Some Musings on Financial Innovation

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.

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  1. Anonymous

    I would have thought that if the ‘vicious circle’ described is truly only the result of a mathematical breakdown, then SOMEONE would be taking large-scale advantage of this mispricing on the sell side.

    (* Listens to sounds of crickets chirping. *)

    Ockham’s razor, on the other hand, might incline one to the view that it was the previous CDS prices that were too low, rather than the current ones being too high.


  2. Anonymous

    My feeling is that finance has tried very hard, through innovation, to decouple itself from real world economy; what a pity that, being on the verge of a complete success, it has experienced an “unexpected” collapse.
    The fact that such an outcome was to be expected is trivial, it was just like trying to decouple circulatory system from all internal organs… what I think is more interesting is the following question: what kind of efficiency (or deficiency) is a financers-controlled economy supposed to have with respect to an entrepreneurs-controlled one?
    I think that the answer lies in the different behavior of a pure financer and a pure entrepreneur: their interests and loyalties diverge, and so their objectives and their strategies. While the former is focused on making money per-se, and so is fast to put or withdraw money according to his perception of an investment’s profitability, the latter sees profits as instrumental to the health and growth of his enterprise. Maybe, if a proper equilibrium is kept between the two roles, so that one cannot bully the other, things can go on nicely. But such an equilibrium will not be reached or kept spontaneously, it must be established and enforced by a third party, which of course is the government (or governments, on a global scale).

    PDC, Italy

  3. JKH

    The objective of innovation usually is to transfer risk in a “new” way. The initial purpose is always presented as hedging. It follows its own Minsky process to full speculation. The disasters always come from using innovation to write insurance – options, CDS, whatever. Insurance writing is the usual source of systemic risk. There is no ultimate hedge for writing insurance.

    So innovation is a channel for more insurance writing. Insurance writing is the risk; innovation is the means; but obviously not the only means. Sly Warren Buffet tends to avoid specious innovation, but his attitude to the use of insurance premiums as a free lunch is different only in degree to that of AIG financial products.

    The only feasible solution unfortunately involves risk limits, regulation and supervision at a systemic level.

  4. Marcf

    Securitization was indeed innovation to get back to an unrestrained credit money creation. It was used to obsolete glass steagal. How quickly we forgot and how fast we are relearning.
    CDS per se are a good thing IMHO by transferring risk to a wiling and able counterparty. Naked CDS on the other hand are an abomination that should be outlawed and killed. Naked CDS basically multiply bad debt.

  5. DoctoRx

    The main reason for the creation of financial derivatives is to suck more money into the pockets of financial industry people.

    It is always about the money, in any industry, whether that industry be food, computers or money. The industry will always have at least superficially sound arguments as to why it deserves a greater share of the economic pie.

    There should be at the very least the financial equivalent of the FDA before a new derivative is allowed, and most should be taken off the market unless they can show safety and efficacy.

  6. ruetheday

    We’ve had forwards/futures on physical commodities for hundreds of years. We’ve had some sort of plain vanilla options (or warrants/refusals) on individual equities for almost as long. However, most pure financial derivatives only date back to the early-mid 1970’s with the more exotic stuff dating to the early 1990’s. So the world economy managed to exist and grow just fine up until the last 20-35 years without most of these derivative contracts. Just as the mortgage market relied on local banks, with local loan officers, originating and holding mortgages for many decades without the need for securitization and CDO-cubes. I’d say most financial innovation is unnecessary casino gambling with little redeeming social value.

  7. run75441

    Good Morning Yves:

    You point to a very real problem with Supply Chains and commodities. It is not only based upon the commodity; but, it hurts on the currency side as well.

    Many tier one companies making parts and product for automotive found themselves in dire straits when copper as priced at $1/pound in their contracts went to >$3?pound in the market. Car companies were not so willing to grant relief on the increase. Instead the tiers absorbed it in the supply chain coming out of Asia and Mexico/Nicaragua/etc. The other issue is a cheaper $as compared to foreign currency. Again, a cost adder which is absorbed in the supply chain.

    You are correct in that companies do not do a good job of hedging against cost increases due to commodities or currency today as compared to the past. The globalization of the market has made it very volatile and prone to disturbances. A manufacturing cost increase does not translate into higher product prices in the market place and it cuts into profitability. It would be interesting to dissect supply chain costs related to the economy over the last 20 years and see if it is as profitable as some deem it to be.

    Given that many suppliers are foreign, it has become harder to force price concessions from them as there are other outlets. We cede a certain control of our costs.

  8. Anonymous

    A critique if I may …

    Yes, there are two schools of thought on financial innovation because financial innovation falls into two broad categories, useful innovation, where the word innovation is truly descriptive of the innovation created, and; deceptive innovations (the scams) where the word innovation is instead used as a decoy word to mask and sell the scam to an unsuspecting public.

    Your title, “Some Musings on Financial Innovation”, parrots the MSM language that has set the battlefield of discourse and in great part contributes to the problems at hand in the world of finance. How? By discussing — and thereby in effect ‘branding’ — the scams under the positive heading of innovation, those scams co-opt the positive meaning of the word innovation. It inadvertently aides, abets, and legitimizes the scam artists.

    It is a hallmark of deception that the perps always camouflage themselves in anything that is good, like the word ‘innovation’. After all, who would be against innovation, or for that matter; growth, or capitalism, or free markets, or democracy, or Jesus, etc.?

    Sooooo … before you muse and confuse … qualify to clarify …

    “Some Musings on Useful and Deceptive Financial Innovations”

    This will defuse the decoy aspects of the word innovation and get us to the deceptions and their causes more quickly … a totally corrupt and non responsive to the people government.

    We need some musings on eliminating that non responsive to the people government and double speak in the language.

    Deception is the strongest political force on the planet.

    i on the ball patriot

  9. OSR

    I think the inappropriate use of models was a major amplifier of the severity of the meltdown. In real engineering, it’s understood that if all of the inputs aren’t known, then neither are the outputs. This is intuitively obvious when you consider that weather forecasts aren’t useful more than 5 days out.

  10. Thoreau

    Poor poor KPMG. Wonder who KPMG will blame this time? This is just the beginning. New Century is nothing, Citi Bank the KPMG audit client has helped to bring down the entire world economy with its fraudulent financial statements containing sham tier 3 investments and over valued derivative positions. No one can say that as early as 2005 no one saw this coming, several papers written by distinguished economists predicted the exact result that has obtained using math and decrying the false accounting premises that were being used at the time. Interestingly, in 2005 when all of KPMG’s fraudulent accounting practices for 100s of million in fees were coming to a head, KPMG engaged in the age old art of obfuscation and misdirection by handing over 16 tax partners to the DOJ for a life of ass raping to avoid a detailed prolonged legal battle which surely would have brought to light its massive financial accounting fraud and massive purveyance of corporate tax fraud (at least according to the KPMG employee Mike Hamersley’s definition of tax fraud and to add insult to injury KPMG exchanged the lives of 16 of its tax partners for a halt to the investigation and received audit fees from the DOJ). Nice work Messrs Flynn, Bennett, Holmes, Lonnan and Taft. What are you going do this time, how many audit partners are you going to throw under the bus? Too much litigation will expose your fraudulent sham offshore Bermuda captive insurance company, Park, which not only engaged in massive tax fraud but with the help of Taft defrauded future KPMG partners. What is the now high level government lawyer Mike Hamersley going to do, while at KPMG he engaged in massive corporate tax fraud by his own definition when he helped structure sham paper foreign companies and helped back date documents to create 100s of millions of phony tax losses (word on the street is that in the next 60 days many of Hamersley’s emails showing he engaged in his version of Tax Fraud will be released publicly)? Are KPMG and Hamersley going bankrupt?

  11. Independent Accountant

    I never liked CDSs. Why? If you own a bond and don’t want to assume the credit risk, you have an out: sell it! The CDS can only transfer the risk. I believe this innovation should be banned. Period. I have felt that way ever since I first learned of the existence of CDSs.

  12. Kien

    Perhaps we do really need the financial market’s equivalent of the US Food and Drug Administration (“FDA”) to approve financial products, and perhaps a “white list” approach, categorising financial products into “on-shelf products”, “prescription-only products”, and “on-trial only products”.

  13. Namazu

    Yves: Are you familiar with Robert Shiller’s proposals in “The Subprime Solution,” including the one to allow individuals to hedge exposure to the value of their own homes? I’ve seen no feedback at all, and would be interested in yours.

  14. Anonymous

    Yves. great post. Despite the criticism of a previous poster who felt you should rename this “useful and deceptive financial innovations”, I think your post fleshed that idea out quite well. no need to state the obvious.

    this dovetails with a concept I’ve used (I believe I came up with this myself, but perhaps others also have) that I name “peak complexity”.

    there comes a point where all of the variables simply cannot be understood by the human (or even computer) brain. thus we rely on short cuts or “blackboxes”. but that pollutes the information that you get.

    this financial “innovation” is so complex that even most of the architects don’t really understand it. If they do they lie anyway.

    although financial innovation did give people a brief glimpse of the American dream, it also left them with a huge slice of the American nightmare. the hangover isn’t worth the bender.

  15. rd

    Your post below on the problem with mortgage modifications is the primary argument against unlimited financial innovation. Innovation brings many secondary effects that are unknown at the time of origination. As a result, the innovation needs to be kept relatively small for a while until the product lifecycle can be worked through in real-life instead of a salesman’s presentation.

    Limiting the use of off-balance sheet vehicles would be a good place to start in keeping innovations initially small.

  16. Anonymous

    Taleb’s thoughts on efficiency are relevant here. The point of financial “innovation” would be to create more efficient markets. However, this presumes that we can understand and predict how those markets will behave, otherwise we wouldn’t know how to optimize based on the efficiency criterion. To the extent the future is uncertain and we are overconfident of our grasp of that future, we are setting ourselves up for colossal system failures by pursuing a narrow notion of efficiency. The flipside of a “just in time” inventory system is that you’re screwed if your supply chain experiences any disturbances, particularly if you no longer own it.

    The more “efficient” financial markets get, the more companies will have to build in their own protections against the vagaries of those markets. This would be to self-insure against the volatility those markets would bring.

  17. CTMM

    “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?”

    Remember, at a casino, the house always wins. If I can be allowed to torture a metaphor, consider a man taking money out of his pocket and playing roulette in the casino. He may have short runs of “luck” but over the long term the averages will conspire to drain away all his money.

    However, if someone continually pours money into his pocket while he’s playing, he might even appear to come out ahead if his income out paces his gambling losses.

    I think what we have seen is a economic system that enjoyed decades of monetary growth (in the form of stagnant wages, expanding markets, falling energy prices, rising property prices) but now is facing a reversal (maybe temporary, maybe permanent depending on your peak oil views).

    Realistically, the last three big bubbles (dot-com, housing, CDS) allowed an awful lot of morons to make huge fortunes on speculation, rather than actually contributing a product or service that benefits society.

    Lacking a growth margin to cover losses, the gambler finally realizes he is not, and cannot make money at the casino.

    Ranting is fun, but not what? I’m cynical enough to think there will be no core regulatory changes, prosecution or the creation of more oversight until we reach the pitchfork stage. Pres. Obama walked into office with more political latitude than pres. in the last 20 years, but so far I haven’t seen any real efforts on reforming this mess.

  18. Anonymous

    Is there such a thing a financial innovation?

    Or is everything new just a different way of dressing up the risk of borrowing short and lending long?

  19. Leo Kolivakis

    Yves wrote:

    "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."

    >>You know Yves, my father is a 77 year old psychiatrist who still puts in an honest sixty hour work week. One thing he told me a long time ago: "…Leo, when it comes to money and sex, only too much is enough."

    We have witnessed an unprecedented financial orgy over the last decade. Most of these "new, improved" instruments have done nothing to help the real economy. All that's happened is that they diverted important resources in the financial sector, generating huge commissions and fees for the shadow banking system, which has also grown exponentially in the last decade – fed by huge pension funds searching for "alpha"!

    In order for our society to progress, we have to break the FIRE industry's (Finance, Insurance, Real Estate) stranglehold on our economy and get back to real innovation in biotech, alternative energy, and all forms of engineering except for financial engineering.

    The Obama administration and the Fed are doing the same mistake as the previous administration. They are desperately trying to reflate the securitization and real estate bubble using taxpayer funds.

    In doing so, they are turning the U.S. economy into a giant hedge fund and the ripple effects will be felt around the world for a very long time.



  20. Anonymous

    “Proof” is a meaningless concept in economics if you mean something akin to a “scientific” proof of the Newtonian genre. It’s a red herring. I would suggest you use the word “demonstrate” or “convince” because that’s the best you can achieve. Even assuming you can “convince” people that “financial innovation” isn’t a good idea doesn’t mean much since the basic problem is that our computer mediated financial system is creating tremendous pressure to produce “financial engineering.” The day of the spectacled banker peering across the desk is gone until the machines lose their grasp. Not soon enough to squash the deep and violent instabilities inherent in any system whose bandwidth has been suddenly increased manyfold. Engineers had a saying that when you attempt to design an amplifier you’ll end up with an oscillator. It’s only after the components have been carefully tuned that the circuit settles down into linear behavior.

    There is only one economy and it isn’t subject to classical engineering techniques. One doesn’t snub the output of the economy with some kind of dissipative tweak to inhibit bad outcomes (vicious cycles as you call them). What happens in an economy is fundamentally unpredictable. All we presently know is that we’ve entered a period of radical instability and, aside from perching in the peanut gallery and making snide asides, there is “nothing to be done,” as Sam Beckett would say.

    Marshall McLuhan is supposed to have said, “It is the business of life to be dangerous.” Always liked that quote.

    All this talk about “Greenspan did it,” and “Fannie and Freddie blew us up,” just makes a simple minded mockery of the situation. Lots of things went wrong but the central fact is that the system itself is highly unstable. Why? Because the value of money is, finally, a measure of a community’s faith in itself. That faith is as unpredictable as is human optimism and pessimism. A community losing faith in money is a community that plunges deep into pessimism about itself and its future.

    One seldom mentioned aspect of WWII is that the United States emerged from that war as a knight in shining armor (literally!!). We felt very good about what we had achieved in a fight against evil. This, as much as savings, contributed to an explosion of optimism, babies and faith in the infinite expandibility of the “good life.”

    A quick look round shows that the conditions for a repeat of some event that will allow the US to again regain that euphoria are most unpromising.

    The hack phrase that “history doesn’t repeat but rhymes” should remind us that a rhyme is the weakest form of connection between two lines of a poem. It relies on the similarity in the way words sound without regard to their meaning. I suspect Twain was mocking when he uttered the phrase and is laughing in his grave how many “economic wizards” quote him while pulling thoughtfully on their hairless chins. He was actually pointing out that what we see as similarities between various economic episodes are as fatuous as the dragons we see when we stare at the clouds. History is very entertaining but there’s little practical advice to be gained from studying it. Thanks be!

    What really astonishes me is the persistent belief that we are a “democracy” and that the “will of the people” is a viable concept. It’s obvious that the banksters are a lot more powerful than the hoi polloi below. Why would one expect them to be crucified or put to the rack? It’s irrational in the extreme. Why should Obama listen to the little folks? He only needs them once each four years and he can gibber “Yes we can!” a few times and have us in his pocket. Obama, let us not forget, is a Chicago Pol with all that implies. And he’s a helluvalot smarter than the ex-governor.

    Spending a lot of time trying to figure out how to “regulate” the system might better be spent sidled up to a roaring fire with a copy of Beowulf or any of the Greek classics. The potent regulation will and must come from the depressed animal spirits of the population. If we continue to hoard and save one may feel confident that the conditions for euphoric Ponzi schemes on such a grand scale will not reappear for many years. Through a twist of fate we truly were the spenders of last resort. Those days are over.

  21. mmdonner

    It comes back to the incessent need for GROWTH. when an economy is not making real things yet needs to grow each year…enter the synthetic economy.
    the financial sector grew by 100% over the past 20 yrs as its share of the gdp. they did this by basically circulating the same money and counting it many times over…each count adding to the necessary GROWTH of the economy each year.
    growth, inflation, bubbles…how are we going to grow our way out of this mess when we continue to make.manufacture/create fewer real things??
    i am not an economist..but its it obvious the music has stopped and there are fewer chairs by far? CDSs, xyz, abc…all the same in the end..count the same money many times and continue the illusion of growth.

  22. lililam

    I have to agree with CTTM and Leo above. I know it is a simplistic way of looking at things, but throughout the aforementioned bubbles, my intuition was on high alert to the inherent lack of tangibility in them. There was little in concomitant production or technical (non-financial) innovation involved. Common sense implies that they were ephemeral and “derivative” from unreality. One of the few exceptions would be the actual construction yielded by the real estate bubble, although now we know that much of that was speculative as well and not necessarily based on true need for commercial or residential units, as seen by the high vacancy rate.

  23. IF

    I’d like finance to be old fashioned, but then again I am German.

    What are good financial innovations? Everything that makes financial services cheaper and reduces the size of the financial industry. The ATM is obvious, debit card payments, online banking, ETFs. TreasuryDirect. A company model like Vanguard. (Isn’t it amazing that there are – intentional – nonprofit financial companies in the US?) Some of securitization (I should be able to directly invest into my neighbors houses, without the bank having all the fun), but only when reasonably transparent. Etc.

    It appears that financial innovation, as it was employed in the last decade, allowed the economic system to suspend disbelief longer than it would have without. (Who really wanted to earn 1 percent dividends, ignore energy dependence, have off-balance wars, deny their kids inexpensive housing etc.) I am sympathetic of Keynes view, who wanted the opposite of liquidity. If you buy something, you own it. Till maturity, however you want to define it. (Of course that concept is somewhat self-contradictory: who is selling to the buyers?)

    How about financial education to the great unwashed, is this innovative? Several of my colleagues are afraid of buying 20 year TIPS or 30 year corporate bonds (“I want to buy a house one day and I don’t want to bind my money up for so long”) – yet they don’t mind putting the same money into non-dividend paying stock.

  24. Anonymous

    DoctoRX’s comment is great and should be emphasized whenever financial “innovation” is discussed. Obviously, almost all financial innovation is the result of individual actors trying to maximize their profit. Certainly, some innovation does actually add value to the system. But there is such an enormous incentive to cheat that at the very least a non-negligible amount of financial innovation will be of the scam variety. I would think that the unwinding of the recent (30 years in the making) scheme gives a lot of credence to the idea that *most* of the financial innovation was in fact a collective (though non-collusive) scam intended to convince the world that risk had truly been diminished (i.e., value was added) when in fact risk had not diminished in any significant sense but merely been shifted onto later generations of savers. This enabled a truly massive transfer of wealth to participants in the financial sector, as can be seen by how large a proportion of the economy the financial sector had become.

    The history of the world shows that this phenomenon has occurred over and over again. You would think at this point at least a few intrepid souls would realize that vigilance is appropriate when such large incentives exist to cheat.

    Also, in discussing any policy, follow the money. Every law creates winners and losers. Always think about which group falls into which category and why.

  25. Anonymous

    Since you all insist on prognosticating in the face of its obvious futility, – cast a suspicious eye on any “innovation” that increases leverage. Not that any of the commenters here have the slightest authority to institute such changes. Carry on Mouseketeers! Pretend you’re Imagineers!


    “More derivatives is ever and always better” is certainly true if you’re collecting the fees, up front, for selling them, or if you’re the shill who ropes in the rubes. Otherwise, I’m with the guy who said the bender’s not worth the hangover. Assume that all most people really need to finance is housing, schooling, possibly transport. And they need to save for retirement. Isn’t it really unconscionable to take that money, which should be used for human purposes, and blow it on the ponies? Why not turn the banks into regulated public utilities? Then, if the investment people want a casino, they can set one up on their own dime. How about “Keep It Simple, Stupid” for the kind of innovation we really need?

  27. john bougearel

    It seems to me that “less is more” has been a very good mantra for me to live by. It comes in quite handy for filtering information, but I admit to being challenged in this crisis, which has been forcing me to read more, filter a bit less.

    When it comes to creating more and more unregulated derivatives, Mayer has it right, more and more “innovation allows you to go back to some scam that was prohibited under the old regime.” This is precisely why these products have all been unregulated, not just cds, but cdo’s, clo’s etc.

  28. K Ackermann

    When the process of securitization requires Monte Carlo simulations to price, and when it allows ‘junk’ assets to slip in with an AAA grade, then innovation is coming from criminals.

  29. Jacob


    Interesting post. On the question of hedging, I think the simplistic response is that there are situations where a firm should hedge because it will increase its value. Certain financial products are needed to accomplish that. Added value could typically arise from at least one of three potential benefits to less volatile cash flows: lower taxes arising from convexity in the tax code, preservation of a growth option by maintenance of a minimum level of working capital, or reduction in the likelihood of incurring costs of financial distress. There are also strategic reasons to try to mitigate certain risk exposures.

    In principle, this potential for some kind of hedging strategy to create value justifies the need for financial innovation. It’s precisely the lack of sophistication of the average corporate treasury and the difficulty of hedging many operating exposures that makes a genuinely useful product attractive and a net benefit to the economy.

    It seems to me that this needs to be examined on a case-by-case basis. To use your Motorola example, were there some ingenious way to bundle all the exchange and operating risks of Italy or Norward or Poland into a tradeable security, Motorola could potentially benefit from that, and I would argue that such an innovation might be worthwhile.

    Equally important, however, is that there should also exist a regulator which, like the FDA, could examine the offering and assess its inherent risks. I don’t think speculation in the market for a hedging product is necessarily harmful, since the added liquidity (theoretically, at least) sets a more appropriate price for the asset. However, I think the key thing going forward is for some institution to take a hard look at each of these proposals and figure out if they should be existing in the first place (and relatedly, whether they are being developed and marketed in a predatory manner, like some of bond issues in the 80s).

    I suspect that under such a system we’d still have options and MBS, but very few CDS on MBS or other higher orders of complexity.

  30. Merry-will-go-round

    Although the Keynes quote made for an interesting segue into the topic of financial innovations, Keynes clearly intended to caution governments from allowing speculative activities to become a significant cog in a country’s economy. At about 40% of our GDP, the U.S. government has allowed the FIRE sector to capture a dangerously large portion of the economic engine. This sector’s growth seems to be less about finanical innovation than about changes in accounting; the state’s regulatory and enforcement actions; economic policy-making and taxation; increased capital inflows into the FIRE sector; communication and information-processing technologies; and fraud / cronism levels.

    Focusing on the topic of financial innovation in a broader context, it seems that innovation is always a double-edged sword. Consider the automobile, industrial food production, improvements in public health, and weaponry developments. Whenever decision-making relies more heavily on a value system of short-term profits than on a value system of sustainability, innovations tend to result in benefiting some groups and passing costs and risks to others. Oft touted efficiencies and growth are usually due to unrealized or socialized costs.

    As to whether some level of financial “innovation” might be desirable, the levels of transparency and accountability for both stakeholders and innocent bystanders will best guide public policy making. This cannot occur when government officials are betting heavily in the casino.

  31. Yves Smith


    The issue is theory versus reality. The idea that a company can know when to hedge is questionable. If you believe markets are reasonably efficient, which MPT assumes, you also believe no one has superior knowledge, that the markets already incorporate that information. And per the wrong footed hedges mentioned in the post, getting it wrong happens pretty often. A lot of people when oil was $125 thought it was going much higher. And it did, briefly.

    The best hedge is probably to buy the equivalent deep out of the money puts, to try to contain risk of extreme downsides. But that has been figured out in stock market, deep out of the money puts trade at higher vols than puts at closer to current levels.

  32. albrt

    “I don’t think speculation in the market for a hedging product is necessarily harmful, since the added liquidity (theoretically, at least) sets a more appropriate price for the asset.”

    Allowing speculation on an insurance product theoretically increases liquidity, but almost never in practice. The only person who benefits from buying insurance on an asset he does not own is the person who believes he knows more than the insurance company about the risk to the asset.

    Perhaps all the speculators are just deluded fools who think they are smarter than underwriters, but their opinions are distributed randomly. In that case you have a market that increases liquidity with no other significant effects. But is that realistic?

    Real insurance companies and regulators figured out a long time ago that the person with the greatest incentive to buy fire insurance is an arsonist. Comparable moral hazard exists in every insurance market, and greatly outweighs the benefit of increased liquidity.

    The only thing different about the finance industry is that the insurance companies ARE the arsonists. Through much of the 20th century, the financial industry was small enough and cohesive enough to keep the game going and keep most people from figuring it out.

    The odd thing is that now everything has burned down, and it still doesn’t look like the majority of people are going to figure it out.

  33. Hank R

    Monday, September 17, 2007

    Posted 10:55 AM by Ken MacLeod

    Anarchist bankers

    At a Libertarian Alliance conference a few years ago, I heard an anarcho-capitalist economics lecturer explain that financial regulation was no big deal because the speculators were always one step ahead of the regulators – as soon as the regulators had one financial instrument tied up in red tape, the financial services industry came up with another instrument even more complicated and opaque than the one before, and by the time the regulators had caught up with that one … and so on…..

  34. Jacob

    Yves and albrt, thanks for the replies, and point taken–I’m placing a little bit too much faith in market prices, particularly given the arsonist problem. Perhaps there is a regulatory solution here too that restricts participation, but I don’t think we should disregard the need for price discovery in some kind of market for derivatives like CDS that are difficult to model accurately. (Granted, if all market participants use the same unrealistic assumptions, say constant default correlation, maybe aggregated expectations will still be systematically biased).

    As for the oil hedging at $125, of course it looks bad in hindsight, but hedging may still have been the optimal choice under uncertainty. I agree that options would be a better hedge than futures in that instance, and that in many situations the best strategy is not hedging at all. However, I think that there are still situations where hedging is desirable, and therefore so are the financial ‘innovations’ that make it possible.

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