I missed the opportunity a few weeks ago to offer my thoughts on the debate between Dani Rodrik and Steve Randy Waldman about financial innovation. Rodrik sparked the debate by asking for:
... some examples of financial innovation -- not of any kind, but the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?
My answer to Mr. Rodrik would be... Mortgage Backed Securities.
Unbelievable huh? How can I possibly say Mortgage Backed Securities are financial innovations that have made our lives measurably and unambiguously better?
Well, I can say it because the creation of the secondary mortgage market has been invaluable to millions of Americans (perhaps even hundreds of millions). By creating a secondary market for mortgages, more people are able to borrow to get the home they want. MBS's allow regional banks to diversify their mortgage pools and stay afloat, even if tough economic times hit their region. For instance imagine if, in sunnier economic climes, the automakers collapse but no secondary mortgage market exists. All the Michigan autoworkers would default on their mortgages and the regional banks holding all those mortgages would also fail (if the banks had been willing to lend to everyone in the region in the first place). The domino effect caused by failing banks in a state that's also decimated by job losses would be catastrophic. Failing regional banks would cause "Main Street" problems on a terrible scale for whatever region they're in. But by packing up mortgages and sending them somewhere else (or by buying mortgages from a different region), the regional banks, and the region itself, are more insulated and protected from this kind of catastrophic failure.
What we have to understand (and what Mr. Rodrik should understand) is that the ability to securitize a mortgage has been exploited and although Mortgage Backed Securities are now seen as tools of financial destruction they've probably helped every homeowner who is reading this blog to buy their home.
Financial engineering instruments are tools, plain and simple. They're neither inherently good, nor inherently evil, they're just tools. So the right question isn't "what financial innovation is good?" The right question is, "How do we stop shysters from using financial innovation for evil?"
After all, nobody asked whether or not airplanes were good after 9/11. We asked how to stop terrorists from flying them into buildings. The current situation is no different. There are a huge range of financial innovations that offer loads of potential benefits to millions of people both directly and indirectly. When I pull out my "FE toolbag" (if you will), I'm able to structure payments and cash flows from any investment in any way imaginable. Smooth cashflows from an investment are incredibly helpful and desired by every business on the planet.
But, as the good finance profs teach, all financial engineering relies on prior assumptions about the underlying investment. If your assumptions are wrong, then your FE instruments won't matter in the least -- and might actually exacerbate your problems. Financial Engineering in its (relatively) short rise to popularity, has instilled a lot of false confidence in the investors who have used them. First it was Salomon in the '80s, the LTCM in the '90s and then (apparently) everyone in the 2000s. All these people, at some point in their use of FE instruments, either believed they had successfully engineered their way out of danger, or had magically FE'd their way into fantastic profits. They all forgot, or didn't care, that if the assumptions about the underlying investment are wrong, then all the FE instruments in the world won't matter in the least when the piper comes calling.
Now then, I can understand if Mr. Rodrik, and others, want to say that FE instruments have no value because accurate predictions about the future of any investment are a crap shoot at best... but that's a completely different argument. The argument should be whether or not we can stop the exploitation of financial innovation for profit (and also the disturbing tendency of risk managers to blindly trust derivatives as perfect hedges). It doesn't matter whether the answer to this problem is oversight and regulation of the instruments, oversight and regulation of the people who use them, or even if the eventual answer is a consensus that abolishment is the only way to stop their abuse. In the end, the only thing that matters is making sure financial innovation isn't abused anymore.
And if, in the end, we can't stop people from profiteering through financial engineering tools and abolishment becomes our only answer, then that says more about human beings (and the MBA whizzes on Wall Street) than it does about the instruments themselves.