The Trouble with Financial Innovation, 3/22

Unanticipated events and gaming the system

Our recent session for paid subscribers on financial institutions was a review of the financial crisis of 2008. Toward the end of the session, a participant asked a key question: is financial innovation a good thing? After all, the crisis seemed to center around many of the exotic instruments that had been recently designed. Recall the initials, CDO, CDO-squared, and CDS.

(Note: I have not yet scheduled the fourth meeting of the seminar.)

In the context of a free market, innovation is a positive-sum game. The innovations that survive—most don’t—are the ones that conserve resources and improve quality. In the case of financial innovation, improving quality could mean better risk management.

But financial innovation does not take place in the context of a free market. Our financial system is permeated with government guarantees. Some guarantees, like deposit insurance or pension guarantees, are explicit. Other guarantees, like “too big to fail,” are implicit.

These guarantees can be exploited by firms that take on excessive risk. If a gamble pays off, the gains go to owners and managers of the firm. If the gamble turns out badly, some of the losses go to taxpayers. Even though managers might not consciously be searching for ways to game the system, the competition for returns will push them in the direction of doing so.

Innovative financial instruments and practices can facilitate gaming the system, without regulators realizing it. Clever innovations can enable a bank to comply with the letter of a regulation while violating its spirit. Sometimes, even the executives of the bank are fooled. They do not realize that their profits are coming from this “regulatory arbitrage,” rather than from real business skill.

The question of “what caused the financial crisis of 2008” is too complex to be covered here. My best effort at answering it can be found in this extended essay. Instead, what I want to attempt in the remainder of this post to explain some of the mechanics of the relevant financial transactions, in order to illustrate the challenges posed by financial innovation.

Start with four participants in the U.S. government bond market. There is the U.S. Treasury, which wants to borrow, say, $10 million today by issuing a ten-year bond. There is a pension fund, which in three weeks will be ready to buy the bond and hold it until it matures. There is a Wall Street dealer, which wants to borrow money to buy the bond from the Treasury and then sell it in three weeks to the pension fund. And there is a corporation, like Amazon or General Motors, with $10 million in excess cash that it is willing to lend to the dealer for a week.

The dealer can borrow a little bit less than $10 million from the corporation in order to buy the bond from Treasury. After a week, the dealer owes the corporation $10 million, so that the corporation has gotten a tiny return from its loan to the dealer. If for any reason the dealer did not repay the loan, the corporation would take possession of the bond. This is known as a repurchase agreement, or repo, because legally the dealer sells the bond to the corporation while committing to repurchase it a week later at a slightly higher price.

After a week, the dealer needs to find $10 million to pay the corporation. It does this by making another repurchase agreement, either with the same corporation or a different one. After three weeks of repo, the dealer finally sells the bond to the pension fund, which by that time has accumulated funds from regular contributions made by the participants in the pension plan.

A Treasury bond is not the only security that can be used for repo, but it is ideal. The corporation with the excess cash is looking to eke out a small return on its excess cash. The corporation does not think this small return is worth any risk. If the dealer defaults on the repo loan, the corporation will have the Treasury bond. This seems safe for the corporation, because the U.S. Treasury has never defaulted on its debt.

During the run-up to the financial crisis, Wall Street packaged mortgages into innovative financial securities, called CDOs. Large segments, called tranches, of these CDOs were rated as low risk, and hence could be used as collateral for repo. The CDOs had been structured in such a way that even if mortgages were to default at an unusually high rate, the tranches usable for repo would pay off completely, just like U.S. Treasury bonds.

But starting in around 2006, mortgages began to default at an unusually high rate, beyond what had been contemplated when the CDOs were structured. Even if the CDO tranches were still paying full principal and interest, corporate treasurers became aware that at some point they might not do so. This fear of what might happen was too much risk for corporations to want to bear with their short-term investments of excess cash. So they stopped making repo loans backed by mortgage securities. Even securities issued by Freddie Mac and Fannie Mae, which had limited government backing along with a vague “too big to fail” reputation, became suspect.

So dealers had repo loans coming due on their securities, and they needed new repo loans. But now they had a hard time getting repo loans, because of the perceived risk of mortgage-backed securities. The dealers were faced with what economist Gary Gorton dubbed a “run on repo.”

A dealer that can’t get repo loans is like a bank where too many depositors try to withdraw funds at once. It has to sell its assets in a hurry, at a depressed price. The more that dealers tried to unload their mortgage securities, the less desirable those securities were as repo collateral, so that this turned into a vicious cycle. Regulators bailed out one dealer, Bear Stearns. But then they waited for other firms to right themselves, rather than rely on getting bailed out. When another dealer, Lehman Brothers, could not come to terms with potential saviors from the private sector, regulators let it fail. This had repercussions, some of which no one had foreseen, that greatly increased fears in the money markets, and the crisis took a sharp turn for the worse. Soon Congress felt obliged to provide a gigantic bailout fund, known as TARP.

Regulators are in a dilemma regarding bailouts. Doing bailouts creates an incentive for firms to game the system by taking gambles that benefit owners and managers if they work, with losses pawned off to taxpayers if they fail. But when big banks get in trouble, not bailing them out tends to exacerbate the crisis.

If it were up to me, financial regulation would operate differently. But given the way it works now, regulators should be wary of financial innovation. Regulators need to be able to spot problems early in order to avoid being caught in the bailout dilemma. But innovations tend to undermine transparency. As innovations proceeded in the mortgage securities markets, only a few specialized financial engineers understood the details of these instruments. High-level bank executives, as well as heads of regulatory agencies, were clueless.

Another participant in our seminar had read an article about problems that sanctions on Russia are creating with innovative financial instruments. Many money managers who had bought Russian bonds in the past had purchased credit insurance from other companies. This insurance was supposed to pay off in case those bonds lost value, which they clearly have as a result of sanctions.

Under terms of some of these contracts, some money managers have been able to collect insurance claims. But other insurance contracts stated that in order to be paid, the money manager had to transfer the bonds to the insurer. But the sanctions will not allow the bonds to be transferred! Once again, innovative financial instruments proved to be fragile in ways that were not anticipated.