Economists are often in the “it works in practice, but does it work in theory?” mode, but here we see a case where some are grappling with why some of their prized notions pre-crisis came a cropper.
A clever post at VoxEU discusses why financial innovation isn’t what it is cracked up to be, and typically leads to what economists call “rent seeking” and mere mortals call “ripoffs”. (As an aside, the Orwellianism of the branding of financial services tricks and traps as “innovation” is annoying. Readers are invited to come up with better nomenclauture and encourage its use).
Finding that “innovation” is mainly, if not solely, beneficial to the new product pushers seems so obvious in the light of the developments of the last twenty years of the financial services industry that it scarcely seems worthy of mention. However, the post by Bruno Biais, Jean-Charles Rochet, and Paul Woolley offers another insight:
We describe the evolution of a financial innovation and show how rents rise progressively to the point where the agents end up capturing the bulk of the return from the innovation. The key assumption of the model is the presence of information asymmetry; the agent has more information than the principal and the agent’s interest and objectives are not necessarily aligned with those of the principal.
Despite being based on a single innovation, our analysis can be used as a metaphor for the financial sector as a whole. The model also shows how innovations and rents carry the seeds of their own destruction to the point where principals are no longer receiving an adequate return and refuse to support the innovation, which then collapses. Perhaps in line the global financial crisis, the model suggests that high and rising rents of agents offer a lead indicator of crisis.
Yves here. This is a very powerful finding. If there is a way to further substantiate this observation, it proves what many believe: that an overly large (in terms of profit) financial sector is unstable. Its real economy cost become too high and users withdraw from the particularly abusive products. This would give arguments to rein in the financial services more heft.
The authors flesh out their ideas:
First consider the frictionless benchmark case in which principals and agents have access to the same information. The principals are a set of rational, competitive investors and the agents are a set of similarly imbued fund managers. A financial innovation is introduced but there is uncertainty about its viability.
As time goes by, investors and managers learn about this by observing the profits that come from adopting the new technique. If it generates a stream of high profits, this raises confidence that the innovation is robust. This leads to an increase in the scale of its adoption and therefore the size of the total compensation going to managers. Because of the symmetry of information, these gains are competitively determined at normal levels and the innovation flourishes.
Alternatively, profits may deteriorate, market participants come to learn of its fragility and the innovation withers on the vine. In both cases, while learning generates dynamics, with symmetric information there is no crisis….
In reality, innovative sectors are plagued by information asymmetry. It is hard for the outsider to understand everything the insiders are doing and difficult to monitor their actions.
We explore the implications of this lack of transparency and oversight using optimal contracting theory. Our model assumes that managers have a choice:
* They can exert effort to reduce the probability that the project fails even though such effort is costly.
* Alternatively they can cut corners and “shirk” – the term used by economists and familiar to every schoolboy meaning to avoid work. When agents shirk they fail to carefully evaluate and control the risks associated with the project.
Yves here. The authors mention CDOs as an area where this took place. While there were a lot of investors that were “shirkers”, the uglier reality is that CDOs were so complex as to be effectively unanalyzable in a granular fashion. A asset backed securities CDO contains 100 to 250 instruments. In 2006-2007, a “mezz” CDO would be 80% subprime bond tranches. Each subprime bond contains roughly 5000 mortgages. So the CDO contains exposures to 400,000 to one million mortgages. Oh, and each bond has a different waterfall, so you can’t throw them all together and analyze them tout ensemble. Oh, and another 10% of the CDO is tranches from OTHER CDOs, which means that each of those bits contains exposures to another 400,000 to 1,000,000 mortgages.
Now of course, people did miss the elephant in the room: that these pools were effectively a very junky subprime index. But how can you figure out how junky with so many moving parts? This was an inherently abusive product. Even if a buyer had the luxury of time and money, how can you make anything more than very approximate judgments about something this complicated?
Back to the post:
Our model also assumes that managers have limited liability. The inability to punish gives rise to the moral hazard that characterises finance at every level from individual traders to the banks that employ them (our simple moral hazard model is in line with that of Holmstrom and Tirole 1997).
This combination of opacity and moral hazard is the core of the agency problem. Investors have to pay highly to provide managers sufficient incentive to exert effort, and the greater the moral hazard, the larger are likely to be the rents. Our model shows the probability of shirking is higher when the innovation is strong than when it is weak. After a period of consistently high profits, managers become increasingly confident that the innovation is robust. They are tempted to shirk and it becomes correspondingly harder to induce them to exert continuing effort. As the need for incentives grow, the point is reached where agents are capturing most of the gains from the innovation.
Investors then become frustrated at the rents being earned by the agents and at their own poor return and eventually give up on incentives. The dynamics are such that when confidence in the innovation reaches a critical threshold, there is a shift from equilibrium effort to equilibrium shirking. Innovation collapses as managers cease to undertake the necessary risk assessment to maintain the viability of the innovation. In the end, an otherwise robust innovation is brought down by the weight of rents being captured.
The handling of portfolios of CDO’s in the run-up to the recent crisis illustrates this well. Fund managers had the option of diligently scrutinising the quality of the underlying paper or they could shirk by relying on a rating agency assessment and pass the unopened parcel on to the investor. While securitisation is a potentially valuable innovation, it also requires costly effort to implement properly….
Referring back to our model, this suggests that rent extraction was occurring at all operating levels within the institutions.
Our model’s second prediction is that innovations under asymmetric information are vulnerable to collapse. The current crisis seems to validate this prediction since structured credit, CDO’s and CDS’s were the immediate cause of the global financial crisis.
The article also refers to some empirical work by Thomas Philippon and Ariell Reshefalong similar lines:
Their study observes a burst of financial innovation in the first half of this decade and rapid growth in the size of the finance sector, accompanied by an increase in the pay of managers. They estimate that rents accounted for 30 to 50% of the wage differential between the finance sector and the rest of the economy. Philippon and Reshef point out that the last time this happened on a similar scale was in the late 1920’s bubble – also with calamitous consequences. It is significant that a high proportion of the net revenues of banks and other finance firms went to the staff rather than shareholders.
While correlation is not necessarily causation, the pattern is awfully persuasive.
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Yves
It was obvious to me for years – and I am sure many others – that a situation where the finance sector garnered a high and increasing percentage of total corporate profits in the economy was inherently unstable. After all where was the additional money to come from? Answer – either from ‘nowhere’ that is, credit not backed by self liquidating loans to productive enterprise, or from the productive enterprise sector itself (through reductions in profits and/or wages.
I can’t claim to have had any idea of the details of how the collapse would come, but being unsure of the mechanism doesn’t excuse governments from inaction in the face of inevitable catastrophy. After all, if you’re driving at 100mph in a car with no brakes and no steering you may not be able to predict when and where the crash will happpen – but you sure as hell know it will. The solution – cut the engine before it does.
“if you’re driving at 100mph in a car with no brakes and no steering you may not be able to predict when and where the crash will happpen – but you sure as hell know it will. The solution – cut the engine before it does”
Good analogy. Applies to Toyotas too.
“The principals are a set of rational, competitive investors and the agents are a set of similarly imbued fund managers.”
My alternative theory is neither is rational. And I agree with Volker that the only real innovation in the last 20 years is the ATM. It is human vanity to think oneself smart, and the smarter one fancies oneself, the more difficult to acknowledge one’s success as luck. The vast majority of house purchasers had no idea of what they were doing, despite the fact that undoubtedly some did sell just at the right time. The vast majority of Realtors likewise who did well was more luck than thought. Same with investors – a thousand monkeys picking stocks and one picks Cisco at the right time and sells at the right time. The monkey will claim he is the smartest monkey.
Several of the bosses of large financial institutions claim they really didn’t know what was going on. Maybe that is to disguise venal and illegal activity. But more disturbing to our whole way of thinking and economics in general is that the market has no idea of how to value most labor – now that would upset the apple cart.
How is it bankers were all paid so much and knew so little? How is it that this continues?
If Bernanke didn’t know what was happening than, how does he know what is happening now?
The vast majority of Realtors likewise who did well was more luck than thought.
At the most abstract level, the problem is that most of what FIRE engages in is rent-seeking.
While this requires a little work in the case of “F”—showing that Wall St doesn’t do anything productive (i.e., that they’re not making capital markets more efficient, which is what we’re supposedly paying them for), it’s easy in the case of Realtors: they have a legal monopoly on their trade, which is why we’re stuck with this idiotic realtor commission structure.
I was a part-time MBA student in the mid 1980s and took a class in graduate-level Marketing. The class was discussing “innovation” and asked the class for an example of an innovative product. One student threw out the example of a pet rock being an innovative product and the prof thought that it was an excellent example.
I was the only one out of about 20 people – including the prof – who disagreed and we spent most of the that night arguing. Me versus the rest. Slick? Yep. Novel? Yep. But it wasn’t innovative since it didn’t actually provide a new way of addressing something, like the first automatic hay baler for instance.
Honestly, that’s the night that I decided the MBA route was a load of crap and the system was symptomatic of a greater decline in ethics and critical thought.
Never finished that degree and don’t see a need to do so. We lost the ability to not only critically think, but also to choose to decline to do something based upon something other than a profit/loss motive.
Very interesting on the degree to which the mainstream is locked into to a narrow and further narrowing paradigm is “The Cancer Stage of Capitalism” by John McMurtry. Light reading it is not, but well worth the effort.
@Homedad43,
GREAT OBSERVATION!
Once business ‘educators’ began to proselytize that innovation was equivalent to ‘anything that can make money’ we should have known we were in trouble…
Nothing against pet rocks or the guy who thought them up. And I have nothing against him making some money from it. But a pet rock is NOT an innovation…
It’s this kind of thinking that leads to politicians believing they can solve ‘real economy’ problems with ‘innovations’ like casinos… or exotic budget manipulations.
Pet rocks and casinos are fun in small doses, but either out of ignorance or greed, our financial/political leadership have confused that with building a sustainable society.
Outstanding comment, Homedad43, and I would add that your comment is also a preeminent example of “personal responsibility.” I would dare say “You’re my kind of guy.” (But not in “that” way. :D) Similarly, I dropped out of an engineering school when my ‘Mechanics of Solids’ professor (among others) tried to feed his students a load of non-demonstrable, unverifiable crap. Alas, what was more “frightening” was the Dean of the college shrugging his shoulders and saying “That’s the way it is” when I informed him of the sham. This speaks volumes to the dismal charade that is accepted as “education” today. The entire system, from K-12-PhD, smacks more of indoctrination and instilling belief, more insidiously than religion, than transference of knowledge and skill.
As to replacing “innovation” with respect to financial “constructs,” let’s just call it what it is… fabrication, as in something that is “made-up,” a fiction. Of course, substituting an “i” for the first “a” (fibrocation) may be more poignant.
How about “sinnovation” ?
Pretty good.
Spurred me to think of “spinnovation”, to capture the premeditatively deceptive quality.
Sometimes you can sin by accident, when you get overpowered by demon rum or by the devil. LOL. But you can’t “spin” by accident. Oh no, it takes malice and forethought.
How ’bout just innovation?
The internal combustion engine was an innovation. And we know how well that turned out. Should have listened to the Luddites.
The nucular, sorry, nuclear bomb was another innovation.
I can go on: gunpowder, DDT, polyester, inorganic food, antibiotics, free trade, pet domestication, paper money, genetically modified/altered things…
what about the wheel?
boow aha aha ahahaha ahahahaha hahaha !!!
Yves,
For over two years, the concepts of information asymmetry and freezing of the securitization market have been central to the credit crisis. I’ve linked here in the past a telling submission to the FDIC which details the interaction more concretely:
http://www.fdic.gov/regulations/laws/federal/2010/10c02AD55.PDF
If the dots are not sufficiently connected, try this post on my blog or its counterpart on Seeking Alpha:
http://rwbeerdiet.blogspot.com/2010/02/future-of-securitization-part-i.html
Stiglitz’ Nobel prize winning work on information asymmetry explains why buyers walked away in 2007. It also explains why they have not yet returned and why the FDIC, ECB and now the Bank of England are trying to restart securitization by leveling the information playing field.
There is far more going on here than captured in the VoxEU piece. The authors policy prescriptions are almost TRACE-based in their nature. TRACE was originally offered as a prescription for restarting securitization at the ABS conference in Orlando in 2007. It was summarily rejected by the buy side because it did not address the actual information asymmetry that led to enormous Wall Street profits and even greater losses for investors.
The number of mortgages involved is not the issue. If we had a transparency database, that would not be a problem. More detail about how this can be done can be seen in the FDIC submission referenced above. A somewhat less rigorous analysis can be found here:
http://rwbeerdiet.blogspot.com/2010/02/towards-transparency-based-financial.html or its counterpart on Seeking Alpha:
http://seekingalpha.com/article/190075-towards-a-transparency-based-financial-system
With the transparency database, a CDO manager would not have to input over 100 variables, only to find that the resulting valuations were problematical at best. He could track the cash flows on the underlying mortgages that were put into the CDO. The CDO manager would likely have access to a sophisticated computer model that would analyze the data. This point was made quite strongly by a joint submission by ESF/AFME in response to the European Central Bank’s request for public consultation as to ABS loan-level data requirements.
I’ve quoted the relevant passages:
http://seekingalpha.com/article/192338-eu-trade-groups-reject-just-say-no-approach
Yves, the issue is not the complexity of the instruments. It is the lack of data made available to the buy side that prevented the instruments from being properly valued, especially after issuance. This fact was highlighted in Moody’s testimony before Congress in September 2007 and by its special report on structured finance dated September 25, 2007.
Someone more expert than I can explain the way CDO modeling and expected returns could be handled and compared once loan-level detail was available in a useable format and on a more timely basis.
Suffice it to say that the solution is not TRACE. Reported trades without loan-level data isn’t helpful. The FDIC, ECB and now Bank of England have come to that conclusion.
The solution is a transparency database.
A non-Orwellian name? How about “financial chicanery”?
I thought this was another excellent post. I wish I had some great nomenclature for you. Alas, I will have to think about it more.
I wanted to comment on your post a few days back on PE fund fees but didn’t have the time; so I’m going to sort of comment on both here.
As you state, economists call this rent-seeking. Anyone with just the slightest grasp of the basic tenets of microeconomics understands that the monopolist is in a far better position than an operator in a competitive market. The monopolist can better restrict supply and use price discrimination to capture consumer surplus.
So the natural incentive of any businessman is to create a monopoly in whatever way possible. In real estate, every piece of property is its own little monopoly. That’s what I like about the business. There is no other building on the southeast corner of Hollywood & Vine, and as long as someone owns it, he has a monopoly on that space and the potential customers drawn to that space (yes, there are close substitutes, but sometimes not really that close). Monopolies can also be created by positive network externalities and government intervention (e.g., Microsoft and copyright law) or by what appears to be superhuman talent (e.g., LeBron James). With respect to the PE funds, the monopoly (or better termed oligopoly) is based on size, relationships and access. Yes, certainly there is a huge principal-agent problem at big funds like CalPERS (because the ‘agents’ at CalPERS want to get on the gravy train as soon as they depart CalPERS and don’t have much incentive to cut funding to their future employers), but the people running the PE funds are really selling something at close to a “market” price because they are selling something no one else is selling (access to investments otherwise not available to certain investors that are available to the PE fund because of relationships and infrastructure). This has become more pronounced as wealth has concentrated in fewer and fewer hands, making those prime relationships more and more valuable. We’re living in Extremistan.
With respect to financial innovation, it *is* innovation for the sellers. It’s exactly the type of innovation that every businessman strives for. They are innovating to create their own monopolies based on size and information asymmetries. Just because it’s not positive innovation for the masses does not make it any less innovative (at least by the plain meaning of the term).
So while I’d like to get a better, longer and more descriptive term for this type of innovation, “innovation” by itself is not keeping me up at night. What bothers me is that we don’t understand the beauty of *competitive* markets. Each individual actor instinctively understands that his incentive is to *create a monopoly*, yet society as a whole should understand that it is far more efficient to have a competitive marketplace; hence, the individual actors might find it beneficial to join together to promote society-based rules that discourage the natural incentives for innovation that leads to less competitive markets. We have to fight monopolies, of most all types. That’s the lesson I take away from all of this.
So I guess I don’t really feel the need to jettison the word “innovation.” I want to champion the word “competition.”
I have been reading this blog every day for at least a year. It is an excellent source of detailed information on the ins and outs of securitization, credit swaps, financial innovation generally. My only conclusion is that the entire financial industry is a toxic dump which will not cease to undermine and devour the real economy until it is blown up and all the bankers, legislators and regulators are safely incarcerated. You cannot permit naked gambling with insured bank deposits. You cannot permit financial reporting that hides assets and liabilities in SIVs, SPVs or SUVs. You cannot justify financial monopoly and banks too big to fail. You cannot permit custodians of other people’s money to buy ‘products’ they cannot understand, merely because they will be fired if they do not buy them. All of the arcane gibberish of the academic establishment, the bank economists, and the regulators is smoke and mirrors. They cannot price risk, or disburse risk, and most of them cannot even identify risk. The idea that people who think of finance in this way have some superior intelligence or insight or contribution to make to society is idiotic. For ten years I was amused by Greenspan’s double talk before Congress, but this shit is no longer funny. Finance cannot function without full disclosure and personal responsibility and losses that remain where they fall. Our system makes all three a dim memory. Sorry, but it is just that simple.
Jake: Why not turn the banks into regulated public utilities? Why is access to credit any different than access to water, power, or light?
Yves: Corrente has tried to come up with a good synonym for (economic) rent several times. Besides “skim,” I’ve also heard “the vig,”
“the rake,” “the house cut,” “private tex,” and “toll.”
Nothing quite seems to work, and so I’ve taken to putting “rent” in quotation marks. I think “the vig” is the cloest. The key thing is to connect to the information asymmetry, and I’m just not sure there’s anything superior to “rent” for that.
During the 80’s I earned my rent and tuition driving a limo in Beverly Hills — and for awhile after graduation until I found “meaningful employment”. One of our biggest customers was Drexel, Burnham, Lambert. (I hope I spelled that correctly). I was privileged to overhear many an interesting conversation from my front seat vantage point. DBL brokers and dealers were rarely concerned about being overheard by a mere lackey limo driver. I heard many a tale about how DBL was “screwing little old ladies”, pension funds, and the general ignorant masses. They were proud of it, fully aware to the last drop that what they were doing was both illegal, and an unequivocal “rip-off”. The parties, hookers, and always abundant recreational pharmaceuticals were never ending. All paid for with the thieves ill-gotten gains.
I knew full well how deep and interconnected this thieves gallery was in the financial and real estate worlds and I was not at all surprised by the S&L scandal, real estate collapse, financial crisis, DBL’s own demise, and the deep recession that followed. Despite a few high profile trials, most of those from DBL went on to continue their “noble work” in other “reputable” financial wizard shops.
In the later 1990’s, when a great deal of “posturing” was going on in Washington and on Wall Street about correcting the evils that led to the great mess, I said to myself and to others that absolutely nothing had changed, nothing at all had been fixed. Most of the thieves and criminal “players” were still in the game and still had all the tools they needed to start right back on that same play again.
We are not experiencing a new recession, great or not. This is merely the continuation of what was started back in the 80’s, started by Reagan’s cronies and all the “rent seeking” bastards of our glorious financial “industry”. Of course, much of what is wrong now and was wrong then began much, much earlier, but at least for most of the post WWII era we had some semblance of regulation, some semblance of regulator diligence, some semblance of caution on the part of the kleptocrats and Wall St. thieves, and some semblance of caution and intelligence from the “ignorant masses”. But the “geat leap forward” into ponzi-everything and kleptocracy came from Reagan and his successors.
Having seen what these people will do to escape responsibility, punishment, and regulatory consequences of their vile acts, and the complicity that our “representative” government has in this ponzi-thievery, I have no hope that anything will be “fixed”, cured, or brought back to sanity short of a massive and catastrophic collapse, perhaps reminiscent of the “guillotine age”.
AP
I think it’s too late to save “innovation” from its fate as a euphemism.
“Finesse” is a related victim. Certainly in contxt with financial complexities.
What the bookkeeper did before having been found out might be called “innovative” – people know what you mean. He “finessed” the books a bit…
The “toilet” was once simply one’s grooming proceedures; the road to unmentionability draws terms down, one after another. I’m sure you recall substitute terms that have been trampled along the way from “crippled” to “disabled” to “challenged” to “special” for not saying other unspeakables. On a streetcar in Milan I did a shocked doubletake seeing a sign that reserved certain seats for “Mutilados.” Wow.
But maybe we should associate the infamous innovations with appropriate names. The inspiring example is “Santorum.” (I will NOT explain what that is if you don’t know. It’s not nice.)
I think “Greenspaner in the works” has a nice ring to it.
Bernankesheins?
“Yves here. This is a very powerful finding. If there is a way to further substantiate this observation, it proves what many believe: that an overly large (in terms of profit) financial sector is unstable.”
I have a little dog. Sometimes he gets a tic on him and I have to pull it off. Yuk.
If he were to become infested with 100 or 200 tics, he’d have problems, but he’d be OK (especially once I got the parasites off him) since they’re small.
The trouble with the parasitic derivatives-creating Wall Street Financier, if you regard the massive amount of derivatives created as a drain on the value-based money system that it is based in and speculating upon, is that the parasite is BIGGER than the host.
I keep envisioning a tic that’s as much bigger than my dog as the derivatives-monster is than the underlying economy.
That’s not going to work out well.
Yves: As an aside, the Orwellianism of the branding of financial services tricks and traps as “innovation” is annoying. Readers are invited to come up with better nomenclauture and encourage its use.
Scamovation.
Dammit!
I just entered a long and comprehensive comment, but when I tried to submit it my browser hung.
Did it come though or do I need to retype the whole thing?
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