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Did Financial Innovation Cause the Crisis?

As we discuss further in Chapter 4, "Innovations in Housing Finance," the housing sector has seen a considerable amount of financial innovation in recent years—and a number of commentators have argued that this played an important role in causing the crisis.19 Although new mortgage products and the predatory practices of many lenders in persuading people to take on mortgages they could not afford exacerbated the impact of the meltdown, we believe they were not its fundamental cause. There are clearly many factors that drove the crisis and a wide divergence of opinion about their relative importance. For example, a number of people argue that moral hazard caused by the government safety net and the prospect of bailouts for banks and entities like Fannie Mae and Freddie Mac led to excessive risk-taking by financial institutions. While we believe this was an important factor—and an area in which financial innovation needs to focus in the future in order to better align incentives—we argue that the primary problem was a loose monetary policy that led to a massive run-up in home prices.

Carmen Reinhart and Kenneth Rogoff have also pointed to the outsized bubble in house prices as the primary culprit.20 They tracked real housing prices in the United States from 1891 until 2008, showing that prices remained remarkably stable until the early 2000s, when they spiked dramatically before starting to fall precipitously in 2006. In the decade between 1996 and 2006, real housing prices in the United States grew about 92%—three times more than the total increase (27%) they had posted from 1891 until 1996. When this bubble burst, it first hit subprime mortgages before spilling over to the rest of the financial system.

The United States was hardly the only place that produced a housing bubble. Spain and Ireland, to name just two examples, were also hard hit—and, interestingly, in neither of these countries was financial innovation a major factor. Securitized mortgages in Spain were required to have loan-to-value ratios of 80% or less (meaning borrowers had to contribute at least 20% down payments).21 In Ireland, the main financial innovation introduced during the bubble years was simply the lengthening of mortgage terms.22 Yet both of these countries have felt even more severe consequences than the United States. In Spain, the impacts have been serious, even though the major commercial banks (such as Santander and BBVA) came through the crisis much better than most of their international counterparts.

John Taylor has made a direct connection between lax monetary policy and the bubble in home prices in the United States, Spain, and Ireland.23 He considered what would have happened in the United States if the Federal Reserve had maintained the same approach that had prevailed since the 1980s, during the period known as the Great Moderation. His simulations suggest that under that scenario, the housing price boom would have been much smaller. Although Spanish interest rates never approached lows like the 1% rate set by the Federal Reserve from 2003–2004, monetary policy was nevertheless very loose, taking into account the high rate of inflation in Spain at the time and other economic factors. In fact, Spain had the loosest monetary policy and the largest housing boom in the Eurozone. The story in Ireland was similar.

The growing issuance of subprime mortgages in the United States, particularly as home prices moved toward their peak, meant that the bursting of the bubble caused immediate damage. Because many subprime borrowers had little to no cushion, their default rates went up soon after home prices began to fall, sparking problems in the money market. Given what happened in other countries with less financial innovation, a major crisis would have occurred even without subprime mortgages. Reinhart and Rogoff cite real estate bubbles as the causes behind banking crises in Spain in 1977, Norway in 1987, Finland and Sweden in 1991, Japan in 1992, and many Asian countries in 1997. In all these cases, a collapse in housing prices caused banking crises.24

Many of the recent financial innovations in the mortgage market were aimed at expanding homeownership to people with low incomes and few assets—and this policy is in fact desirable in many ways. However, these new products relied heavily on the assumption that home prices would continue to rise. As long as this was the case, an individual's mortgage could be refinanced or the house could simply be sold to pay off the mortgage if problems occurred. Although it seems obvious in retrospect that there was a bubble in housing prices, it was not so clear at the time. Some observers, such as economist Nouriel Roubini, did sound warnings. The Economist even ran an analysis in mid-2005 cautioning that "it looks like the biggest bubble in history."25 But nevertheless, the Federal Reserve, the other bank regulators, and many market participants missed (or chose to ignore) the signs. The rewards to anybody who realized the existence of the bubble and invested appropriately were staggering. For example, hedge fund manager John Paulson made $3.7 billion in 2007 by taking positions to exploit the fall in house prices.26

There is no sugarcoating the fact that some of the complex mortgage products developed during this period were explicitly designed to mislead people. But making things complicated to fool people is a practice that is hardly restricted to financial innovation. In the markets for many products, from car rentals to mobile phones, vendors take advantage of the unwitting. Xavier Gabaix and David Laibson have shown how this can happen even in competitive markets.27

This book is about the many benefits that financial innovation can create. This is not to say that financial innovation is universally beneficial. Some "innovations," particularly those that are complex for complexity's sake, with the aim of fooling consumers, are not desirable. However, these aberrations should not obscure the past accomplishments and future potential of financial innovation. They should instead motivate the financial community to find new ways to safely test new products, manage risk, and increase transparency.

The major lessons from the crisis can be boiled down to this: Complexity does not equal innovation, and leverage is not a synonym for credit. Everything new under the sun is not automatically an innovation. As noted in our discussion of the vocabulary of finance, equity emerges from the variety of interactions that build real value in an enterprise, be it a household, business, government, or community. Credit, as its root, implies the reliance on the truth or reality of something—its ability to be valued in a manner that becomes an accounting entry, representing the balance of cash in one's favor. True innovation in capital markets and finance has made access to credit and the ability to build equity more flexible and less costly.

But in recent years, as new products became increasingly Byzantine and financial institutions became dangerously leveraged, credit was often used for speculation, not necessarily to enhance value or productivity. A host of Rube Goldberg financial products were introduced simply for the sake of product differentiation and marketing; many were embedded with high leverage or disguised with intentionally opaque structures. The recent financial crisis illustrated vividly that excessive complexity is the enemy of transparency, ultimately hampering the market efficiency that financial systems need to operate.

With the advent of banking, insurance, securities, futures, and other derivative markets, the strengths and imperfections of finance have remained. As in any area, innovation in finance is dynamic, disruptive, and nonlinear. Financial growth, despite its newly broad reach and seemingly boundless potential, is still inadequate and unequally shared. Until the evolution of finance and the markets serving it are fully complete, the risk of crisis remains present—and that risk has even intensified over time as an intricate web of global connections has formed.

But risk management is a fundamental component of financial innovation, and new breakthroughs will be the key to controlling the potential for outsized global shocks. The overall objective is to reduce the cost of capital while mitigating systemic risk—the cascading failures of businesses, financial institutions, and intermediaries that sometimes arise when economic actors trade without possessing adequate information.28

It is crucial to look beyond the hype and hysteria that surfaced during the most recent financial crisis. We believe that financial innovations are the cure for instability, not the cause.

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