Innovations in Financial Engineering

The decades-long push to the nearly complete deregulation of banking was supported rhetorically by the idea that regulation was stifling innovation in finance.  Now that we've had a chance to dig through the wreckage of Enron, Bear Stearns, and many others, a couple of things seem obvious about financial innovation.  One, in a broad sense there isn't any financial innovation--it's all about leverage and obfuscation of risk, just like it's always been.  Two, although innovations that get adopted in other fields generally displace permanently something inferior and ultimately lead to something even better, in the financial field "innovations" often fail and have to be replaced by the "way we used to do it." 

Update on Tuesday, June 17, 2008 at 08:10PM by Skeptic

Financial innovation meets bottom line. 

Update on Friday, April 17, 2009 at 02:33PM by Skeptic

Fed Chairman Ben Bernanke is concerned about obfuscation.

"Regulation should not prevent innovation, rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes," said Mr. Bernanke in a speech at a community-affairs forum in Washington. "We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience."

Thanks to Mark Thoma for the quotation.  Dani Rodrik agrees, and so does Paul Volker.

Update on Tuesday, July 21, 2009 at 05:38PM by Skeptic

Elizabeth Warren disposes of the main objections to a new agency to regulate financial products offered to consumers.  Why does the MSM not cover this?  Hat tip to Mark Thoma for the link.

Update on Saturday, August 1, 2009 at 08:47AM by Skeptic

Oops.  I omitted another goal of financial engineering--evasion of taxes or regulation, as Financeguy reminds us in a comment on this Rortybomb post. 

The post itself recounts how Lewis Ranieri, the inventor of securitized mortgages, has been insisting for more than 2 years that millions of mortgages must be restructured and that the financial industry can readily innovate a way to do that efficiently.  Hasn't happened, perhaps because the players in the middle who could possibly do it get fees for administering defaulted loans and foreclosures and get nothing for restructuring.  Also, the tax lawyers and accountants, whose views apparently were never previously solicited in connection with home mortgage renegotiations, are now advising that such restructuring gives the borrower forgiveness-of-indebtedness income and that lenders must send 1099s and borrowers must pay income taxes on it. 

Update on Thursday, August 13, 2009 at 11:17AM by Skeptic

Dani Rodrik describes 4 failed promises of financial innovation (emphasis added):

Here are some of the lies that the finance industry tells itself and others, and which any new Fed chairman will need to resist.

Prices set by financial markets are the right ones for allocating capital and other resources to their most productive uses. That is what textbooks and financiers tell you, but we have now many reasons to be wary.

In the language of economists, there are far too many “market failures” in finance for these prices to be a good guide for resource allocation. There are “agency problems” that drive a wedge between the interests of the owners of capital and the interests of bank CEOs and other finance executives. Asymmetric information between sellers and buyers of financial products can easily leave buyers vulnerable to abuse, as we saw with mortgage-backed securities.

Implicit or explicit bailout guarantees, moreover, induce too much risk-taking. Large financial intermediaries endanger the entire financial system when they use the wrong risk model and make bad decisions. Regulation is at best a partial remedy for such problems. So the prices that financial markets generate are as likely to send the wrong signals as they are to send the right ones.

Financial markets discipline governments. This is one of the most commonly stated benefits of financial markets, yet the claim is patently false. When markets are in a euphoric state, they are in no position to exert discipline on any borrower, let alone a government with a reasonable credit rating. If in doubt, ask scores of emerging-market governments that had no difficulty borrowing in international markets, typically in the run-up to an eventual payments crisis.

In many of these cases — Turkey during the 1990s is a good example — financial markets enabled irresponsible governments to embark on unsustainable borrowing sprees. When “market discipline” comes, it is usually too late, too severe, and applied indiscriminately.

The spread of financial markets is an unmitigated good. Well, no. Financial globalisation was supposed to have enabled poor, undercapitalised countries to gain access to the savings of rich countries. It was supposed to have promoted risk-sharing globally.

In fact, neither expectation was fulfilled. In the years before the financial crash, capital moved from poor countries to rich countries, rather than vice-versa. (This may not have been a bad thing, since it turns out that large (net) borrowers in international markets tend to grow less rapidly than others.) And economic volatility has actually increased in emerging markets under financial globalisation, owing in part to frequent financial crises spawned by mobile capital.

Financial innovation is a great engine of productivity growth and economic well-being. Again, no. Imagine that we had asked five years ago for examples of really useful kinds of financial innovation. We would have heard about a long list of mortgage-related instruments, which supposedly made financing available to home buyers who would not have been able to purchase homes otherwise. We now know where that led us. The truth lies closer to Paul Volcker’s view that for most people the automated teller machine (ATM) has brought bigger benefits than any financially-engineered bond.

The world economy has been run for too long by finance enthusiasts. It is time that finance sceptics began to take over.

Update on Friday, September 25, 2009 at 07:58PM by Skeptic

 Johnson and Kwak also point out that not every financial innovation is good, and they give criteria for discerning good from bad. Link.

The main purpose of financial innovation is to make financial intermediation happen where it would not have happened before. And that is what we have gotten over the last 30 years. As Ferguson said, “New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds, and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers.” But financial innovation is good only if it enables an economically productive use of money that would not otherwise occur. If a family is willing to pay $300,000 for a new house that costs $250,000 to build (including land), and they could pay off a loan comfortably over 30 years, then that is an economically productive use of money that would not occur if mortgages did not exist. But the mortgage does not make the world better in and of itself; that depends on someone else having found a useful way to employ money.

In addition, financial innovation can go too far much more easily than innovation in other sectors. Financial intermediation creates value by making credit more available to people who can use it effectively. But it is possible for the economy to be in a state where people have too much access to credit. With the benefit of hindsight, it is easy to see how the U.S. housing sector passed this point earlier this decade. With negative-amortization mortgages (where the monthly payment was less than the interest, causing the principal to go up) and stated-income loans (where the loan originator did not verify the borrower’s income), virtually anyone could buy a new house, leading developers to build tens of thousands of houses that are now rotting empty, their current value far less than their cost of construction. In short, excess financial intermediation, the result of hyperactive financial innovation, destroys value by causing people to make investments with negative returns. Put another way, we cannot say that innovation is necessarily good simply because there is a market for it. The fact that there was a market for new houses does not change the fact that building those houses was a spectacularly destructive waste of money. Therefore, when it comes to financial innovation, we must distinguish beneficial financial intermediation from excessive, destructive financial intermediation.

Update on Monday, January 18, 2010 at 03:47PM by Skeptic

Paul Krugman and Naomi Klein agree.