There are two schools of thought on financial innovation. One is the mainstream view, repeated faithfully by a compliant media, that financial innovation is really really important and under no circumstances must be threatened. Then we have the Old Fart view, best represented by two men who by any standards ought to have retired by now: Paul Volcker and Martin Mayer. Volcker deems the ATM to be the most important financial innovation of the last 30 years. Martin Mayer tartly noted,
Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of Congress.
And the moderate view comes from a dead man, John Maynard Keynes:
When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.
While Keynes disapproves of side bets taking the pride of place in capital markets, th implication is that there is a level of trading and speculation that is positive for an economy. But how to determine where the threshold is?
I’ve been plenty skeptical of many of the financial innovations of the last decade and find myself hard pressed to put much stock in their defenses. I remember taking an instant dislike to credit default swaps. Increasing the liquidity of credit risk, even assuming it worked as advertised, seemed guaranteed to mean that everyone would be more casual about assuming it. If you are stuck with a lending exposure, even if you can sell the paper but it is not terribly liquid, you ponder taking it on more seriously than if you believe you can get out of it readily. And on top of that, CDS settlements in some bankruptcies have been lower than the expected loss on the bonds (witness Delphi).
Other defenses of CDS were that you could use them to create synthetic bonds. Did investors thought there was a shortage of corporate bonds? Another argument was that CDS would lower the cost of borrowing for corporations by making the markets more efficient. I’d be curious to see if there was any empirical evidence to support that contention. By contrast, there is considerable evidence that starting in 2006, CDS wound up increasing the cost of borrowing. The first except is from a Bloomberg story in early 2007:
The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.
“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “…
The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company’s ability to repay debt.
As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market….
“The banks that have been using correlation to calculate their risk will have to go back to scratch,” said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. “By using correlation models as the main means of risk management, the engineers threw out sound banking practices.”….
The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.
Note this problem started in 2006, and I suspect is due to AIG ceasing writing CDS.
Now I may be unfair and unimaginative, but I also react skeptically when I read stuff like this (from the Economist):
Enormous though the cost of bailing out the banks has been, there is nothing inherently undeserving about finance; even in their flawed state, more liquid markets have brought huge benefits to the rest of the economy. The lower cost of capital has made it easier for industry to invest, innovate and protect itself against interest and exchange-rate risk. Trying to single out financiers from entrepreneurs is a fool’s errand: you will end up hurting both.
The reason I have doubts about the ability of companies to use financial products as effectively as the Economist says is that there is plenty of evidence even with simple products that they don’t get it right (how many times have you read of an airline hedging oil at precisely the wrong time and raising rather than lowering their costs). And last year, lots of exporters to the US hedged against a falling dollar and paid for it.
And if you think investors got snookered by complex products, do you think corporate treasury departments are in a much better position? Yes, there are some that are world class savvy. But that is far from universal.
But the real problem is that in many cases, their underlying exposures have too much optionality for them to be able to be hedged affordably. Consider Motorola (I was involved an eternity ago in working with them after their treasury incurred big losses with wrong footed currency hedges (my client was a derivatives trading firm that was giving them access to their trading system on an ASP basis, this before ASP was an established concept). Motorola 15 years ago closed its books every two hours, an amazing feat. But even with an unheard-of understanding of its positions on a current basis, its ability to project out its exposures had important constraints.
Say it is assembling cell phones in Korea, with chips from Taiwan. But when the phones are made, they could be shipped to Italy or Norway or Poland. How do you hedge that? Not much of its business was subject to long term contracts or predictable orders. With extended supply chains and more and more companies moving to demanding more responsiveness from their suppliers, I suspect the number of companies in the sort of situation that Motorola faced has not gotten smaller.
Financial economics holds that creating more derivatives is ever and always better, but my instinct, per Keynes, is that there is a level beyond which more is in fact sub optimal. But I am certainly not able to prove that, much the less suggest how to ascertain when so called financial innovation is in fact at the expense of the real economy. Reader discussion very much encouraged.