have to worry that the home price was in some bubble, because the banks required a legitimate, independent appraisal of what would become their collateral to hold for 30 years. When they told you the monthly payment, you could be sure you would always be able to afford it (unless you lost your job) because it was never going to change. And the bank wouldn’t even give you the mortgage without proof that you could afford the payments. Buying a house required no more understanding of a mortgage than driving a car requires knowledge of automotive engineering.

    These underpinnings of a sound housing market began to erode with the introduction of ARMs (an admittedly reasonable response to the wild inflation of the 1970′s), and were completely gutted with sub-prime, alt-A, and the securitization of those. All of this needs to stop, plain and simple.

    One more thing: in my field, health care, we often talk about “access.” Often we are genuinely concerned about sick people who need care and can’t get it. But nowadays, when you hear the health care industry talking about access, likely as not what they really mean is their access to your money! Access has become a “weasel word.” I think Litan’s table is another example of that.

  24. Many good comments.
    The ultimate problem is that the industry has a huge amount of money and get get anyoine to say anything they want for as long as they want. Plus you have lobby money, and political donations that gain influence and access. This isn’t about being right. this whole crap is about giving those who make policy plausible deniability. then they can say the data was unsure, not concrete, etc.
    the whole thing is a theater. Everyone knows what the truth is (excpet maybe the general public which is made up of fools) but now the guy who allows the innovation to pass in his congressional committe can justify it. You really think Rubin, Summers, Paulson, geitner and others didn’t know there were potential problems with gutting regulations. Of course they did. The best way to think of the efficient market theory is that it waws a theory that was invented and adopted because it justified a way for the crooks to maximaize their profits with the least government getting in their way.
    Take the problem, spin it backward, then justify it with a theory. “how do I justify making the most money, with the least regulations?”. answer: efficient market theory and you know why the crap was adopted. Notice they never adopt paradigms which limit their income. This is how you know they are full of BS

  25. I can’t believe Litan gave private equity a + on GPD/Productivity. I guess he never heard of Simmons Mattress. Or read http://www.amazon.com/Buyout-America-Private-Equity-Credit/dp/1591842859

  26. Economics is not a hard science. Originally they tried to mimic physics and math to model capitalism but it has been already proven that most of economic models are pure drivel.
    Whether it is statistics, quants or what have you. It is trying
    to model a non-linear world where man cannot model path
    of a billiard ball after certain iteration, how can you expect to model the real world. Statistics are suppose to find pattern in a random, noisy data. Again this is just trying to pattern match until something doesn’t fit then we come up with another useless theorem. In fact quants (main culprit in the economic collapse) are being used in political science department even after the collapse.

  27. This is a great point.

  28. I meant Russ’s point linking the current climate to the Dreyfus affair.

  29. This may be repetitive or besides the point, but speculation with credit default swaps is a big mess, oil price speculation makes me pay an extra buck or two for each gallon of gas I buy (although this is almost never brought up) and, incredibly, the total derivatives market is something like $500 trillion and currently growing by leaps and bounds, due to the lack of financial oversight, business as usual by all financial institutions.

    It’s either Citi or B of A – one of them has in the works a product companies can buy which makes them a profit if their business collapses/defaults. Wonderful, isn’t it? Credit insurance which motivates mayhem in the markets, the collapse of capitalism and everything else. Back to cave tribes and anarchy. Some Nihilist has finally figured out how to end the double-dip recession – end the process.

  30. Modern financial innovation has been described as a form of — alchemy — one of the kinder perjoratives. Eg, the financial products that lead Greece to the brink of bankruptcy is “alchemy”.

    Which brings me to this question. What is IOFM? I genuinely do not know what IOFM is the acronym for. (I Owe Funny Money?)

  31. tippygolden rote:

    “Modern financial innovation has been described as a form of — alchemy…..”

    “Alchemy, originally derived from the Ancient Greek ….. an ancient practice focused on the attempt to change base metals into gold.”

    Also known as credit derivatives. In practice it seems to work in the opposite fashion. :-)

  32. Yep … working on a Baseline Fable called “The Alchemists”

  33. Brooksley Born and the Trolls!

    You’ve innovated a new mythology, and I’m grateful.

  34. thanks Zic

  35. Finanicial “innovators” are “innovating” to make more money for themselves and their buddies, not to serve any broader interests or any social good. “Access” or “convenience of users” are not even on these guys’ radar. Rather it’s: How do I get as much money as possible, as quickly as possible, without going to jail? That’s it, and leave the PR to others.

  36. DakotabornKansan

    “Innovation has now cost us $7 trillion. That’s a pretty high price to pay for innovation.” (referring to the loss in household wealth that has resulted from the economic crisis) – Martin Mayer, Brookings Institution – quoted by Gretchen Morgenson/ It’s Time for Swaps to Lose Their Swagger/New York Times/February 27, 2010

  37. As a former Information Technologist who believes in “innovation” I take offense to the Wall Street casino salespeople calling most of these “new” products “innovations” when what they really are in most cases are products of mass confusion or even deception: more complex, less transparent, at the worst of times less liquid. It has been widely reported that many of the CEOs of the companies who caused the current calamity did not understand the possibly mortal risks that they were placing on their firms, the money and security of their clients, and the economy at large. I don’t know if these products could be safe if regulated or even if they can be regulated, but after such an awful result, the finance industry should not be given a second unfettered chance to destroy millions of people’s economic security and almost completely destroy the world economy.

    In my opinion, many of these products are not innovations at all, only a screen for excessive leverage – plus a lot of grand larceny, which nobody even talks about. If you read about the investment trusts of the 1920s, they were supposed to be innovations also, but again they were merely screens to obscure excessive leverage and big helpings of larceny. They also ended the same way.

    “No investor ever went broke failing to invest in a new mutual fund product.” You would rarely go wrong by following this simple advice: if it is called a “new product,” particularly if it is called a “hot new product,” do not invest in it. – Bogle on Mutual Funds, 1994