A post from a reader, “Toothless Fed,” argues that the latest wave of financial innovation has produced “profit grabs” by the few at the expense of the many, Ponzi schemes, and an erosion of traditional values like prudence.
Overheated? Overwrought? Perhaps. Or maybe he’s just calling a spade a spade.
Other people are coming to the similar conclusions, they simply aren’t always stating them as emphatically. We have the sober John Authers, who writes the “Short View” column at the Financial Times, invoking the notion of “Minsky moments” which we described:
Economist Hyman Minsky observed that creditors become more lax about lending standards during times of stability. He divided borrowers into three types: the upstanding sort that can pay principal and interest; speculative borrowers (or “units”), who can pay interest but have to keep rolling the principal into new loans; and “Ponzi units” which can’t even cover the interest, but keep things going by selling assets and/or borrowing more and using the proceeds to pay the initial lender. Minsky’s comment:
Over a protracted period of good times, capitalist economies tend to move to a financial structure in which there is a large weight of units engaged in speculative and Ponzi finance.
What happens? As growth continues, central banks become more concerned about inflation and start to tighten monetary policy,
….speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently units with cash flow shortfalls will be forced to try to make positions by selling out positions. That is likely to lead to a collapse of asset values.
So according to Minsky, during protracted periods of stability and growth, lending becomes so lax that more and more funds go into speculative activities, until central banks start raising interest rates and the dodgier schemes (and the asset prices that escalated due to their operation) collapse.
Now the argument that no one is willing to make (yet) is that all this financial innovation is in fact disguising (or perhaps even promoting) what Minsky would call “speculative units” and “Ponzi units.” Let’s start with two views of innovation. The first is from New York Fed president Timothy Geithner, from his speech “Credit Markets Innovations and Their Implications:”
The rapid growth in these new types of credit instruments is, of course, a sign of their value to market participants. For borrowers, credit market innovation offers the prospect of increased credit supply; better pricing; and a relaxation of financial constraints. For investors, new credit instruments bring the prospect of broader risk and return opportunities; the ability to diversify portfolios; and increased flexibility. And for lenders, innovations can help free up funding and capital for other uses; they can help improve credit risk and asset/liability management; and they can improve the return on capital and provide new and cheaper funding sources.
By spreading risk more broadly, providing opportunities to manage and hedge risk, and making it possible to trade and price credit risk, credit market innovation should help make markets both more efficient and more resilient. They should help make markets better able to allocate capital to its highest return and better able to absorb stress. Broad, deep and well-functioning capital markets complemented by strong, well-capitalized banks, able to provide liquidity in times of strain, make for a more efficient financial system: one which contributes to better economic growth outcomes over time.
In the interest of brevity, we have foregone the arguments Geithner makes to support the “shoulds” in the second paragraph above.
Now to another bit of Fed defense of innovation, this for a harder-to-defend cause, mortgage market innovation, but note the parallels. From Robert Cole, Director of the Division of Banking Supervision and Regulation for the Federal Reserve, in his Senate Banking committee testimony this week. His written remarks and the commentary (more accurately, evisceration) from Tanta at Calculated Risk, in “Cole Testimony: Cui Bono?.” The first paragraph is Cole, the rest Tanta:
Homebuyers have also benefited in this environment of financial innovation and market liquidity. More lenders are actively competing in the mortgage market, product offerings have expanded greatly, the underwriting process has become more streamlined, borrowing spreads have decreased, and obtaining a mortgage loan has become easier….
I am simply irritated in the extreme by the inclusion, without qualification, of “streamlined underwriting processes” and “easier” obtaining of loans under the heading of benefit to homebuyers. First, as we’ve already noted here at CR, all this streamlining and easing has often made potential homebuyers prey of unscrupulous lenders and sellers, as well as having made lenders and sellers prey of unscrupulous homebuyers. But I want us to take this a little further. What I see here is the Fed falling for advertising slogans and confusing it with public policy. Like Queen Victoria, I am not amused.
Come on. How streamlined and easy does the mortgage lending process really have to be? Look, I like innovations in grocery shopping, like scanners, self-scan aisles, express lanes, debit card readers, and so on, because I have to shop for groceries a lot, and it’s drudgery. But how often do you buy a home or refinance your mortgage? Is it really such a terrible burden to you to get your documents out of your desk drawer, drive down to the local bank, and plop yourself down in a chair across the desk from Louise Loan Officer for an hour? Is saving that kind of time and effort ultimately important enough to you that you are willing to accept the risks to all of us, to our economy, of unsafe and unsound lending by federally-insured depositories that is the effect of these “benefits”? I’m not at all sure I am.
The issue of access, specifically, is certainly important. If you live in Podunk, you might not be able to drive to the office of a national lender with a really good interest rate….
But that’s not at all the same thing as saying that “speed” and “ease” are always true benefits to borrowers. They’re benefits to lenders. The story is that lenders pass on the efficiency savings to borrowers, in the form of lower rates and fees. Forgive me for shooting some Kool Aid out of my nose here, but I think I see these “savings” going mostly to executive bonuses, originator commissions, and investment in overcapacity, which just begs for more loose loan writing to keep the mortgage mills busy..
Now of course, some readers might think this is unfair, generalizing innovations in the retail market, which may indeed have been used to prey on unsophisticated borrowers, to innovations in the wholesale markets. There everybody is an institution, so they can all take care of themselves. Right?
I don’t buy that one either. I worked in the very very early days of the derivatives business. Even the smart investors were willing to acknowledge that there were only perhaps 5 people in the US that had an intuitive understanding of the products. And there were a lot more than 5 people buying the stuff. The securities industry has a proud history of investors putting their money in things they don’t understand. John Augur, the former head of Schroeder’s global securities business, notes in a recent Financial Times article, “Adam Smith’s hidden hand is vanishing,”
Whereas in traditional securities businesses, commissions and fees have been under pressure in a way that Smith would recognise, the opposite is true in structured derivatives trades. It is difficult for clients to understand the make-up of these trades and still harder to challenge prices since they are often protected by confidentiality agreements.
Read that again. Clients are buying things they don’t understand. And the “clients” are financial institutions and other fiduciaries.
We’ve seen similar, worrisome comments about lack of buyer understanding (and even formal reports that a high proportion of dealers aren’t on top of risk management). This quote came from a January Financial Times story:
“Hi Gillian,” the message went. “I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.
“I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions . . . with very limited capacity to withstand adverse credit events and market downturns.
“I am not sure what is worse, talking to market players who generally believe that ‘this time it’s different’, or to more seasoned players who . . . privately acknowledge that there is a bubble waiting to burst but . . . hope problems will not arise until after the next bonus round.”
So I for one am not optimistic that these supposedly sophisticated investors really know what they are doing, at least with these newfangled instruments. And as you can read in a related post, “Toothless Fed, Part 2,” Deloitte doesn’t think even the top institutions are on top of their derivatives risks. And all big players have very big derivatives exposures.