Ballooning Finance: How Financial Innovation Produces Overgrowth and Busts

Via Naked Capitalism:

Ballooning Finance: How Financial Innovation Produces Overgrowth and Busts

Yves here. It’s a welcome surprise to see economists devise a model that delivers generally sensible results. Here, three economists looked at how financial innovation leads to an bloated financial sector as well as greatly increasing the risk of meltdown.

One quibble is that they characterize financial innovation as a benign process at the outset that is all too quickly abused, particularly when the authors assume information asymmetries (as in the investors don’t fully understand what they are buying). One of their examples, collateralized debt obligations for subprime securitizations, disproves the thesis.

The writers miss that an earlier version of this type of asset-backed CDO also existed in the 1990s, and as in its 2000 reincarnation, was critical to keeping subprime mortgage securitizations going. As we discussed long form in ECONNED, the ability to sell these deals was constrained by the difficulty of placing the least attractive tranche, the BBB slice. Those (along with more attractive financial sausage constituent parts) were rolled into CDOs, which were tranched just as the original mortgage backed securities has been.

Now astute students of finance know that pretty much any product defect can be solved by price. That means those deemed-to-be-drecky BBB tranches could have sold if they had had higher interest rates. Of course, that would have meant some combination of higher interest rates on the underlying mortgages (as in less product to sell, since fewer people can afford payments on more costly mortgages) and/or lower fees to the deal participants. So these CDOs, which proved to be a Ponzi scheme in both their 1990s and 2000s versions, were a “financial innovation” created to get around the need to price RMBS more realistically. And the result in both cases was too much subprime origination and a CDO crash.

Dan here:   See Vox post:

By Bruno Biais and Jean-Charles Rochet, professors at the Toulouse School of Economics, and Paul Woolley, Senior Fellow at the London School of Economics. Originally published at VoxEU