Is financial innovation worth it?

Half Sigma’s post has face validity, but I am aware of my lack of knowledge of how the financial system works.  So instead of agreeing with it, I will ask for comments so I can learn more.

Government run industries tend not to be very innovative, but the only useful innovation to come out of the banking industry in the last century is the ATM machine. Otherwise, when banks innovate, that’s when it’s time to hold on tight to your wallet. Bank innovation tends to fall into two categories: (1) sneakier ways to trick people into getting into more credit card debt and pay more outrageous credit card fees; and (2) complicated financial products like mortgaged backed securities and derivatives which have led to the recent financial collapse which not only ruined that banking industry but took down the whole economy with it.

via Half Sigma: What’s wrong with nationalized banks?.

Thoughts?

25 thoughts on “Is financial innovation worth it?”

  1. The problem is that given the existence of the FDIC and the expectation of bailouts for ‘too-big-to-fail’ banks, combined with compensation that is very sensitive to short-term profits and stock prices, it’s usually a good financial bet for a bank CEO to take on a big risk of a blowup in exchange for higher near-term profits, even if the package has negative expected value for the company and the economy.

    Thus, financial innovation to take the upside of risky bets while putting much of the downside on government guarantees is a major industry. Likewise, a great amount of effort goes into structuring transactions to avoid tax. There are also real financial innovations like catastrophe bonds, but often the majority of innovative effort will just be going into the profitable subversion of regulation through the creation of new and ‘innovative’ products that don’t fall under the technical definitions of the regulations.

  2. There have been lots of useful innovations: ATM machines, drive-throughs, Bank branches in grocery stores, on-line account access, Money market funds, indexed funds, mass-access mutual funds (anybody get bet in a a mutual fund).

    Mortgage-backed securities and first order derivatives have also been useful. Bad math models, fraudulent data inputs and over reliance on the genius of MBAs were there downfall.

    A corporate governance system that is broken doesn’t help.

    A federal government that interferes to artificiality distort supply and demand and to dampen creative destruction effects is a big negative.

  3. I don’t think the issue here is the processing of monetary transactions. Banks are really, really good at processing transactions. Lately, they have become very good at making money off of processing those transactions (fees, ect.). I’m sure if the government were to nationalize banks this function would hardly be impaired, it might even become less expensive.

    Risk management is a whole different story. Just as borrowers have been more concerned with what they can borrow than what they can afford, banks have been more interested in how much they can lend rather than how likely they are to be repaid.

    I don’t see any reason why a government run banking system would be any better at risk management than the current banking system. It might even be worse at it (too conservative is just as bad as too liberal).

  4. I think that a tough sell for politicians (and for the banking industry) is that most of its innovation is largely invisible to the wider public. Tweaks to retail banking like ATMs are fine as well as they go, but as Arherring correctly identifies, these are just variations on a theme of transaction processing.

    The most important innovations have been those transparent to the public (such as those that have drastically reduced the cost of borrowing and the broadened, perhaps dangerously, the portion of the public that can borrow money) and those that have fueled the explosion of cross-border investment and trade. Politicians cannot explain that which they do not understand, and political ignorance of banking both helped lead to this crisis and are furthering it with flawed solutions.

  5. Is “it” worth “it”? Thats an impossible question to answer. “It” all depends.

    I suppose we have all enjoyed living in a credit rich, liquid rich environment these past 100 years or so. And I suppose we wouldn’t enjoy going back to a trade and barter system too much. Moreso do I think we wouldn’t want to go back to the centuries old legal framework, and instead have enjoyed the freedoms of contract, rights to property, and other such privileges we have acquired… all a result of protections afforded to the financially innovative culture.

    So in the view of the past 100 years, and in view of the quality of life that Americans now have, you have to say financial innovation is worth the various setbacks along the way. Millions of business that have provided extremely valuable goods and services to the world over that time period have only done so because financially innovative products allowed them to fund their operations… whether they be operating in good, bad, or indifferent times.

    But what about in the view of the last 10 years? Is “it” worth “it”. Clearly not, because America’s economy is basically right where it was 10 years ago. No bang for our buck, as they say.

    So should we get rid of the whole project based on a 10 year sample, or should be ok that the gains won’t be realized until we’re long dead?

    I dunno. I thoroughly enjoy what I do. And I know that the government would never do this, it is far too risky. But I suppose if they did I’d find something else to do. It’s really an unknowable question I think.

    But I do know this, geo-political power rests firmly in the hands of those nations who can shape the world with financial innovation, taking the unseen power of capital and applying it to the world to create wealth for its people.

    This is no apology for “banks”. It is simply an historical point. A super-power lacking financial innovation is an oxymoron. They require each other to exist.

    Better regulations could have easily prevented where we are today. But will they prevent where we end up the next time? Probably not.

    And what would happen if all the financially innovative wizards moved off shore? We are about to find out.

  6. Federalist X,

    Thank you fror your comment, and for clarifying the my original question.

    But what about in the view of the last 10 years? Is “it” worth “it”. Clearly not, because America’s economy is basically right where it was 10 years ago. No bang for our buck, as they say.

    So should we get rid of the whole project based on a 10 year sample, or should be ok that the gains won’t be realized until we’re long dead?

    I guess I should rephrase it as follows: is a system that allows the rate of credit innovation that we saw in the past 10 years worth it?

  7. I’m in way over my head on this one, but I think many of the prime suspects, the financial instruments, will be exonerated over time.

    Building 10 million houses for buyers who had no capacity to pay for them was a government-led initiative, and, like Lee Harvey, I think the final analysis will be a lone gunman shot the economy. And, sort of like with JFK, many will find it hard to believe something so pedestrian as a little person missing a mortgage payment on a bungalow could do so much harm.

  8. AIG’s FP unit in London sold CDSs. The executive described them as sure bets. Why? Americans and Europeans had a very reliable debt payment history. If not for the 10 million houses sold in the 2000s that were doomed to foreclose, he would have been 100% right.

    Until now, nobody ever built and sold 10 million houses that were destined for nearly immediate foreclosure. In the past they had always built homes the vast majority of which were not destined for foreclosure – ever.

    Not making the monthly payments is what did this.

  9. i dont think its right to characterize this as soley a residential real estate phenomenon. and by this, i mean the greater financial crisis. almost all asset classes were heavily inflated and over-valued. lots of people were making loans for lots of things that were “sure bets” and then securitizing those loans and selling them off. the underlying assets, though for a time skyrocketing in value, were bound to bust at some point. now, it is true, as a class, real estate promotes a bigger problem because it is highly illiquid. and this reveals another part of the cause…

    if the MBS were never sold in the first placed, but parked at the mortgage originator like always, do you think for a moment that sub-prime would have occurred? would the originator, with all the skin in the game, have taken on such a risk? of course not. in times before, your mortgage banker knew you, could evaluate you as a risk individually, and make exceptions if truly warranted, and raise suspicions if necessary. that whole system is gone. how many people really know their mortgage banker anymore? very few. and the few who do tend to have homes they can afford, even in downtimes.

    to be honest, if i had to pick one cause, and i really can’t because there are just so many major failures that are so glaringly obvious that it would be dishonest to fail note them all, but if i was forced to pick one thing and one thing only, i would say that greenspan’s failure to burst the tech bubble with higher rates was the biggest culprit. by failing to raise rates then, and instead relying on speeches about “irrational exuberance” to do the job, greenspan effectively threw in the towel on monetary policy as we know it. we’re still trying to get back in the game from that, and with ZIRP and an era of quantitative easing now heralded, the game is just beginning. my biggest fear is that we’re only going to create another boom bust cycle… but with the government now directly involved in market manipulation, i suppose that risk is somewhat tempered.

  10. Some people say MBS started in 1938. Others say the modern version began with the RTC in the late 1980s. Either way, they had been around a long time without creating a once-in-a-century global economic crisis.

    The AIG unit started selling Credit Default Swaps, CDSs, around 2000. The debt rating system failed, but that is no excuse for AIG. Many people sailed merrily along thinking the Titanic had iceberg insurance that precluded its sinking.

    Greenspan raised rates like crazy just prior to the election at the end of Clinton’s 2nd term. He caused a recession, and got major plaudits for being the maestro of soft landings and gentle takeoffs. I can’t agree at all there. His failure to regulate exotic subprime will get its own chapter. Bernanke did that with a flick of his wrist, but it was way too late.

    4 million extra foreclosures is a huge number, and they were extra. 6 million more potentials staring them in the face – it was/is a catastrophic blow – a tsunami of nearly endless red ink.

    Would this have happened if all mortgages were still in the vault at George Bailey’s S&L? Probably not. But this also never would have happened without 10 million homes being financed via of unregulated exotic subprime. I do not see how that conclusion can be avoided. When Bernanke first looked at it, his staff showed the stunned Bernanke a stack of mortgages that had gone into default on the 2nd payment. Not good. To sink the point, they showed him a bigger stack that had gone into default on the 1st payment. He opened Greenspan’s dusty drawer and killed exotic subprime.

  11. lew ranieri is the man responsible for what we term today residential MBS. i watched with my own two eyes at salomon when he did it. but i think you’re missing my point…

    securitization of residential MBS is not truly bankruptcy remote (this has been my view since i first saw what lew was up to… only about two law professors share this view… but one circuit court of appeals shared it, and was universally denounced as a panel of heretics in robes by the corporate press). it only became that way after some bad bankruptcy reform in 2005. the investors still have, imho, skin in the bankruptcy and an aggressive trustee would and could (at least for notes printed prior to 2005, and possibly some after) clawback those contracts.

    but they aren’t. because everyone is afraid if that happens the world will come to a screeching halt. but i don’t think it will. i think virtually every major bank in the US will go insolvent, but there is plenty of capital to sweep up the mess left on the sidelines. and besides, about 2/3 of them are already insolvent.

    in the end though, i dno’t have much argument with you. exotic mortgages were a major component. but they were not the only component. in your post you cite several others even, dare say it, lax regulation. the list is long, and it stinks.

  12. First, i went and read all about Lew. Thanks.

    I’m just a little oil and gas guy. Can you expand on what all of this means:

    “securitization of residential MBS is not truly bankruptcy remote … the investors still have, imho, skin in the bankruptcy and an aggressive trustee would and could (at least for notes printed prior to 2005, and possibly some after) clawback those contracts. …”

  13. well if you read all about him, you now know that he’s gone from the right hand of god, to the deepest pit of despair: his own bank was received by FDIC. talk about losing it all. though most of us have never, and will never, have what lew had, at least we won’t ever lose what he lost!

    the only reason securitization of residential MBS works is because it is premised on the theory that once the mortgage goes through its conduit, the debtor’s rights in the contract are extinguished. thats why SPVs exist… to clean the paper from the threat of the debtor’s bankruptcy. it is literally (oh geez, i can’t say that anymore without thinking of joe biden, god help me!) a money laundering operation, except it is laundering debt instead of laundering cash.

    so you have a scenario where the debtor’s right in the paper is extinguished and a debtor’s bankruptcy cannot “redeem” the contract for a bankruptcy dividend.

    scenario a: a 2nd mortgage is sent through SPV and then packaged and resold on the street. debtor files bankruptcy… the note is no longer part of the bankruptcy estate and thus cannot be “primed” by other liens in the debtor’s bankruptcy.

    scenario b: a 2nd mortgage is sent through SPV and then packaged and resold on the street. debtor files bankruptcy… the note is still a part of the bankruptcy estate, and shares in the bankruptcy dividend with all other general unsecureds.

    scenario a yields a creditor with full rights to enforce his note but with little way of collecting.

    scenario b yields a creditor with only those rights of a GUC and is forced to swallow whatever the estate is able to pour into the pool, if anything.

    right now we have scenario a, in large part because the foundations of securitization have never fully been ironed out. so we are at a standstill. and no one knows what the paper the creditor has is truly worth.

    but if we had scenario b, there would be no standstill. the bankruptcy process would cram down the GUCs a cents on the dollar compromise after the estate was liquidated… thus providing exactly the tonic everyone now seeks: a floor on the losses. eventually, vultures like myself would fly in and swoop up any kernels of undervalued scraps, and then we would have what capitalism always seeks: a market, with buyers and sellers.

    but under scenario a, we will never have that because no one would ever be willing to buy something that they can’t approximate a fungible value for. the administration is trying to crack the nut by generating a fund with NRLs to the investors to go on in and do the price discovery needed under scenario a (a move i selfishly support).

    but the thing is, we’ve always had a means to do that, we’ve just never had a congress willing to allow the bankruptcy courts to do it for the 10 million homes that you say are now worthless. it was a much cheaper fix, in their opinion (c. 2005), to carve out securitized assets under the code and “let the banks work it out.” seemingly, giving the banks all the cards, but unwittingly, bringing us to the cold war of finance we now find ourselves in.

    debtors, with virtually no bankruptcy rights, and with underwater homes, are perfectly rational to send in their keys and walk away from the home. an empowered bankruptcy court makes that choice less rational, and provides a market for clearance.

  14. sonofsamphm1c,

    Yeah, it’s a good summary of the Wired article on the Gaussian copula function [1].

    I’ve been using R [2,3] to work some of the components of the GCF, such as the gamma matrix, as part of my doctoral research.

    One conclusion is that the quants on Wall Street appear to be radically overpaid, as the math is increasingly typical of what you find in social science research. I think the pay differential comes from a Wall Street structure that does not understand basic probability. If you have a very competitive environment, promote a sliver who do the best, and get rid of everyone else, then you naturally encourage people to make risk predictions. Obviously, this eventually blows up.

    Take the p = .05 level, the 1 out of 20 chance that results are wrong (which is typical of social science research). Of course, this presupposes that the model is valid in a lot of other ways, and that robust sampling procedures were used, etc. But for the sake of argument, take that 1/20 chance.

    If you’re in a situation where things physically explode, burn, or die if you get your study wrong, that level is unacceptable. Industrial engineering research uses the p = .01 level. Medical research uses p = .001, and pays much more attention to validity issues. And so on.

    If you’re a Wall Street analyst, though, and you have two choices
    a) a 5% return using a model, p = .05
    b) a 50% return using a model, p = .10
    c) a 100% return using a model, p = .20

    and so on, (c) is probably the best answer. Low performers are let go, it’s a young man’s game anyway… best to bet big, and hope for the best.

    Razib Khan and gnxp used a similar line of reasoning to consider the death penalty for Wall Street investors who lose billions for their companies. Otherwise, under our bankruptcy laws, you can’t lose the game with much less than what you’ve started with.

    [1] http://www.wired.com/techbiz/it/magazine/17-03/wp_quant
    [2] http://www.tdaxp.com/archive/2009/01/07/r-and-deep-ux.html
    [3] http://www.r-project.org/

  15. tdaxp:

    “Otherwise, under our bankruptcy laws, you can’t lose the game with much less than what you’ve started with.”

    whuh?

  16. FYI – the gaussian work is quickly entering urban legend territory. i’m not saying that morons at the prop desk of some giant financial don’t play with this and that, of course, but i am saying that the people we speak of doing the “financial innovation” are not the same.

  17. Fed X,

    Thanks for the comments!

    “Otherwise, under our bankruptcy laws, you can’t lose the game with much less than what you’ve started with.”

    whuh?

    I was simply saying that being bankrupt is pretty much the worst-case economic scenario. Certainly this outcome sucks, but bankruptcy does not increase in severity, whether one is bankrupt for medical reasons, or becasue the Subway franchise you bought failed, or you destroyed millions or billions in wealth.

    FYI – the gaussian work is quickly entering urban legend territory. i’m not saying that morons at the prop desk of some giant financial don’t play with this and that, of course, but i am saying that the people we speak of doing the “financial innovation” are not the same.

    Could you say more on this?

  18. tdaxp: on the gaussian work, i simply mean that while some people, in fact, probably did believe that there was a formula that got them a return every single time, they were mostly marginalized idiots. of course, the whole downfall of wall st. could perhaps be traced to allowing too many idiots too much leeway. but when you’re talking the hedge funds that ran, and are still running (albeit at defcon 5 alert) the shadow banking system, no one ever used one set of formulas for any one thing. financial innovation in the last 20 years was sourced from the proprietary account activities of extremely well run hedge funds, not the idiots at merril, or lehman, or goldman, or any such place. those major i-b desks were where the products were packaged and sold, not invented in the first instance. i say this with a degree of personal familiarity, as well as creator’s pride 🙂

    on the severity of bankruptcy, let me suggest this hypothesis:

    there is a reason that financial institutions don’t go through bankruptcy ordinarily, and it has less to do with their “systemic” importance, and more to do with criminal negligence and fraud.

  19. Fed X,

    Thanks for the information!

    It his helpful!

    What is your perspectives on the salaries paid to folks at Goldman, etc. For hedge funds, it makes sense that if they were innovating that quickly, and one employee could add millions to the company in revenue, the company would rationally pay millions to capture that potential wealth. What were Goldman’s et al.’s calculations?

    there is a reason that financial institutions don’t go through bankruptcy ordinarily, and it has less to do with their “systemic” importance, and more to do with criminal negligence and fraud.

    Fascinating…

  20. tdaxp: “fascinating” or f-ing scary… depending on whether you’re having lunch with a bond trader or a stock-jobber. bankruptcy implies a public airing of all your dirty laundry. receivership is a back room deal.

    salaries paid to folks at goldman… hmm… GS was a beast. and did as much as anyone to inflate compensation for ibankers at the other major firms. if davis polk was paying associates $160K to start, then GS needed to best that, because, they’re GS afterall. nevermind that the average associate bills more hours (and as a result, works more hours than s/he bills) than the average firsty ibanker. bankers must make more than lawyers. that is the rule.

    we are actually giving a talk on “lessons learned in hr in the financial industry” or some such bs topic in a couple of months to some people who have asked. i’ll have more to say after that. but it is ugly. mainly, these jokers gave bonuses based on “revenue” not profits. so as a result, each employee’s book to value was perpetually fucking them up.

    our shop is unusual in that all employees, and there are only six, have skin in the game. the better they do their job, the better the fund performs, the more money they make. but its all based on profits, not “revenue”. and of course, the more senior they are, the more they are able to participate in profit incentives. the principals, can and have, had a year where they draw a salary of $1 because they simply didn’t meet their profit expectations. when employees know that, and when they see that they still get a pay check even though their boss is getting a $1 because, in part, of their fuck ups, they work extra hard. this is true whether the employee sits at the front desk, or whether they sit at the trading desk.

  21. Fed X,

    tdaxp: “fascinating” or f-ing scary… depending on whether you’re having lunch with a bond trader or a stock-jobber. bankruptcy implies a public airing of all your dirty laundry. receivership is a back room deal.

    This is an important point.

    salaries paid to folks at goldman… hmm… GS was a beast. and did as much as anyone to inflate compensation for ibankers at the other major firms. if davis polk was paying associates $160K to start, then GS needed to best that, because, they’re GS afterall. nevermind that the average associate bills more hours (and as a result, works more hours than s/he bills) than the average firsty ibanker. bankers must make more than lawyers. that is the rule.

    we are actually giving a talk on “lessons learned in hr in the financial industry” or some such bs topic in a couple of months to some people who have asked. i’ll have more to say after that. but it is ugly. mainly, these jokers gave bonuses based on “revenue” not profits. so as a result, each employee’s book to value was perpetually fucking them up.

    our shop is unusual in that all employees, and there are only six, have skin in the game. the better they do their job, the better the fund performs, the more money they make. but its all based on profits, not “revenue”. and of course, the more senior they are, the more they are able to participate in profit incentives. the principals, can and have, had a year where they draw a salary of $1 because they simply didn’t meet their profit expectations. when employees know that, and when they see that they still get a pay check even though their boss is getting a $1 because, in part, of their fuck ups, they work extra hard. this is true whether the employee sits at the front desk, or whether they sit at the trading desk.

    Fascinating!

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