Financial Innovation: Beware!

Companies must innovate to stay ahead of the competition. Innovation improves quality and lowers cost. Better still, it opens a new product line, creates new demands, and turns on a new stream of revenue.

Consumers also enjoy the fruits of innovation in terms of lower prices, better performance, more attractive products, and higher satisfaction. Nowhere can you see this more apparent than in personal computers, cell phones, autos, and television.

Product innovation is easy for the consumer to verify. The important yardstick is the result rather than the complexity of the product. For instance, the consumer does not need to know the mechanics of the automatic transmission, or how a hybrid car changes power from gasoline to electric. It’s the performance and the cost of the auto that count. If it does not work well, the consumer can always take the product back to the manufacturer for repair or compensation.

One kind of product presents some difficulty for verification: medicines. The effect and performance of a medicine is less obvious than other products due to subtle effects exhibited by the human body. If it does not work, it may be too late because the consumer has already taken the medicine for some time. It has already delayed the correct treatment that should have been employed. It may even have caused the body some damage.

Financial innovation is an entirely different creature. You must beware of its attractiveness. You cannot tell its effects quickly until a few years later. By then it will be too late. You have to understand the detailed mechanics of a financial product such as a loan and its repayment terms. The reason is that all kinds of tricks can be hidden in the fine prints. The consumer is not given the chance to test it out. If it works out badly later, the consumer will shoulder the damages caused. To deceive the consumer, the financial product is made arbitrarily complex so that the deceptions cannot be easily seen.

The US financial meltdown of 2008 is the result of irresponsible innovations such as sub-prime mortgage, securitization, derivatives, and credit default swaps. What are these things anyway? The fact that you ask this question means the innovation has gotten out of control. It not only confuses the public, but also brings down many big banks where the innovation originates.

Sub-prime mortgage is easier to understand than the others. You might have been burned by one already. The mortgage features a low or zero down-payment, and a variable interest rate lower than the current prime rate for the first few years. The purpose is to seduce as many people as possible to use the mortgage to buy houses, regardless of affordability. So a housing bubble is created.

Most people didn’t know what they were getting into when they signed a sub-prime mortgage. When the initial sub-prime period expired, interest shot up to float with the current rate. Many people suddenly found that they could not afford the mortgage payments. They defaulted and the banks foreclosed on their houses. So millions of foreclosures caused the housing bubble to burst.

The millions of foreclosures came back to haunt the banks where the sub-prime mortgages originated. The foreclosures became a toxic asset because they generated no revenues for the banks. The total value of foreclosed properties amounted to hundreds of billions of dollars, enough to cause some big banks to fail, thus forcing the government to bail them out in order to maintain financial stability.

Securitization is an innovation to spread risk. The banks chopped up the mortgages and combined the good and bad ones together into securities to be sold to other investors, including foreign banks. The tidal waves of foreclosures in America caused those securities to become toxic too. So the financial meltdown spread around the globe.

Derivative is a bet that can become exceedingly complex. Buying a stock for it to go up is in fact buying a derivative because the price is derived from the performance of the company. To go one step further, you can buy the bet that bets on the stock to go up. This can go on further and further until nobody knows what they are buying or selling. This is how things got out of hand in the special exchanges for derivatives.

Credit default swap is mainly invented by insurance companies to insure against the failure of other banks. AIG had the most exposure to this innovation. When more banks were failing, AIG found itself in deep trouble and required the biggest bailout from the government to prevent collapse.

In conclusion, an innovation must bear fruits that benefit both the company and the consumers. As shown in the 2008 financial meltdown, innovation in financial products only benefited the company for the first few years. It confused the consumers and seduced them to make bad decisions like buying a house that they could not afford a few years down the road. In the end, the disaster came back to revenge on the big banks and caused a worldwide recession. It will take a long time before the world economy fully recovers from this tragedy.

(June 2010)

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