Financial Innovation for Beginners

(For a complete list of Beginners articles, see Financial Crisis for Beginners.)

Kevin Drum pointed me to Ryan Avent’s insightful review of Ben Bernanke’s recent speech on financial innovation. (How’s that for the Internets in action?) Bernanke’s brief was simple: to defend financial innovation in general while acknowledging that at the margin it can be counterproductive and may need to be more closely regulated. “I don’t think anyone wants to go back to the 1970s,” he said in a line that was clearly supposed to make his point. Unfortunately for Bernanke, Avent was listening closely. His rejoinder:

neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in…the 1970s.

With one exception:

Tasked with defending deregulation as a source of financial innovation, Bernanke reached for subprime lending.

This helped at least partially crystallize some thoughts I have had floating around about financial innovation for a while.

Where I come from (career-wise at least), innovation meant that you invented something that people wanted, or you figured out a cheaper way to make something that people wanted, or you figured out a way to improve something that people wanted. Think of the iPod, or floss with a thin coating that makes it slide between your teeth more easily, or those little plastic things that keep the tips of your shoelaces together. These are things that make our lives, in aggregate, unequivocally better.

Financial innovation, however, comes in two forms. There are financial innovations that make our lives easier. One is the automated teller machine (ATM). ATMs are great. They mean that you don’t have to wait in line at bank teller windows or rearrange your schedule to go to the bank when it is open, and most importantly you can get cash at any hour if you need it . . . almost anywhere in the world. I would pay real cash money to use ATMs if I had to (and occasionally I do, if it’s not at my bank). Another example is the debit card, which saves me the trouble of dealing with cash altogether. There are corporate versions of these innovations, like corporate purchasing cards, which help automate the process by which employees buy stuff for their companies and get reimbursed for it. These types of innovations increase the quality of service and reduce costs – it’s hard to argue with that.

The other kind of financial innovation has to do with extending access to credit. Here I think it’s less clear that innovation is unequivocally good.

It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)

Securitization is one innovation that helped overcome this problem and increased access to credit, and I think securitization on balance is a good thing. But it’s not in the same category as the iPod, or better floss, or better shoelaces, which are things that make people’s lives better directly. Securitization is something that increases access to credit, which may or may not be good, depending on the context.

The effect of securitization should be to moderate differences in interest rates – mortgage rates can come down as money moves into Florida, but they may go up as money leaves Iowa – and perhaps to lower them overall by making more money available to the market as a whole. If we were in a situation where too few people were getting mortgages, this is a good thing. But it is also possible for too many people to be getting mortgages, as we now know. Something similar happened with venture capital and startups over the last fifteen years. After the IPO rush of the late 1990s, billions of dollars of new money piled into the VC industry; that money flowed to thousands of companies that should never have gotten funded, resulting in lost money for investors and lost time and effort for thousands of generally bright and well-meaning entrepreneurs. Even credit cards – which I think most people would say are on balance a good thing, and which I personally use multiple times almost every day – can sometimes be a bad thing: they can prompt people to make unwise purchases they might otherwise not have made, with negative consequences for themselves.

In short, financial innovations whose sole function is to increase access to credit do not in and of themselves make the world a better place. They can help by providing the credit that people need to make the world a better place, but they can also make it possible for people to do irrational and economically destructive things. So when people say that innovation is the source of all progress, that may be true – but not all types of innovation are equal.

You can stop reading here if you want; I’ve made my main point.

The story I’ve told so far is a little simplistic: real innovation is good, some financial innovation is good, but some financial innovation just pushes money around, which could be good or bad. What’s simplistic is the clear line between “unequivocally good” and “double-edged” types of innovation; many innovations are double-edged to some degree.

Imagine we invented a new way to make a whole new class of light, strong, flexible, and cheap materials that made it possible to manufacture millions of different products more cheaply, vastly increasing the material wealth of middle-class households. Wait a second – we did that. They’re called plastics. In the process, we accelerated the depletion of our natural resources including fossil fuels; we created an enormous amount of garbage that is now collecting in giant pools in the middle of our oceans; we poisoned our waterways; and we may be poisoning ourselves as toxins leach from our containers into our food.

The point of this caveat is that many innovations, even “real” innovations, can have negative aspects. (And if those negative aspects are externalities, they will not get incorporated into the aggregate societal decision to produce and consume the resulting products.) So it is never appropriate to say that innovation is always unequivocally good. Still, however, there is a difference between better shoelaces and option ARM mortgages – or between ATMs and option ARM mortgages. The former is a product or service that provides utility directly; the latter is a financial product that enables people to use their money in ways they could not use it previously, with consequences that can be good or bad.

Update: That thing on the end of your shoelaces is called an “aglet.” Thanks to Teotac. See also K Ackermann’s comment right before Teotac arguing from first principles why that thing must have a name. Now, the reason I thought of that example is I vaguely recall hearing in a TV show about someone who made a fortune by inventing those things. But I can’t remember if it was a fiction or nonfiction show.

Update 2: Nemo pointed out to me this brilliant Michael Kinsley article on Avis. It’s only tangentially related, but still a fun read.

By James Kwak

71 thoughts on “Financial Innovation for Beginners

  1. I think there is an additional downside to the expansion of credit that you have not mentioned. When credit is extended into a particular line of products or services, the prices of those products get bid up.

    Two examples come to mind. One is personal–I once lived in a cooperative apartment building where mortgages were not permitted. Then, the Board changed the rules, initially requiring 50% down payment, and then ultimately allowing 20% down payments. With each change, the prices for apartments soared as more potential buyers entered the market to bid them up. It was a great windfall for the original owners, but clearly the buyers were disadvantaged and paid much more than they would have otherwise. (Well, of course, some would not have ever bought because saving up the price was not in their plans.)

    Another good example, I think, is higher education. Fifty years ago, education loans were hard to get and tuition at colleges and universities was relatively low. Admittedly, some people were priced out in those days. Then, a flood of student loan money was made available, intended to make higher education more accessible to everyone. Certainly enrollments went way up, and the education industry grew massively both in terms of numbers of institutions and their size. In that sense, it worked.

    The education product has been “improved” by adding lots of student services and other amenities, but the basic product, learning, if you will, is IMO unchanged.

    Meanwhile, tuition and fees have gone up far faster than general inflation and today the typical college student graduates with 5 or 6 figure debt. Those who complete graduate or professional school nowadays are in a state that is best described as indentured servitude.

    So it seems to me that the net result has been to expand enrollment and bloat the system with frills, but education has actually become less affordable and increasingly paid for by the age group who can afford it least! Another price that has been added on is that many graduates forgo the careers they really wanted to pursue because they must do something more lucrative in order to meet their loan payments.

    Cui bono? The banks, of course.

  2. I think one of the things that don’t get talked about enough is the lack of finance education. Not the Gaussian Formula kind of finance education, but, paying your credit card in full is good — kind of finance education. Readers of this blog will probably find that too obvious to be taught, but you’d be surprised to see the kind of questions people have with respect to their finances.

    A lot of this financial innovation is making people relatively dumber, because the world around them is getting more complex. That needs to be addressed using some sort of financial education that is absent in today’s world.

  3. I find the argument that securitization caused this situation terribly frustrating; it’s like securitization is the SUV of the financial realm. I never heard anyone suggest a decade ago that trading ownership interests in a company was a terrible innovation.

    We had extremely accommodative interest rate policies and a global savings glut. Investors changed their standards. And our government is now rewarding them for it.

  4. Before the 70’s companies didn’t widely use hedging for protecing their commodity positions, and I had surmised all of these years, that this kind of corporate hedging is what prevented wild swings in inflation…but as much as this hedging helped level out seasonal surprises, i am afraid that that effect has been negated by the powerful effects of derivatives that were made on “blue sky” that is, mortgage back securites…instead of letting the players in this arena die off a natural death, they have been strengthened with every last dollar our country can print–now we are back to facing wild swings of inflation in the future.

    But, if you consider the fact that even a little tiny player in the market like me could figure out that there was a huge bet on Lehman via shorting and CDSs, and for Paulson and Bernake to deny the 6 billion dollar bridge loan in effect giving every big player on the street an immediate win, it goes to show how our trusted government officials paulson and bernake really deceived us and misused our trust by refusing Lehman the bridge loan then insisting that money flow through AIG instead of taking it into receivership.

    Little players aren’t making even a tiny ripple in the dark pond of effects from financial innovations being bought and sold. But, just like the bank oligarchy being destructive, large players have affiliated companies and funds, and more funds created, and essentially they can put on the same trade across many different companies without being noticed.

    If I don’t really don’t know or understand the fine points of financial market regulations, consider how an average citizen might have no idea what i am even talking about! This is why there are laws for fiduciaries, detailing what is required, and i don’t see that paulson or bernake are above these laws, nor are the stakeholders that benefited from the self dealing that was done.

    Integrity is needed when a person or government official acts as a fiduciary, and it has been a long time since we could depend on the integrity of our government and regulators. It is the mystique conveyed in the idea of financial innovation that has been a device used to manipulate and decieve the public massively, and now used to run a machine that is like a massive ponzi scheme called “quantitative easing” Ask an average person what that means!

    The complexity of financial market innovation is the perfect front for those who want to deceive and manipulate,…but when you boil it all down none of it really is all that complex…we just need to dispell the mistique and ask for honesty and integrity in our leadersm and purge our system of the evil that has infected it with private bankers winning when America looses.

  5. The point regarding education is one that I think perfectly illustrates the relationship between access to credit and asset prices. I graduated from an elite new england private school in 2008 with 6 figures of debt, largely because I was lucky enough to be enrolled during the greatest credit bubble this world has ever seen. The ironic twist is that, when the financial aid dept was doing their calculations for my family, they used “home equity” as an indicator for wealth. Good thing our “home equity” was at inflated levels as the price of our home tripled in value from 1999 to 2007. So for the years I was in college, because of this inflated measure of wealth, instead of getting aid, my family got saddled with loans. Now, that same home has fallen in value back to its 1999 level. Great. If we wanted to sell the house, the mortgage would be covered, but not my 6 figure mountain of student debt.

    Ultimately, I believe that I should bear the consequences of my decision to spend the money on a private education rather than the local state school. However, because universities are set up as non-profit institutions (with tax advantages), I do believe that they should not hide behind the argument that they are charging the “market rate” for their service. Surely, Ivy League colleges could charge double what they currently do if all they wanted was to enroll those who were willing to pay for it. But that’s not the point of higher education.

    Here’s a secondary consequence of this mountain of debt: My school was an elite technical school in the Boston area (whom one of the authors should be quite familiar with), where the large majority of undergrads study some form of engineering (around 33% are in electrical engineering or computer science). However, somehow when it came to job time, of the 2008 graduating class 27% went into finance, and 13% into management consulting. Now, maybe 40% of my class are actually destined to be business and financial hot shots as opposed to engineers. BUT, I would venture to guess that when you’re staring at a mountain of debt, the 6 figure salaries that first year analysts on wall street took down in 2006 and 2007 would look mighty tempting…

  6. Technical point: inexpensive plastics are, in fact, by-products of fuel production–they’re made from what’s left over after fuel is made from petroleum. If we abandon petroleum as a fuel source, as is very likely, plastics will become much, much more expensive and much less of a problem. Presumably we will return to biologicals.

  7. Nissam Talib’s article on April 8, 2009 in Financial Times”10 Principles for a Black Swan proofworld” actually suggested outlawing derivatives,…wow, when you consider the dangers and no the fact that there is likely no way around a system not being gamed, it makes me wonder…

  8. An “innovative” financial product, is one that operates smoothly, unnoticed, and should be taken for granted. What I have said many times, is that “finance” is now viewed as an industry, which it is not. Finance is a service, and should be treated as such in the future. Manufacturing is an industry…finance is not. Exactly how many “innovative” financial products can there be? On-line banking is innovative, as are ATM’s. I believe when I-Banks got mixed up in securitization just for securitizations sake….things got convoluted. Securitization to spread risk is probably a good thing, no doubt. But once you introduce greed and I-bankers into it in a big way, well, we all know what happened. Seperate the bankers from the politicians too…a good place to start. Also, STOP hiring Wall Streets lobbyists and retired CEO’s to work at the Fed and treasury. They are NOT acting in YOUR best interest.
    Keep it simple in the future, and put a leash on your bankers.
    My 2 cents.

  9. “There are financial innovations that make our lives easier. One is the automated teller machine (ATM)…”

    The ATM isn’t a financial innovation, is it? It’s a product innovation that has much more in common with the ipod: it’s about convenient access to something you already have (your money or your MP3 files). ATMs don’t allow new types of transaction or really any different behaviors.

  10. IMHO, the fundamental problem with the cost of higher education is not the “frills”, but rather the dramatically increased emphasis on publishing to gain tenure at even mid-tier and low-tier institutions.

    This has been met with a proliferation of lower-quality journals (well, at least less competitive journals). Likewise, tenured professors rarely teach more than a few classes a year. Once they’ve done preparation for a course, if a tenured faculty member teaches 2 courses a semester, that’s 6 hours of teaching a week for only 26 weeks out of the year. (Then they have 26 weeks of vacation.) We expect 9 hours out of class for each 3 hours in class, but in practice this is much less after the first couple years. And “office hours” are often spent on… publishing. The typical tenured faculty member at a tier 1 institution spends perhaps 15 hours a week (generously) on teaching and teaching related activities for about 30 weeks out of the year (including grading finals), which averages 10 hours or less over the entire year. At tier 2 and 3 institutions, the demand is somewhat higher – perhaps as many as 3 classes a semester (an impressive 15 hours a week averaged over the course of the year).

    This model is focus on tenured faculty for status (rankings), which means focus your best minds on publishing, and then hire adjuncts to teach. Teaching is viewed as a necessary evil, NOT the primary function of a professor.

    This is heavily supported by the incentive structure as well, and over time the selection-effect has caused those professors who do focus on teaching to fall out of the system. So the remaining professors actually _like_ research more than teaching, and reinforce the incentive structures that ensure research remains the chief priority at their institutions and in their professions.

    In that sense, the “problem” with finance – bad incentives – is just as bad as the problem in academia. This is the first year in many that tenured faculty are coming under pressure to teach slightly more (as universities cast off cheap adjuncts who don’t have job security).

  11. Well, actually ATMs do allow new types of transactions. Namely, a bank or company owns the ATM, but even if you aren’t part of that bank you can still get cash. (You pay a fee.) You can’t normally walk into a branch of Chase and pull out money if you aren’t a customer. Obviously there are IT considerations, but there is also a financial innovation requiring greater levels of integration in the banking system.

  12. I have the ultimate financial innovation.

    It’s called Infinite Money for All. Go into a bank and take all you “borrow.” One condition: you will pay some interest on what you take. (Of course, you can always take more money to cover that interest.)

    All the financial innovations ever invented, and will ever be invented, sit on an innovation continuum with Infinite Money for All at the endpoint.

    The ultimate innovation will take one business day or so to blow up, so you better be quick. The time to detonation for all other financial innovations, including fractional reserve lending, is a function of how much “innovation” they have.

    That time is now.

  13. The so many and repetitive references to financial innovations are plain silly. What we most suffered from over the last years and which caused the current crisis were not really financial innovations but regulatory innovations.

    The regulators innovated and said “we have to control for risks” and so they allowed for incredible leverages as long as they perceived default risks were low and appointed the credit rating agencies as their official risk sentries… and then they went either to congratulate each other for a job well done or to sleep.

    And what did these brilliant risk sentries do? They gave AAA ratings to securities collateralized by very traditional and awfully plain but never before so badly awarded mortgages to the subprime sector.

    And who were the ones who took advantage of that regulatory faux-pas? Was it Simon Johnson’s bank oligarchs? No! It was some few investment banks who packaged the securities and then cadres of real-estate and mortgage brokers who not believing their good fortune, or much less understanding how someone could want such lousy mortgages, delivered them like pizzas, making real good money.

    Now about the issues that should really be discussed no one speaks. Like for instance how can you build up a system based on some non-transparent credit scores and that now have many parents in the US worrying and caring more about their children’s credit scores than about their school grades? Like for instance, how can you settle for a system where your credit officers stay glued to monitors instead of walking the street learning their clients business, looking in their clients eyes and shaking their clients hands?

  14. I hate to be the bearer of bad news, but there may be a significant conflict between two possible objectives described by various posts on Baseline:

    1) Cut down the size of financial institutions

    2) (Possibly) limit securitization

    Note that _logical_ argument for securitization is to facilitate the distribution of risk through a market mechanism. This allows small savers, or small institutions, to “buy into” much larger assets that they normally could not have any ownership in. In essence, it’s like the stock market – I own a tiny sliver of several large companies in my 401k.

    Without securization, we would require complex (ad hoc) legal contracts to facilitate such risk sharing, and the cost in writing those contracts would exclude smaller players.

    The absence of securitization _encourages_ the existence of big finance, and the concentration of huge assets in big banks. This is how big transactions (buyouts, etc.) get financed.

    The challenges with securitization appear to be information-based. 1) small participants don’t have good information, and so rely on sleazy self-serving ratings agencies 2) small participants don’t have anything close to the kind of access that large participants have in ad hoc deals 3) small participants lack expertise

    There may also be challenges with liquidity – in other words, there is an INHERENT CONFLICT in whether liquidity is a good thing:

    1) The derivatives market NEEDS to be liquid in order for the market to generate enough information to understand the true price/value of the securities being traded.

    2) HOWEVER, if the market is sufficiently liquid, then it is almost certainly highly volatile. But UNLIKE the stock market, which is EQUITY-BASED, the securities market is CREDIT-BASED, and therefore highly leveraged. Volatility in such markets is incredibly damaging to the entire system.

    In short, I would offer two main conclusions:

    A) Yes – there are theoretical arguments in favor of securitization, but in order to achieve these benefits, you inherently suffer incredible volatility in credit-markets (and that volatility has immediate impacts on legal capital requirements and indeed the solvency of various institutions, as well as the money supply itself).

    B) If we do away with securitization markets (which I mostly favor), we must recognize that this creates problems with banning institutions that are “too-big-to-fail” in a modern economy with global mega-corporations that require massive credit-transactions for single projects (consider Dow Chemical’s 9 billion dollar attempt to invest in a single chemical plant). In other words, big finance will need… big finance. This doesn’t mean big deals are impossible, but it could disadvantage US banks relative to other international banks. (Or, the US govt. could start to make direct investments, as some other countries do.)

  15. Note: The latter argument about the inherent conflict between the anti-securitization position and the anti-big-banks position does NOT apply to the mortgage market. (Nor do I see a problem with capital immobility across US state boundaries in the days of internet banking.) Thus, there seems to be a strong argument for limiting securitization to very large transactions, and re-creating the basic savings/loan model of community banking for house loans. For the life of me, I do not understand the technical arguments in favor of bundling and securitization of _small_ assets. Rather than PIMPCO buying CDOs, can’t they just buy bank bonds and invest in bank equity? Aren’t the bank equity and bond markets are lot deeper, better understood, and less vulnerable to manipulation by lousy ratings agencies than the CDO market?

    Or do we believe that the stock and bond markets are so messed up that we need CDO and CDS markets – which presumably are more liquid and stable (uh, right…)?

    If anyone can explain to me even the shell of an argument about how the CDO market really makes life better for small loans, I would be grateful.

  16. Yes, the investment bankers reaped unusually large rewards for what appears to be a bad kettle of fish, But people often fail to realize that the ACTUAL dollars that vanished, really went to the sellers of the over-inflated houses. It was the sellers of the real estate assets that got the proceeds of the loans. So, who actually got the cash from the proceeds of the mortgages? The sellers of the bricks.

  17. What, exactly, is the technical argument as to why we need to bundle and securitize home mortgages when we have a very liquid stock market to provide banks equity, a very liquid corporate bond market to provide banks credit, and a highly nationalized mortgage market due to online banking and the ability to search across multiple lenders?

    But I do agree that killing CDO securitization doesn’t fix the problem by itself. SJ and JK think the fundamental issue is too-big-to-fail (aka, moral hazard). I think the fundamental issue is excessively low capital asset ratios (aka, volatility and systemic risk).

    … but I do think too-big-too-fail may be closely related to the problems with capital-asset ratios. Community banks, for instance, are concerned that Basel II may put them at a disadvantage:

    “A paper released last year by J.P. Morgan Securities Ltd London entitled “Basel II—And the Big Shall Get Bigger” concludes that if Basel II were to be adopted in its present form, the Basel II banks would have a “decisive competitive advantage” over other banks and will look to expand and arbitrage their capital by purchasing smaller, less sophisticated banks.”

    Click to access stmt092606.pdf

  18. Adios Amigo writes “So, who actually got the cash from the proceeds of the mortgages? The sellers of the bricks.”

    Not necessarily Amigo. The following is another quite different take.

    The financial engineering bubble!

    If you have been able to convince Joe to take a 300.000 dollar mortgage at 11 percent for 30 years and if then, with a little help from the credit rating agencies, you can convince Fred that the risk structure of this mortgage is such that it merits an investment at a rate of only six percent, then you can sell him the mortgage for 510.000 dollar, and pocket a tidy profit of 210.000 dollar.

    We then have Joe, with a real liability of a mortgage of 300.000 dollar guaranteed with a house that might o might not be worth it, and Fred, with a 510.000 dollar investment in the willingness of Joe to service his original mortgage at 11 percent for 30 year.

    And so, when all is sliced and diced, 210.000 dollar of this 510.000 dollar toxic asset has little to do with easy money or a house bubble, and all to do with the wizardry of an immense structured-finance-endorsed-by-the-credit-rating-agencies bubble.

  19. I think there’s a fundamental difference between the coop and education. In a capitalistic society, the costs of labor-intensive goods always increases as the cost of material goods declines because of productivity increases. That’s one reason health care and education are so costly — we can’t get the same economies of scale in those areas that we do in production. Both health care and education have been following the same projectory — ever increasing costs. And there’s no “credit” issue with health care – and that has resulted in a declining percentage of Americans having access.

  20. The vast amount of financial ‘innovation’ has simply been a scam that hid risks and allowed actors in the financial sector to pocket profits. If you could make more money by selling risky products that didn’t seem risky to the consumer, why wouldn’t you do so? Because you won’t be in business long term? Would you really care if you were pocketing an 8 figure income in any particular year? It’s absurd to think people operate in any other manner.

  21. Another technical point: those things on the end of shoelaces have a name.

    I don’t know what it is, but there is a machine, or part of a machine that makes those things appear on the end of shoelaces.

    If it’s an entire machine, then the inventor of the machine would want to tell their spouse and friends what they are doing, and after a while would get sick of saying, “I’m making a machine to put the things on the end of shoelaces on the end of shoelaces.”

    In fact, the original inventor of such a machine would be at a complete loss to explain what was being invented because nobody would know what was supposed to be on the end of shoelaces at that time.

    There is also the problem of marketing such a machine. How would you market a machine that makes the things that go on the end of shoelaces before people knew what was to go on the end of shoelaces?

    Maybe it is not a separate machine; maybe it is just a part of a shoelace-making machine. “I’m making a shoelace-making machine,” would be easy to convey to friends and family, and marketing a shoelace-making machine would be a magnitudes simpler.

    However, what would you write in the repair manual for the part of the machine that makes the things that go on the end of shoelaces?

    It’s for all these reasons I can safely say that these things have a name.

  22. All the ratings agencies are still in business, providing the grease for this Rube Goldberg device, finance. Taleb is certainly not the first to suggest outlawing derivatives, but it is easy to agree with him. Every auditor and enforcement body can be comfortably considered coopted. We don’t need this garbage, and if it doesn’t exist, then we don’t need to worry about who’s watching the watcher. Let’s get rid of the con-game of the ratings agencies and the things they rate as well. Just as we really don’t need plastics, we don’t need this.

  23. The banks sure are funny in the way they screwed everybody. They offer loans with no questions asked using teaser rates. It didn’t matter; either someone was going to get screwed paying the reset rates, or they wouldn’t pay at all. Thanks to securitization, it didn’t matter one bit.

    What would be funny is if someone dumped a couple of barrels full of old motor oil on their property that is being foreclosed. They could then report a suspected toxic waste spill and the banks would be on the hook for removing and disposing the top 10 feet of soil on the property.

  24. Hi Statsguy –

    I have no doubt you’re right about this:

    In other words, big finance will need… big finance.

    Although of course that doesn’t mean we need big finance.

  25. What’s most interesting to me about this post is that, although I agree with it given its presuppositions, I’m unable to find the presuppositions convincing.

    It is certainly possible for a society to be below the optimal level of access to credit. Consider the idyllic banking paradise that gets mentioned a lot these days, in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity. The good thing about this model is it encouraged responsible underwriting. The bad thing is that it isn’t very good at moving capital (money) from one part of the country to the other. Imagine in Iowa no one needs a mortgage, so the banks have no place to lend and can only pay their depositors 0.1% interest. In Florida lots of people need mortgages, so the banks offer 4% on savings accounts, but they still can’t attract enough cash and people who would buy houses can’t. (Or, alternatively, people who would take out loans to expand their businesses can’t.)

    Well, I guess according to this I’m an “idyllist”, but I just don’t find anything optimal in the framing of the alleged problem and the alleged solution.

    Rather, existing problems are not solved while new ones are created.

    In this case, the reality basis for Iowa land use is farming. it’s absurd that such a fundamental biological activity is subject to the vagaries of artificial “markets” at all.

    Meanwhile, I’m not sure what’s the reality basis of Florida development, where these mortgages are allegedly so needed. This reads to me like just a scavenger hunt to prop up suburban sprawl, an absurd thing with no basis in reality.

    (And if Florida did make any sense economically, why would it have to go hunting in Iowa for capital? Shouldn’t it spontaneously generate such capital out of its own bursting market robustness?)

    This reads to me like a satire on capitalism. Or rather, capitalism itself is clearly not “optimal” beyond a certain size. We see here how, once it ramifies beyond some tipping point, it requires rigging all markets and laws and bizarre capital redistributions from real activity like Iowa farming to conjure up fictional things like Florida sprawl, all the while requiring ever more risk and moral hazard, and empowering systemic swindling, as a feature, not an abuse.

    Once again we see how size itself is the great evil.

  26. The point about innovation is that it doesn’t really matter whether the new products work or not – it’s just the fact that there is innovation taking place.
    The secret to the Anglo-Saxon model of finance or the Axis of Spin is that it has to retain intellectual and cultural “leadership”. It has to keep showing us, no matter how often it screws up, the way to the Promised Land

  27. My point was not that securitization is necessary, but that it is not the problem. Critics treat securitization as if the instrument itself gave originators an incentive to cheat the system. A tool can’t ever be a problem, only how it is utilized. In this case, sure, the originators did not care about who they were making mortgages to because they were not going to hold the mortgages on their books. But the investors who purchased such things did not care either. If they did, there would have been a lot of questions asked about the rating agencies, origination practices, fraud, etc. before we even got to this place. But money was easy for everyone. No one cared.

    It would not have mattered in this instance if securitization was available or not. That money would have found a home somewhere else, where it would have inflated the value of an asset and diminished investors’ attitudes towards risk. It just happened to find a home in housing.

    This is not a failure of securitization; it is a failure of monetary policy.

    But, as to your question about why securitization is necessary or attractive, most financial innovations of late have been created not just to open a particular market to new investors, but to tailor certain investments to investors. For example, interest rate, inflation, credit default, etc. swaps can be designed to address very specific risks in a portfolio during a very specific time frame. Securitization works much the same way. Get a slice of what you want.

  28. There are some unarticulated assumptions in your post that are a little troubling to me. If I am wrong, please correct me.

    Your argument w/r/t subprime mortgages seems to be that they have good and extremely bad sides. First, you state, “But it is also possible for too many people to be getting mortgages, as we now know.”

    Then, “[c]onsider the idyllic banking paradise . . . in which people deposited their savings with local banks which, in turn, lent money out to trustworthy local homebuyers and held onto those mortgages to maturity.”

    Then you conclude with, “So it is never appropriate to say that innovation is always unequivocally good. Still, however, there is a difference between . . . ATMs and option ARM mortgages. . . [T]he latter is a financial product that enables people to use their money in ways . . . with consequences that can be good or bad.”

    So, here’s my problem: a lot of what I have been reading about subprime lending is more of the same, with new nomenclature. Many people (women, blacks, latin@s, the poor, and other minorities) could not obtain access to credit before subprime lending because banks would not lend to them for racist, sexist, ethnocentrist reasons. To this day, many banks refuse to set up offices in “poor” neighborhoods, because they don’t want to serve “those kinds” of communities. Key Bank made an actual attempt to enter into poorer neighborhoods and was astonished at the amount of cash “those people” held, if for no other reason than “those people” did not trust banks.

    In fact, one of the biggest pushes for giving mortgages to the traditionally under-served poor was the astonishing revelation (for the banks) that the poor people paid their bills.

    Next beef: option ARMs, negative ARMs, 5/1 buydowns, etc., etc. were sophisticated financial products aimed at the wealthy and financially sophisticated. The banks expanded them to (and pushed them on) the poor – the least financially sophisticated, the group least likely to experience a sudden explosion in income in 5 years, and a group that was already not entirely trusting of banks to begin with.

    There are government programs in place to give loans to the traditionally under-served, but these programs don’t have enough teeth to make sure that poor people don’t get these complicated, sophisticated loans shoved down their throats (which happened A LOT), as they are THE LEAST LIKELY TO AFFORD THEM. Blacks, Latinos, and women of all colors/races were much more likely to get bank loans with excessively high interest rates, fees, and closing costs when their credit scores qualified them for better loans for three reasons: Racism. Sexism. Ethnocentrism.

    Bernanke says “innovation.” I say more of the same – shove the bag on those least able to hold it. Stating that some people got loans who shouldn’t have ignores the class, race, ethnic, and sex discrimination lines in our society in general, and in finance in particular.

  29. I mistrust the term “financial innovation”. For me it’s another scheme to extort again money from the economy to create another financial industry. When will people finally learn that real money is made from REAL ECONOMY, not playing with other people’s money.

    I thought by now that was crystal clear, but them criminals in pin stripe suits will always try to ambush the real economy again and again, old wine in new bags.

    Forget “financial innovation”, all we need is “financial conservatism”.

  30. While everyone can agree that education costs have skyrocketted, I’m not sure you are going to get too many people to agree with you that the cost increase is because there is too much money chasing too few spots. You are generallizing too much in equating an education with a commodity.

  31. publishing what?

    … and the grading is done by assistants, Higher education is a farce. A bunch of crap classes and a few real career standouts. Most lazy prof’s at my grad school teach a little, assign numeous group projects and waste 3/4 of the semester having the groups “present.” I have found a new grad school where brilliant professors actually teach and lecture and spend the 2 hours giving insight, explaination and analysis. That is worth the tuition, the rest of it was a rip off – similar to a life insurance agent receiving 90% of your first few years of policy payments as commission.

  32. I have to disagree that the tool cannot ever be the problem. Take for a simple example a gun that is built that has an inherent flaw where it backfires 10% of the time regardless of how it is taken care of or used by the shooter resulting in a high percentage of injuries and deaths. In this case the tool would be the problem, not the utilization and I believe this is a real world example from one of the 20th century wars not a hypothetical.

    At the risk of making a false equivalence, it is possible to argue that securitization has an inherent flaw, perhaps by inducing fiduciaries – through their opaqueness and complexity – to violate their duties of diligence by making those duties either impossible or disincented. I do not say this is necessarily the case, but to categorically deny it’s possible doesn’t work for me.

  33. I am curious what prompted you to defend against the notion that securitization caused this problem. I don’t read such a claim prior to your comment.

    Securitization is no more to blame than “stocks” or “bonds” are to blame. However, clearly the misuse of securitization allowed megabank salespeople to misrpresent the quality of what they were selling.

    However, as this post states, if subprime lending did not exist in the first place it would not have been sliced and diced into the wrethced securiites.

    Digging further, the real problem is we have so many smart people wasting time on “financial” innovation instead of real innovation.

  34. Erich – I received your comment via email, but I don’t see it here, and I do not know how to reply to you any other way than by posting here.

    I do not have a problem with securitization per se. How it has been administered – yes. The fact that finance companies (and I am thinking of mortgage servicers in particular) are relying on Excel sheets and are incompetent to individually track the obligations – huge problem.

    Subprime mortgages, I think, are a different animal altogether. Securitization may have provided the liquidity for banks to continue underwriting subprime loans, or the moral hazard to hide the terms of the individual loans in one big package, but that isn’t what bothers me about this post.

    What I protest is that subprime mortgages should be considered a “financial innovation,” period. In my personal experience, they have been used the same way credit cards have, writ large – as a way of extracting onerous debts from those least able to manage or negotiate them.

    To qualify: as far as I can tell, this post does not say that subprime mortgages should be hailed as a financial innovation. What I would like to point out is that there are huge class, race, ethnicity and gender issues lurking in the mix.

  35. I suppose I went down that path because in the post it is suggested that securitization made it possible for too many people to have access to mortgages. In fact, people (investors) made a decision about where to allocate resources. And they made a decision about how much information they needed to determine where to invest.

    This strikes me as a very important issue because how we choose to frame this problem will determine how we address it. You have many people who would like effectively to kill the practice of securitization because they think the instrument caused the problem (Barney Frank, for example). I don’t think that is where James is going with his argument (since he appreciates what securitization contributes to market efficiency), but that is where many people go from the same premise.

    If you attribute the crisis to a nebulous concept like financial innovation, it is convenient to absolve decision makers from the consequences of their conscious risk-taking (and outright fraud).

    I honestly have no idea what one means when says subprime lending is an innovation.

  36. This is an important posting. If you listen carefully, nearly all the objections to any regulation of the financial system involve the assertion “regulation stifles innovation.”

    If that goes unchallenged we’ll not learn from this experience.

    It’s hard to argue that not enough credit is a problem even today. Sure there are companies that built their business on easy money. Hopefully they’ll survive the reversion to mean. At least part of the bubble was enabled by tax deductable home equity loans and cash out re-financing. Now that folks don’t have an ATM to pull money from, they are cutting back spending. But there never should have been an ATM that allowed folks to buy toys with paper gains. That’s not innovation, it’s looting.

  37. Bond Girl,

    I’m glad you recognize that I put securitization in the “more good than bad” column, simplistic though it is. I agree with your general point that if there is cheap money floating around it will find a place to go at an interest rate that is too low. I think you are saying that if not securitization, then some other channel would make this possible. At an extreme, if you could only put your savings in your local community bank, and it could only invest in local mortgages, then this consequence might not appear, but I don’t think anyone wants to go that far back (if in fact such a time even existed).

    In fact I think what we got was securitization combined with, as you point out, end investors who didn’t figure out what they were buying.

    In case it isn’t clear, I didn’t mean to blame the crisis on financial innovation; I did mean to head off any arguments of the form that financial innovation is always good.


  38. I haven’t thought about this at length, but instinctively I think that securitization is fine. There are some problems with it that should be fixed, like the incentives of bond rating agencies, and I think we will get a healthy dose of risk aversion on the part of the people who invest in these securities (who now belatedly realize that they need to take responsibility for understanding what is inside them), and maybe it would be a good idea to force banks to hold on to some percentage of each securitization that they manufacture. Maybe those small participants who have no business will stay away from these markets, so they will become somewhat less liquid – but that may be a good thing. I guess on balance I would go with keeping securitization and smaller banks. But as I said, I haven’t seriously considered the possibility of scaling way back on securitization.

  39. At the end of the day the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations, and that the benefit from financial innovations far exceeded the benefits from regulatory innovations.

    Try to live with it!

  40. Gripping post.

    Innovation that is illegal, or unethical must certainly always be bad. Conjuring financial products out of irredeemable debt instruments, affording those products AAA ratings, and simply refusing for whatever reason to account or provide for risk, then colluding with regulators, legislators, finance oligarchs, and lenders to increase velocity and volume and paper values in the markets for wanton paper profits that are mostly funnelled to the offshore accounts of oligarchs or predatorclass individuals or cabals – is a kind of PONZI scheme. A very complex, highly innovative PONZI scheme perhaps, but a PONZI scheme wherein the constant increase in irredeemable debt instruments, in irredeemable debt is necessary to sustain the illusion, the smoke and air supporting of the house of cards. As soon as irredeemable debt instruments, the irredeemable debt slows or contracts or heaven forbid stops – the myst and air, the paper numbers that support the monsterous house of cards – collapses.

    Innovation is one thing, – conjuring criminal enterprizes and PONZI schemes framed and sold as innovation are something entirely different, and always unequivocally BAD!

  41. It seems to me the primary end-user-benefit being claimed for securitization is lowering the cost of credit. I do not think anyone has yet measured how much of that reduction was due to:

    A) Systemic improvement that helps the system operate more efficiently than is possible through existing mechanisms (bank equity, bank bonds, competitive mortgage market). This is primarily achieved (in CDOs) by allowing different clienteles to purchase different levels of risk (according to their “appetite”), thus diminishing the risk premium in supplying demand for credit by inducing lenders to open up more of their coffers.

    [P.S. – any time an economist uses the word “appetite”, it means they can’t explain why people are doing things using rational behavior arguments. Be scared.]

    B) Obfuscation of true risk (either deliberate or accidental)… Which has enabled banks and leveraged institutions to exceed normal capital-asset ratio limitations and convince people to buy risky assets for too much money. To understand this, you need to understand how asset limitations work –

    …. begin digression ….

    “A brief digression into capital-asset ratios and risk profile”

    Capital-Asset ratios are set by risk “tier”.

    For near-riskless assets (AAA, such as US govt. bonds), you need to hold much less capital, because the assumption is that the value of such assets is more stable. For riskier assets, you need more capital to absorb possible losses. Thus, riskier assets limit your ability to lever yourself up (but also offer the potential of higher rates of return).

    When everyone thinks the world is booming, everyone wants to lever up as much as possible. CDOs allowed this – by bundling and slicing piles of debt, so that institutions could lever themselves up more aggressively by purchasing only that portion of debt that was AAA – that is, equivalent to US savings bonds.

    Banks will then blame the ratings agencies, pointing out that their fees are paid by the debt peddlers (who want the highest rating possible) – a clear conflict of interest. But banks had their _own incentives_ for not digging too deeply. They _wanted_ those assets to have AAA status so they could buy whole loads of them, and NO ONE thought those CDOs really were the equivalent of US govt. bonds, because otherwise the interest rates on CDOs would be at parity with T-Bill rates (which they were NOT). In other words, banks facilitated the lie in order to evade capital-asset ratios. That’s the plain truth.

    CDS (credit default swaps) had the same lousy regulatory incentive structure built in. By _insuring_ default on a CDO, a bank could fully or partly take the asset off of its books for purposes of meeting capital-asset ratio regulations. (Everyone knew this wasn’t exactly kosher, but hey, no one had ruled against it yet… regulation in the US always comes retroactively in _response_ to harm, not pro-actively in anticipation of hrm). The problem, of course, was counterparty risk!

    But banks didn’t think too deeply about counterparty risk, because they didn’t think the assets would drop in value. The small fee on CDSs allowed them load up on even more leverage…

    …. end of digression …

    I have encountered no credible evidence that CDOs and CDSs on mortgage assets have helped the system operate more efficiently by matching lenders to borrowers more efficiently than banks (with the aid of equity markets, debt markets, and the internet). I would love to see that evidence. Moreover, the logic is questionable: in order for the CDO and CDS markets to really improve efficiency, we must hypothesize some sort of serious market failure in the equity/debt markets. (where is that failure?)

    Without such a failure, the CDO and CDS markets are just another (less regulated) mechanism for doing essentially the same thing as equity/bond markets. And if CDO and CDS markets are simply a parallel and less regulated mechanism for doing the same thing, then this strongly suggests that the _primary purpose_ of these “innovations” was to escape regulation. NOT to improve people’s lives.

    In that sense, I have to agree with Ryan Avent – all financial innovations should be treated with great skepticism.

    In particular, I think we should apply the “do no harm” principle to all financial innovations, just like we do for new drugs. In other words, the burden should be on the financial innovator to demonstrate the new innovation has value that exceeds its risk.

    Govts. have a right to demand this, because if the innovation blows up, it’s governments that own the downside risk (no matter how it’s managed).

    I doubt this will happen, because the oligarchs will raise the flag of anti-government sentiment, but that is what _should_ happen.

  42. I am but an ignorant, naive resident of the nation’s fabled “Main Street” and this I believe firmly: tools are not the problem – it is how people use tools that causes trouble.

    Credit cards are independent of good or bad. When a person charges $10,000 on them yet does not have $10,000 to pay them back, it is the person who caused the problem, not the card.

    Likewise, when lenders – not banks – the lenders – those people who make decisions on who to loan money to – when those individuals decide to hand out loans like candy on Halloween, they’ve decided to act irresponsibly – as if all principles of business have become irrelevant.

    When I bought my first house in 1997, I had a full time job but my husband was a freelancer. Getting a mortgage was a nerve-wracking ordeal.

    Fast-forward to 2004, when the arrival of twins made moving an imperative for my little brood. At that time, we were warned by our real estate agent – not the banker or the mortgage broker – to be very very careful about the amount we asked for – banks were giving money away with no regard for the applicant’s income.

    (And the cost of housing had skyrocketed to the point of absurdity in the seven years we’d owned our first home.)

    People who used innovative finance tools like CDOs and CDSs profited significantly during the upswing. As a naive person, what I see is a flood of money leaving IRAs, 401Ks and college savings funds – all as the bank accounts of those on Wall Street fatten up nicely. Goldman had a great first quarter this year – lucky them.

  43. I disagree. While it’s true that the petrochemical stream comes off the fuel production line, the entire line is optimized for a particular yield of products based on current economic factors. This production problem spawned the discipline of Operations Research way back when. If you need less fuel, you can produce more petrochem feedstock (although, yes, if everyone did that it would collapse feedstock prices). It’s all the same to the platformer whether you use the aromatics stream to increase octane or make p-xylene for the Chinese fibers industry.

    Another basic example is the production of ethylene, a basic building-block feedstock. If ethane were not reacted to ethylene, it would be burned as natural gas. I wouldn’t call a $2 b ethylene plant a “byproduct” of anything.

  44. “…there is a difference between better shoelaces and option ARM mortgages – or between ATMs and option ARM mortgages. The former is a product or service that provides utility directly; the latter is a financial product that enables people to use their money in ways they could not use it previously, with consequences that can be good or bad.”

    I disagree. Take plastics. The innovation is neutral, like ARMs. Consequences are determined by system-wide behavior – in the case of plastics it was replacement of materials, automation of construction, eco-social impacts. Speaking of inherent utility is fantasy. Outside of the living systems that use innovations they have no utility/effect.

    Economists seem to fetishize thinking of the economy and economic activity as so different from the rest of the living system that we are a part of. This ain’t Newtonian mechanics folks!

  45. agreed, but who got the loan proceeds? I believe it was he seller of the inflated value property, no? I’m pretty sure that is the case.

  46. James? You HAVEN’T thought about securitization? Um, isn’t that pretty much exactly what must be considered?

    PS, I’m very glad to hear that you believe that there are a few problems with securitization that need to be “fixed”.

    Can I ask you something? Exactly how old are you?


  47. Yes but he sold his house… and with that the possibility of selling it at ever higher prices… while the other $210.000 was shared out among intermediaries that gave up nothing.

  48. First, let me say I personally like the idea of small/nimble/community banks that are linked together by sophisticated securitization markets that make big-banks unnecessary. It’s like the Silicon Valley version of banking.

    My concern with cutting down big banks, really, is the international competitive aspect. If big banks really do have a competitive advantage, then moving to small banks would only work if all other countries shear down the size of their banks. But there is too much incentive for nations to defect and allow bigger banks in order to capture the rents.

    In finance, big does convey benefits. Until recently, for example, GE Money had much cheaper access to credit that smaller European banks – this was one of their primary competitive advantages, and they certainly made use of it.

    Because of the incredible integration of international capital markets – which are far more integrated than simple trade in physical goods and services – the issue truly is global. Much of the permissiveness in national regulation seems to be motivated by international considerations – a regulatory race to the bottom.

    OTOH, you are correct that lendors have gotten one heck of an education. So maybe CDO and CDS markets will become safer simply by growing into adulthood.

  49. So long as there are economies of scale, there will be large scale investments and big deals. We may not like it, but it’s a certainty when companies like Exxon Mobil pull in $450 billion in annual revenue.

    So the demand is there. In terms of meeting the demand, did you have any specific alternatives to big finance in mind?

  50. The difference between a banker lending money and the loan shark on the street who hires leg-breakers for enforcement is simply a matter of degree.
    You can innovate all you want with the frills and the images and the packaging, but when you forget the basics is isn’t “innovation”. It is a “blunder”.

  51. PBS did a great newstory recently, regarding how the start (or demise if you will), began with the advent of the car. In order to finance something you couldn’t afford, credit was extended. Quite a good story if you’re interested in learning more about this.

    By the way, well written article. Enjoy the depth of knowledge in each and every post.

  52. Innovation is designed to deliver benefit to an intended audience(the user). Intimately this implies that the innovator is familiar with the intended audience’s needs. But this does not imply that the innovator has the intended audience’s best interest in mind. The value of the innovation is not defined by the inventor but by the user and the value is not for the user but for the inventor. It just turns out that the user is seduced to believe that the innovation is of value to him. This is called brand-washing. Do we really need the super-super expensive iPods? I am a member of the iPod-crazy generation but I couldn’t care less about one.

    Healthcare which was established to be of value to the sick is no longer that hopeful field. Healthcare in America is an empire of greed in which the personal health is not a concern-it is a commodity for trade.
    The evil scheme FDA regulators-Pharmaceutical Empires-Greedy Insurance companies and Stuck-Medical professionals spells misery for the average american.
    The FDA is tasked with regulating the incessant innovative output from the pharma labs-for legitimate and not-so-legitimate conditions; and with demand for drugs so high from aging population, the FDA has been reducing its admittance principles for decades. Pharma companies in turn have become the legal drug traffickers in America as today they are allowed by the FDA to incite the consumers to demand and consume the innovative output which the consumer may or may not need. The insurance companies incite doctors to prescribe the pharma output, based on the pressumption that it’s better to prevent what’s-not-there than to deal with a law suit if the thing- -that- is- not- there would be eventually detected to be there. The pharma companies incite the doctors to prescribe left and right (just think of the variety of contraception pills that are available and highly prescribed by ob/gyns) by rewarding them with increased rankings on the pharma websites(surgeons) or by a form of royalty payments. The doctors are stuck prescribing drugs they don’t know very well, or feel that needs not be prescribed necessarily. The american audience is stuck with being drug-and-brand-washed and stuck in the cult only-the-drug-would-make-me-better.The pharma companies produce more whatever-it-is to satisfy the american-sick-beast. The FDA goes on to allow stuff-that-will-be-recalled-in-2yrs-because-it-would-kill-10 million-folks and on the cycle persists.

    If the FDA were to establish consistent high standards across the board and recognize that the population in this country doesn’t need as many drugs as are there on the market, the cost for producing these drugs and marketing them would be higher, which would mean that people would think a whole lot more before demanding these drugs and maybe would be more willing to not be drug-addicts and rely on early preventative measures for their conditions rather that relying on the pill to fix it all. With demand reduced the pharma companies would have less professionals and lay people to harass. If the insureance companies and the pharma companies stopped pressuring the doctors, maybe the doctors would indeed start treating and advising the patients. Needless to say, the average meeting with a doctor is 5-10 minutes. You probably spend more time enjoying the murals in the doctor’s office that in an actual 1-in-1 with your primary care provider. Doctors are afraid of telling you too much. They do unneccessary tests that drive costs for fear of law suits.

    While innovation is very important in the medical field (and I give thanks for the epidural) there is the flavor of greed and the disconnect from the final consumer that has driven healthcare to a shameful and unreliable field.

    In today’s world, we all should be just like the ancient greeks-we should all know a little bit of all, or maybe all. Maybe instead of wasting the kids’ time in school over meeting stupid state and fed requirements, they should concentrate on teaching kids how to meet their life requirements- understand money, undertstand health, understand personal relations, understand professional relations, understand the law, understand what the plumber does, what the garbage guy does, understand the risks and privileges in all professional fields. Kids should be getting vocational trainings and should go through rotations much as are the medical rotations to ensure that they are ready for life and have a plan on how to pay for a particular education and understand the value and future implications of the Women’s History degree that they so desire.

  53. This I guy I know has a great financial innovation. It will earn you a consistent 10% return every year, but you need to know someone to get in, and it is sooo innovative that you can’t spend a lot of time asking Bernie too many questions, ’cause you just wouldn’t understand the answers.


  54. @statsguy

    you could do securitization without tranching — just pool the loans.

    that way you get diversification (a good thing, especially for small investors who don’t have the ability to diversify independently) but you don’t have the problems with valuation and tranches.

  55. that education was very expensive though.

    the cdo and cds markets will become safer simply because people will have to stress test against the past year’s data.

  56. True, but without tranching, what is the point?

    Simple diversification is already achieved by owning bank stock and bank bonds.

    The effect of non-tranched CDOs would simply be de-integration of the banking function, in which the loan servicing component is separated loan ownership component. The model, perhaps, is akin to the de-integration of electricity production from electricity delivery…

    What are the efficiency benefits of this model for mortgage financing?

    We clearly know the problems with eliminating vertical integration of mortgage finance:

    CDO buyers may have worse information than professional banks, and if things go bad who gets to renegotiate???

    Currently, many loans go into default simply because the loan servicing agency has neither the incentive, nor the capability, to secure agreements from debt owners to renegotiate.

  57. I think this is not so much a lot of money chasing too few spots, as the absence of a prohibitive limit on price.

    increasing prices before loans would mean some students would be priced out,
    now students can always cover the price with more debt

    students now “can” “afford” to pay ridiculous amounts, that they would not be able to afford to pay before

  58. If you want some Financial Innovation try NEFS : Net Export Financial Simulation – see at In a one-liner it says that the present financial system is a pre-machine age 15th Century Venetian invention that only seems to work during it’s periodic financial bubbles. NEFS is a first attempt to design financial system that suites the computerised production age that we now live in.
    Thought experiment : If Aliens in outer space had automated and robotised all their production, if they used are old fashioned financial system then they would all be unemployed, on the dole and hungry. Assuming they are not, they must have some other financial system. What ever it is, given our present level of automation, we need half of it. NEFS is a guess as to what the half might be.

  59. I very much enjoy (and find instructive) the posts by Kwak & Johnson as well as the commentary it engenders. Innovation be it financial or other is an important source of debate in economic history (sometimes more heat than light). One might note that a distinction can be drawn between invention and innovation. Every time someone (let’s say your child for the purposes of argument) says, ‘wouldn’t it be great to have a machine on the street corner that dispenses currency’, you have an invention (whether it ever becomes corporeal or not). Indeed, people invent things and even construct physical objects that do something (or, to spread the net wider, ‘are’ something) and are often ignored. There are also plenty of examples of near simultaneous ‘invention’ (archeologically, it appears that agriculture was ‘invented’ in several places highly unlikely to have been in communication at about the same time ditto pottery). Sometimes things lay about as it were, and then are appropriated, sometimes re-purposed, and then rapidly diffuse. To return to the cash machine (ATM) and the debit card, I don’t know who ‘invented’ it (i.e. patented it, given the primacy of concerns about property rights) but it appears to have been in fairly widespread use in EU countries before the U.S. (when I resided in Northern Italy in the mid- and latter 80s, debit cards were already ubiquitous as were ATMs) but even in NYC, they were available but more restrictive in use than in Italy or France). In any case, invention is distinct from innovation (much less their diffusion). It’s perhaps, not the best example but there are many others. The point is, innovation is not ‘innocent’ invention. It’s (socially) ’embedded, to use Granovetter’s term.
    Schumpeter talked about innovation as ,’new combinations’ of capital, labour, and technology emphasizing the dynamic effects of these combinatory processes, many of them unintended (and unanticipatable) consequences of entrepreneurial activity (Marshall may well have in the Organization of industry). So Bond Girl has a good point to the extent she pursues it; that innovation is something like a tool – used for good or ill (responsibly or not). The folk idiom has a useful proviso, the law of the hammer: give a baby a hammer, and it will not only hit nails, but everything else within sight (or reach). But we ought to be careful about the supposed morality (and ethicalness) of tools. Designing a device to waterboard prisoners more efficiently is unlikely to pass scrutiny. It’s not likely to be easily re-purposed as for example, an ironing board.
    So perhaps, we should think about ‘financial innovation’ – what little there actually was since 1970 (per contra Bernancke as a number of commentators have noted) – in a wider social and political economic context.
    Because invention doesn’t lead ineluctably to innovation nor innovation ineluctably to its diffusion we have at least in this case, a problem that ought to be amenable to historical analysis. One doesn’t even have to assume a crude folk psychology of interesting-maximising actors; it’s surely more complex. There are undoubtedly young economic historians busy writing dissertations on this. Ileave it to others more adept to specify to what we should pay attention but it does begin around 1980, under an ethos of anti-governent ideology combined with a religious orthodoxy of ‘free markets’ that are always efficient if left alone, manifested in Congressional action that loosens existing regulatory regimes and inhibits or prohibits the regulation of other (‘innovative’) activity. It’s accompanied by a dramatic rise in income inequality, while at the same time, as C. Maier has shown, de-industrialization in the U.S. and the other changes in global trade and capital flows that now leave China as the largest holder of sovereign debt. During the same period, educational attainment began a precipitous decline in the U.S. and (amongst other UNDP indicators) infant mortaility increased. The U.S. outspent the next 25 national states in military spending. We now export more military ‘goods’ than the next 15-20 states combined as well as primary agricultural commodities. And in a habit of long-standing, dis-investd in infrastructure (as well as human capital). One doesn’t have to be a nietzchean Fukuyama or a declinist (e.g. Kennedy) to acknowledge this. Which factors are critical to an explanation is an historical problem. The point is, ‘financial innovation’ doesn’t occur in a vacuum. It’s not its novelty (invention) but the circumstances of its adoption and exfoliation.

  60. Until recently I understood virtually nothing about the environment- just knew the economy was going down the toilet! I just finished reading a great book titled, “The 21st Century Economy—A Beginner’s Guide” written by Randy Charles Epping and now have the mentality to make clear choices about what to do with my money- which is really all I can do to make a difference in the world right now. I have enjoyed a lot of the posts, it helps me understand things a lot better- thanks.

  61. fyi:

    unless it has appeared somewhere else, the discussion of someone who had made a fortune inventing the plastic thing at the end of shoelaces was from the movie “cocktail”, with tom cruise and elizabeth shue (who have the discussion).

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