Financial Innovation Update
| Wed Sep. 24, 2008 12:28 PM PDT
FINANCIAL INNOVATION UPDATE....Yesterday I passed along Dani Rodrik's question about whether financial innovation has actually benefited the real economy. As he pointed out, it made homes available to a lot more people, but that turned out not to be such a great thing after all. Reader Brian J. then pointed me to Ben Bernanke's take on this issue from last year:
The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.
Nope, neither of those turned out to be the case either. I'm tempted to say three strikes and you're out, but for now let's keep it an open question.
By the way, yesterday Tyler Cowen recommended this 2006 paper on credit derivatives, so I read it last night. It was quite good, and very accessible to lay readers. I was pleased to see that the authors basically concluded that CDOs are little more than a scam that violates basic economic principles and can only work (for a short time) thanks to industrial size helpings of hooey and sales malarkey. That's been pretty much my conclusion too. Credit default swaps are a different story, but the problem there is that, perhaps, hedging of risk might not really be such a good idea after all if it turns into an economy-wide phenomenon. After all, the people making/taking a loan (or issuing/buying a bond etc.) are the ones who are in the best position to assess the risk of the loan/bond/whatever and monitor its performance. Selling off risk to someone else often has real benefits, but it also produces incentives not to bother assessing risk properly and creates serious problems of nontransparency.
Also, it can cause the global economy to collapse via cascading counterparty defaults that send us back to the stone age. But that's a story for another time.
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Comments
So spreading risk accross the economy improves economic growth.
Wouldn't universal health care spread risk accross the economy?
Doesn't Social Security and Medicare spread some of the financial risks associated with old age accross the economy?
There have been quite a few worthwhile financial innovations over the centuries double-entry bookkeeping, 30-year home mortgages, Michael Milken's original observation that junk bonds were underpriced - even mortgage-backed securities. The big problems have occurred when people start mistaking being lucky with being right, or being right once with being right always, or winning an economics Nobel with knowing how financial markets work. In other words, confusing their worldview with reality, and convincing a lot of other people to make the same mistake.
Kevin
Misprint alert!
CDO not = CDS
Collateralized Debt Obligation is when you split up a mortgage backed security into 'tranches' with different rights over the cash flows from the MBS.
Credit Default Swap is insurance against a borrower or bond issuer defaulting.
You can in fact do a CDS on a CDO, accordingly, but not the other way around.
You mean to say CDS I believe?
Drum: Nope, neither of those turned out to be the case either.
And you know this, how? In fact, the economy has withstood several shocks in the past 15 years that in the 70s or 80s probably would have led to recessions. We've had one -- a very mild one -- after 9/11, and other than that have enjoyed a generally healthy, growing economy. We haven't had a deep recession since Reagan's in 1982, and after all this crisis in the past year, we still might avoid one. Chart GDP growth (you like charts), and notice how much smoother the line is since the 90s (and quant risk management). Coincidence? Maybe. But that's for you to prove, not make sweeping statements like the one you did here. Really, really bad stuff.
Actually, it seems very plausible that the resilience of the system has increased: even Paul Krugman has referred to the Great Moderation, i.e., that recessions in the past 20 years have been less frequent and, most notably, much less severe than in prior decades. Note that even through the current credit crisis, GDP growth has continued positive. (Unless we're somehow not allowed to mention this until after the election.)
I like how the wonkish economics posts are the least commented upon. No one really understands or cares to discuss this stuff.
It always strikes me as amazing that people can be so uniformed about the most pervasive thing in their lives.
I might suggest Messers Paulson, Bernanke and the Congress read James K. Galbratih's "Predator State".
This has been coming and thus far there hasn't been a legitimate proposal to remedy the mess. Time to get serious and change some tax policies to those that encourage business investment rather than the enrichment of corporate execs. Wait! We used to have that sort of policy. Reagan and his merry supply-siders got rid of it.
Drat!
Mark R, it's so true. If Kevin Drum wrote something perfectly reasonable about Sarah Palin's daughter, even if it was perfectly reasonable, there would be 100 comments, most of them off-the-wall, in an hour. Financial innovation and the economy, nada.
Most people know the things they need to know about economics.
My argument is that ARM mortgages confuse price-setting and get mixed in with other assets in CDOs (which is bad when one mortgage defaults and throws off the value of the whole) and that CDS insurance policies by and for parties who don't own a CDO is strange (especially when they insure for multiple times the asset value) and risky when the insurer isn't an insurance company and doesn't have sufficient resources to pay off the policies.
Fix those problems by either doing away with ARM mortgages (convert 'em to fixed-rate) or set a maximum yearly rate increase at x% [preferably small like 2%]), don't let mortgages be bound together in CDOs and regulate the heck out of CDS insurers or ban them all together.
This should help people afford their mortgages, value those when they're being traded and not give someone incentive to blow them up for the insurance money.
If you want an entertaining (though scary) read, get a copy of F.I.A.S.C.O. by Frank Partnoy, one of the co-authors of this paper. Before becoming an academic, he was the one of the brains behind Morgan Stanley's derivatives operation. The book essentially details how they skirted the regulations to make money off of their favorite types of customers: "widows and cheaters" (and the Japanese). At one point in the book, he recounts a discussion among the derivatives group about what other jobs they would prefer to do, assuming the pay was the same. Everyone agreed that they would rather shovel manure.
The book was written in the 90's but you could basically swap out the types of derivatives they were selling for mortgage-based ones, and it would read like a manual to our current situation. It provides some interesting insight not only into the types of transactions that are involved, but also the motivations and flaws of the characters involved.
If we assume economists are the experts, which ones do we believe? The liberals or the conservatives, who often contradict each other? On the bailout, I've heard economists and billionaires giving opinions running the gamut from Paulson to doing nothing.
I'll wait until the black art of economics is advanced enough for the one-armed economist to appear. Until then I'll rely on common sense, which is far more advanced. If you're interested in lowering your IQ, there are three proven methods: 1. Brain trauma, 2. Too much TV, and 3. Study economics.
