In The Blogs

Financial Innovation

| Sat Apr. 18, 2009 8:16 AM PDT

Ben Bernanke gave a speech on Friday praising financial innovation and warning that we shouldn't be too hasty in dismantling the progress of the past few decades. Ryan Avent comments:

According to Bernanke, no one, "wants to go back to the 1970s," but neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in...the 1970s.

In fact, the only post-70s innovation Bernanke pointed to was the rise of subprime mortgage financing, which, Ryan points out, might not be quite the compelling example he thinks it is. So what has financial innovation gotten us, aside from massive profits for clever bankers?

Beats me. I remember that Dani Rodrik asked this question a few months ago, and I also remember that he didn't really get an awful lot of persuasive replies. The broad answer usually boils down to "easier access to credit," but in hindsight, that wasn't necessarily such a terrific innovation after all, was it? The innovation crowd probably ought to take another crack at this.

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Kevin Drum is a political blogger for Mother Jones. For more of his stories, click here.

Comments

Prediction

Submitted by bleh (not verified) on Sat Apr. 18, 2009 8:26 AM PDT.

The innovation crowd probably ought to take another crack at this. Hmm, I have this funny feeling that they will.

Innovation

Submitted by Art Eclectic on Sat Apr. 18, 2009 8:39 AM PDT.

Innovation translates into "more ways to create money origami and manufacture profits out of thin air rather than actually producing anything of tangible value." IMHO, innovation should be limited strictly to the high stakes gambling table and no losses should be covered or backed the USG or the taxpayers.

Innovation?

Submitted by Trippp on Sat Apr. 18, 2009 8:54 AM PDT.

"Innovation" is such a nice word, don't you think? It sounds so progressive and sort of like progress without having to explain exactly what is meant. From where I sit since WWII or so financial innovation means weakening the existing regulations, regulations which were put in place for very good reasons based on actual experience. The point of weakening the regulations is so that one may reap obscene rewards while passing all the risks on to the public. As Flo would say, "Now that's innovation!" But hey, I guess if a banker ever cared about humanity he'd be a Doctor or social worker, so what can we expect from Wall Street? It is full of people self-selected for a willingness and eagerness to sell out principles for the worship of Mammon. Tripp

misallocating capital destroys wealth

Submitted by tpx on Sat Apr. 18, 2009 8:58 AM PDT.

Wealth is created by either making things people want or providing a service that provides a benefit to people or markets. Finding ways to improve the distribution of capital would be a wealth creating service, like that Bengali fellow's micro-lending business model has done, which was a new financial innovation since the '70's. Unfortunately for the Wall St. schemers and the economy at large, improving the distribution of capital for the purpose of inflating already existing goods, like homes and equities, does not create any new wealth. Instead of increasing an economy's wealth, a business model that inflates the price of already existing goods and services misallocates an economy's capital to non-value added activities, which ends up ultimately destroying wealth. We are in the destroying wealth stage of our political economic model initiated during the Reagan era.

Lack of optimism

Submitted by Obama, Steelers, etc. (not verified) on Sat Apr. 18, 2009 9:35 AM PDT.

This type of BS is why we are so doomed. Kevin, did you see this? http://www.thedailyshow.com/video/index.jhtml?videoId=224262&title=Eliza...

crack(s)

Submitted by SRW1 (not verified) on Sat Apr. 18, 2009 9:43 AM PDT.

"The innovation crowd probably ought to take another crack at this." Hm, I think they should desist. They were (are?) on crack and have produced to many cracks in the system already.

So what has financial

Submitted by Anonymous (not verified) on Sat Apr. 18, 2009 9:53 AM PDT.

So what has financial innovation gotten us, aside from massive profits for clever bankers? Well, for better or for worse, this "financial innovation" has attracted massive capital inflows since about 1980. These inflows have allowed us to disregard both governmental and balance of payment deficits since then. And if we don't continue to innovate, those inflows just might become outflows. Which would mean that we actually would have to make stuff - stuff that others would be willing to buy. And since the 1970's, we just have not been able to do that very well. And facing up to that problem is what Bernanke does not want to go back to.

Hah! In the seventies I

Submitted by anon (not verified) on Sat Apr. 18, 2009 10:12 AM PDT.

Hah! In the seventies I would get a free toaster for opening a checking account. Today, Jamie Dimon and Chase give me $100!!! Financial Innovation 1, Kevin Drum 0. (And toasters today cost $10.00)

I can actually think of a couple.

Submitted by BigTom (not verified) on Sat Apr. 18, 2009 10:14 AM PDT.

Exchange Traded Funds, ETFs, which are a kinda do-it-yourself mutual fund, are useful for investors who don't want to pay the big bucks to the managers of wealth. The ability to do electronic fund transfer, such as buy things on the internet. Then there are the innovations that can only be thought of as belonging to the dark side: payday loans, universal default (miss one bill anywhere and your credit card interest rate soars), subprime mortgages, CDOs..... Unfortunately the $trillions destroyed by the dark-side innovations greatly outweigh the benefits of the few good innovations.

I think the growth of the

Submitted by Drew Robertson (not verified) on Sat Apr. 18, 2009 10:43 AM PDT.

tagged as:

solution

I think the growth of the shadow banking system can go down as an innovation. And the benefit was economic growth over the last few decades. Was that growth built on a foundation of sand? Is the shadow banking system something we want to preserve and protect after the fall? Probably not. But let's be clear. If we had had a solid, honest financial system since 1981, many of us (perhaps most) would be poorer. Happier? Maybe but poorer. Knowing the demands of politicians, they want economic growth to keep their jobs. So it's imperative that we come up with a good substitute (for shadow banking etc)...and that's going to come from the financial R&D types not Washington.

Counter Point

Submitted by Art Eclectic on Sat Apr. 18, 2009 10:53 AM PDT.

If we had had a solid, honest financial system since 1981, many of us (perhaps most) would be poorer. Except that most of us ARE poorer. What are you paying for housing costs today? What are you paying for health care today? We have made next to no wage gains since the 70's - the illusion of wealth (and an illusion is all it is) is because credit expanded and allowed us to buy all sorts of stuff we couldn't afford back then. Oh, but at a cost. Put that big screen TV on the credit card and pay it off over a year? Guess what, you just paid double for it because of the interest. The "must have it now" mentality and available credit has been a huge financial boon to banks everywhere, which they were happy to feed. Why save to purchase something when you can pay double for it by slapping down some plastic? Debt is not wealth.

destruction of wealth will result in falling living standards

Submitted by tpx on Sat Apr. 18, 2009 11:56 AM PDT.

Many of us (perhaps most) will become poorer as the economic implications of supply side economics continues to be sorted out. It is quite possible the destruction of wealth will result in median living standards falling below those of the early 1980's. Those who took 2nd mortgages on their homes experienced increased living standards in the early Twenty-first Century without any new wealth creation in the economy. Those who have now lost those homes to foreclosure, for a variety of economic reasons associated with supply side economic policies, are experiencing a fall in living standards, and for some that fall will be into poverty. When living standards are artificially increased by asset inflation, they must inevitably return to an economic equilibrium only sustainable through real economic activity, which is adding value to goods and services. Asset bubbles do not add any value to goods and services, and do not produce a surplus. Acting as if asset bubbles do produce a surplus of wealth leads to an economy's misallocation of resources, which destroys previously created wealth because that wealth is invested in non-value adding economic activities.

daniel gross on solar city

Submitted by roublen (not verified) on Sat Apr. 18, 2009 12:12 PM PDT.

Well, there was a recent daniel gross column about innovative financing arrangements at SolarCity. The caveat is that SolarCity is a small company - 380 employees, not sure if it scales up. And the financing arrangements are new, so no way to tell if they will still be working after 5-10 years. http://www.newsweek.com/id/193369 I'm sure there's a good way to differentiate between financial innovation and "innovation", but not sure where to draw the line.

when did we start to ignore old-fashioned belief in dividends?

Submitted by roublen (not verified) on Sat Apr. 18, 2009 12:39 PM PDT.

Actually, I think the main problem re:the asset bubbles is not financial innovation per se, but the widespread belief that stocks have some mystical ability to be worth much more than the dividends that they pay out. Somewhere along the line, management managed to convince investors that dividends are nasty, filthy things; you have to pay taxes on them, management can reinvest your money much better for you than you can do for yourself, etc. Those things are often true, nevertheless the only fundamental point of owning a stock is to collect dividends. Without dividends, a stock is just a worthless piece of paper. I was skimming a book on Buffett & acounting, and read one point that seemed true to me. There is one day a year where you can get an accurate number for a company's profits: the day they pay taxes. So the lesson was to be careful of a company that has large reported profits, for which it pays little in taxes. If a company pays little in taxes, it's possible that its real profits are also little, and that it's "reported profits" are a mirage. Similarly, it seems to me that the small investor needs to be careful of a richly valued stock that pays little in dividends. Especially keep in mind that most corporations have a lifecycle, so if a company doesn't pay out dividends when its profits and growth are fat, there's a non-remote possibility that those profits will never be distributed to shareholders - rather, they will be eaten up if/when the company enters its period of decline, overtaken by new competitors/technologies. Google and Microsoft, for example, are great *companies*, to be sure, great organizations, run by honest and good managements, for the most part. But is there any reason to believe Google and Microsoft are good stocks?

It will be interesting to

Submitted by Jimm (not verified) on Sat Apr. 18, 2009 1:18 PM PDT.

It will be interesting to see, after the dust settles and we do the reckoning, how much "progress" or more simply "profit" really resulted because of this financial "innovation", and whether then we consider it was worth it, compared to approaches we could have taken that encouraged incremental innovation while honoring risk.

Presuming you would want a real answer, rather than polemics

Submitted by The Lounsbury (not verified) on Sat Apr. 18, 2009 2:31 PM PDT.

You might try reading, Drum, something on the development of products. That the Credit Card concept has been around since 1950s does not mean the financial product today is the same as the 1950s product. Same with securitisation. However, it is more than evident, as with the Goldman issue, you prefer the polemics. Pity really. Of course this all leaves aside that the same financial innovations outside of the United States have not proven to have the supposed destructive effects that the holwing mob presumes is the fault of innovation as such. I might also add that cheaper access to credit is a good thing. That the American economy wasted said access on its obsession with houses really speaks more to culture than financial innovation as such.

Cheap Credit

Submitted by Art Eclectic on Sat Apr. 18, 2009 3:24 PM PDT.

I'm sorry, but access to cheap credit is NOT a good thing because it drives up prices. House prices rose to their absurd levels during the bubble precisely because of exotic loans and lax lending standards. The market tends to price things fairly efficiently when it operates normally. If most consumers can afford a $500 TV, then most TV's will cost $500. If consumers have access to foolish amounts of credit that enable them to buy a $2000 TV, TV's will cost $2000. Goods and services will price themselves at what the market will bear. If there were no loans available for houses that were "exuberantly" priced, those houses would be priced at a level for which consumers could obtain loans for them. Cheap credit drives up prices and generates profits for manufacturers and credit providers, while consumers get financially raped.

Sad

Submitted by The Lounsbury (not verified) on Sat Apr. 18, 2009 4:27 PM PDT.

Oh bloody hell, more illiteracy. Cheap credit may drive inflation, or it may not. Depends on how it is used, and whether the economy overall gains in efficiency. The TV example is just painfully stupid.

Lulz

Submitted by Art Eclectic on Sat Apr. 18, 2009 4:47 PM PDT.

Ah, Lounsbury. I was hoping and praying you would show back up to deliver a scrumptious laugh to close out my Saturday. I feel like I've earned that glass of wine now. Don't ever change. /blows kiss

The Lounsbury, champion of the straw man.

Submitted by jrw on Sat Apr. 18, 2009 7:14 PM PDT.

"Polemics", "howling mob", "illiteracy"...your oh-so-arch and painfully condescending comments would be more effective if you ever actually explained your assertions, instead of making irrelevant jibes. Your affectation of the royalty-stooping-to-talk-to-commoners tone makes you sound as if you really don't know what you're talking about, which I suspect you don't. Your comments rather perfectly sum up the attitude of the self-styled masters of the universe, who want us all to believe that only they are capable of understanding the terribly complicated world they have created. If only you were half as wise as you are smart.

And?

Submitted by The Lounsbury (not verified) on Sun Apr. 19, 2009 2:41 AM PDT.

A cost benefit analysis tells me that any effort spent in writing a long comment here explaining items is pretty much wasted insofar as you all, with painfully lmited understanding of what you're going on about, already have your narratives set. Added effort for zero return. What pray tell would be the point? Or is "jrw" seriously pretending that if I write treatise on the innovation in marrying credit card facilities with modelling and portfolio analysis anyone is going to bother to read for understanding, rather than hitting on the phrase "risk modelling" and posting a series of ill-informed diatribes about how the risk modellers have destroyed all, etc. etc. - without bothering to differentiate between those that really did in genuinely exotic securities and the far more fundamental and useful work done. I work in emerging markets, of course I sneer at self-indulgent reaction that calls lowering the cost of credit dangerous. For most of the planet it is a holy grail. That American blew up its efforts does not mean Sub Prime innovation was wrong, merely that you all seriously fucked up. It's a bit of a bloody lesson that in other developed markets, these innovations have not in grosso modo been the destructive agents they are being painted in a facile ill-informed manner here and generally (and which is particularly disappointing as I cam to read Drum for his clear-headedness, but apparently this only applies to Republican era policy proposals) And the lesson of course is about regulation. Where do we see the worst of your problems? In the most unregulated fringes (and in the gaps of your system with its nutter mad-house of balkanization between regulatory authorities, a mad proliferation of competing agencies literally completely unknown in any other proper developed and most developing markets). But rather than focusing on this, no, its preferable to run on about innovation - without actually bothering to investigate what one means or what innovations actually were. That deserves more than casual contempt?

"Innovation"

Submitted by bob h (not verified) on Sun Apr. 19, 2009 3:09 AM PDT.

= finding clever ways to deceive the buyer about the risk inherent in financial instruments you're trying to peddle. We had a rip-roaring 90's economy without all this new "innovation".

Lounsy

Submitted by Trippp on Sun Apr. 19, 2009 7:41 AM PDT.

And the lesson of course is about regulation. Yeah, so why no 'attaboy' to my comment? I suppose it is a lot easier to pluck low hanging fruit and fall back on your pompous college fraternity persona. Sigh. All I can figure is times are tough in the emerging markets financial industry, and you are crabby cause your fellow financial minions have screwed the pooch. And you are tired of getting tarred with the broad brush of backlash from the rest of us crabby abused peasants. So instead of fighting us why not join us? Or are you still on your kool-aid high? How old are you? You sound young. If so I guess your enlightenment and embitterment will have to wait. It is a pity, because we could use your brain and sharp tongue on our side. Tripp

Actually, no business is magnificent

Submitted by The Lounsbury (not verified) on Mon Apr. 20, 2009 9:33 AM PDT.

In my markets at least. There is no attaboy as you're barking up the wrong trees and your hostility generally to innovations is ill-informed (as per comment supra re proper regulation would have banned the innovation - well no actually it would not have and did not in other markets, but proper channeling did occur). As for my age, mate, I am old enough to have actually been reading graduate studies in Uni during the high of the Soviet empire. No worries, you sound like a typical navel gazing American and a leftist git to me. Funny, internet.

Apologies

Submitted by The Lounsbury (not verified) on Mon Apr. 20, 2009 9:35 AM PDT.

I see I mixed up Tripp with JRW. Ergo the comment above is mistaken in part.

Attaboy, Tripp.

Submitted by jrw on Sun Apr. 19, 2009 8:43 AM PDT.

The Lounsbury won't say it, so I will. His is a strange argument isn't it? The lesson being about regulation, that is. He's in favor of regulation, but if proper regulation had been in place the last few decades, much of the so-called innovation he finds so worthy of worship would have been prohibited. I suspect he came of working age during the great game of the last few decades, and takes it for granted that this is how the world has always worked and always should work. He's way to close to his industry and sees trees to the exclusion of the forest.

Innovations

Submitted by MarkH on Sun Apr. 19, 2009 3:38 PM PDT.

Building on previous bricks like insurance and credit and multiplying that by computer technologies have brought us job outsourcing to low-wage places and ATM/bank cards and much more computer modeling of risk and quants. But, like a lot of technology, we musn't let it over-run us before we adjust to it or adjust it to us. Too much credit is one place we must place limits because people don't seem to be entirely able to adjust to having it without blowing up their finances. Switching to ATM/bank/debit cards is probably a major improvement and it might even lead to some other further improvements down the road. Although ARMs are clearly as dangerous as IEDs there's no reason to disregard the availability of more personalized financing because of the assistance computers provide lenders. For example, much more computerization lowered costs, manpower and improved multi-branch banking which benefits everyone. What I've been wondering for a while now is if we might someday free people of the absolute need to store our 'cash' in banks since it isn't actual paper & coins, but just computer zeros and ones. If we could end that practice we'd cut down our personal costs, but seriously impair banking's ability to borrow money from people (at zero interest) to throw at wild speculations in the markets. That might make the free market work a bit better. As it is we are captive to the semi-monopoly banks have over us. We don't have anywhere else to really put our money with the same security and access, so they rape us every way they can. If there were competition for our money, then banks would have to be a lot more service-oriented. Investing is a lot better today for the individual. Even as recently as the 1980s brokerage fees were horrendous and you really had to trade in large dollar amounts and you were at their mercy. Today there are a lot more ways to invest at much lower costs. The Internet is a multiplier effect there. The Internet has really been a huge innovation (if you can call it that) to enable business activity. Every year Internet sales at Christmas are growing and retail store sales are growing smaller. With better security on the Internet it will become mega-huge! It's hard to quantify the effects of computers and other IT. It has changed a lot of human workers lives. There is a lot less drudgery and commerce, accounting and the like are done real-time instead of by snail-mail. Gates may not deserve every penny he's 'earned', but the industry does deserve applause for all it's done. The world is a much better place because of computer technologies. Now, if we could only get software of equal quality! It appears I'm saying a lot of change has been incremental and not necessarily financial or market-related, but whatever the source there has been a huge change in commerce, finance and markets in the last 25 years. Not all has been bad.

MarkH

Submitted by Trippp on Sun Apr. 19, 2009 3:57 PM PDT.

Nice thoughtful comment, but my perspective is a little different. Money itself is an abstraction, and physical currency hasn't really been in use for quite awhile now. There is no current problem with us requiring banks to keep our money safe. To me one of the real problems is that technology has allowed leverage to work on a much greater scale than before. The human impulse to scam and siphon is still with us, but now instead of getting rich by stealing a dime from everyone in the village, or a penny from everyone in the state, we can steal a fraction of a penny from everyone in the world and get rich. I'm speaking metaphorically, really. Globalization allows us to minutely effect everyone which can lead to a massive accumulation. I worked on software that performed credit card transactions within the financial network and it seemed everybody and his brother wanted a piece of that flow, even a minuscule piece, because it was so lucrative. Tripp

CLOs

Submitted by John (not verified) on Mon Apr. 20, 2009 8:04 AM PDT.

Let's not categorically tar all CDO technology with the same brush. The sub sector of Collateralized Loan Obligations has been useful and important. Most purveyors believe the techology will survive the current crush. And in fact the technology caused some of the technical carnage of the late '08 loan market. But during the last cycle, when banks were desperate to shrink balance sheets, CLOs became the only game in town for below investment grade companies. Yes, it did experience a bubble in recent years. But not because of the technology. Too much cash was sloshing around the system. Any 26 year-old could set up shop, and then they had to buy the paper to ramp the vehicle up so that the CLO could then be set up. Consequently the terms of many loans were, um, non-existent. Witness the number of covenant lite, PIK loans, ability to buyback loans. Just way out of wack driven by the technicals, not the CLO technology. This will survive and used judiciously help some of today's struggling companies. Perhaps not those who have CDS, which face other factors. But run of the mill middle market companies will ultimately be helped.

i want to go back to the

Submitted by currency converter (not verified) on Thu Jul. 2, 2009 10:29 PM PDT.

i want to go back to the seventies. There was not that many crooks to deal with in the stock market. Wall street is so sad to watch. I still invest but i am very careful.