Financial innovation: Very necessary, but very dangerous - SmartBrief

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Financial innovation: Very necessary, but very dangerous

8 min read

Modern Money

We all have heard that one of the big culprits in the credit crisis was the collateralized debt obligation (CDO). CDOs are notes backed by baskets or cohorts of different types of receivables. The notes can be backed by residential mortgages, or commercial mortgages, or student loans, or credit card receivables or auto loans, etc (or a mixture of all the above). It is the cash flows from those receivables, not some end borrower, that services the CDO notes, i.e. pays interest and amortizes the principal on the notes.

I don’t want to go into the details about CDOs here or their role in the credit crisis because many other writers have gone into this exhaustively elsewhere. Suffice to say CDOs (or asset backed financing/securitizations) are actually very important and effective ways of financing certain receivables pools (of effecting what is known as ‘non-recourse’ finance). And yet there were fairly obvious issues with many CDO structures before the crisis: their excessive structural complexity (the notes were broken into too many tranches); the questionable credit quality of the underlying assets; the use of too many different types of underlying receivables; the fact that those rating the notes (the rating agencies) were effectively in bed with the originators of the notes; the overly aggressive selling methods of CDO tranches by swarms of brokers; etc.

But there was something else that might have also put a shrewd investor on notice when it came to CDOs before the crisis: they were relatively … new. They were not brand new in the mid 2000s, but still the securitization revolution was one that continued to build steam over the 10 years leading to the credit crisis. The product was being enhanced and elaborated on throughout this period, in many ways to understand the extent of its possibilities. In fact, you could see the 10 years leading up to the credit crisis as a long test period for the CDO product. Bankers and the market were pushing the product to its limits, trying to see how far it could go and what was structurally sustainable.

You see the unique and curious thing about financial products is that unlike other types of products, they are not really testable before being imposed on society and the unwitting customer. When a pharmaceutical company develops a drug, it can be tested at great length before being finally put into the market. So can most simple products – like a car, or a ship or even a hammer. But the problem with financial products is we do not really have a “social laboratory” to test these products before they hit the market. In fact, the same can be said for government macro-economic policy. Social policy (like financial innovation) is therefore always a stab in the dark, often producing unforeseen consequences. Karl Popper, the 20th century political philosopher, was so exercised by this point that he defined the main function of the social sciences as, “to trace the unintended social repercussions of intentional human actions.”

The result is that financial products when first innovated can be dangerous. If you buy a relatively new financial product, it is like taking a drug that is still going through its test trials. Until a given financial product has been used for numerous years in the market – through booms and busts – it always has the potential to surprise in certain ways.

This is not to say we should block financial innovation. As said, CDOs are indeed very useful ways to finance certain asset classes. Credit default swaps (CDSs), which also came unhinged in the crisis, are very useful ways for banks to hedge credit risk. Derivatives of all kinds are useful hedging and leveraging devices (although have equally caused plenty of carnage at certain points). CDOs and CDSs since the crisis are being used in more moderated, regulated and controlled ways, including more simplified underlying receivables pools for CDOs or central clearing for CDS. But all the above tells us that investors should be wary of relatively new, untested financial products. Why should you, as the investor, be the guinea pig who is taken down by the product before it has been refined and understood in deeper ways?

And that’s the real message here – a canny investor is careful about buying any type of new financial product at all. Never mind all the bells and whistles and complications surrounding CDOs; the key point was that they were relatively new – still in social test phase before the credit crisis. Their relative newness should itself have been a warning sign for many investors.

Of course no one is suggesting an investor should not go into new opportunities. Some of the best investment opportunities are innovative companies because being ahead of the game is critical in finance. But I can invest in an innovative business using conventional financial instruments (bonds or stocks). If I am using a new financial instrument, that creates an entirely additional element of structural risk. And if I am going to take that risk I need to make sure I am adequately rewarded for it. This can be very hard to establish until a financial product design has been seasoned.

Financial innovation had been somewhat off the agenda for a while since the credit crisis. But with the economic recovery, financial innovation is back – big time. Blackstone sold the first bonds backed by income from single-family rental homes in 2013, valued at $479 million. Certain big funds have acquired such large real estate positions since the credit crisis that they are creating a new market in rental home securitizations. Others are now in this same issuance game, including Colony, American Homes 4 Rent (with Goldman Sachs), etc. Are these exciting new investment opportunities or untested new financial structures? Perhaps a bit of both, but certainly there is a strong likelihood that some structural elements here remain undeveloped.

Contingent capital bonds are also a new kid on the block. They are essentially the product of the credit crisis, whereby banks issue bonds, but bonds which will be automatically convertible to equity in the event of distress. This allows banks to raise capital more cheaply than equity (since the cost of debt is materially lower than the cost of equity), but provides them with incremental equity protection in the event of a credit crisis-type event. The likelihood of these bonds converting to equity (i.e. the likelihood of distress triggering such conversion) is still unknown, so investors coming into these bonds remain very much in the dark as to the real risks they are taking here.

The above issues don’t just apply to products that emerge in the institutional world of high finance. Insurance companies, pension funds, personal financial planners or wealth managers are also continually innovating with their retail products, variations on their policies and fund offerings. Many of these new variations involve new terms or clauses, or assumptions about likely behavioral patterns in the untested future (like longevity, or the likely economic performance of the economy, or health statistics, etc). The broker may extol the benefits of a new structure, but we know that if a product is new, it could not possibly have been tested before being imposed on investors. Some of the products of insurance companies or wealth mangers are tried and tested, but some are not – the point is to make sure you know the difference.

Be careful of financial innovation and of brokers pushing new products. As the U.S. economy continues to strengthen, financial innovation will inevitably become more common. Financial innovation must happen (from a macro-economic perspective), but why put yourself in the front line of the testing process? Wait for a product to have been socialized. Wait for something to have gone wrong – and been fixed – with a given product. Ask your broker about the provenance and the performance of a product. How did it work over the last 10 years, through recession and booms?

If he cannot answer these questions because the product hasn’t been sufficiently seasoned, then just go home and have a well-seasoned bottle of wine instead.

JEREMY JOSSE is the author of “Dinosaur Derivatives and Other Trades”. He has spent the last twenty-plus years of his career working as an executive in some of the world’s leading financial institutions, including Schroders, Citigroup, and N M Rothschild. He holds a BA in Philosophy and Economics from Trinity College, Oxford University, as well as a Master’s degree in Political Philosophy and Economics from London University. He has published numerous articles on a wide range of financial subjects including the credit crisis, bank restructurings and financial engineering.