Financial Innovation II: Much, But Not All

(Part One is here)

Robert Litan at Brookings has a paper out, In Defense of Much, But Not All, Financial Innovation. You should check it out, it is pretty good. Here’s the summary chart, that Kevin Drum grabbed from the paper:

Each item is marked from – - to ++, with 0 being neutral.

Specific Thoughts

So I have a couple thoughts, and then I want to discuss the terms.

1) I tend to agree that interest rate and credit default swaps have been a net improvement for the market. I think we need to put CDS into an exchange-with-clearing structure, as the current system, dependent on ratings systems in large part, is broken. I think both these types of swaps are important because, as Fischer Black once pointed out, they are kinds of fundamental risks, which, along with cost of capital and liquidity, are the components of bonds themselves. So in general, any type of bond that is bundled with an interest rate swap, with which you can do all kinds of fun things, is innovative. So, though they often cause quite a bit of trouble, I think they are definite net pluses.

2) I’m dubious about the results of enhanced liquidity that comes from the extra trading that comes from hedge funds, particularly in terms of high-frequency trading, because that liquidity isn’t there in a crisis.

3) Litan says a lot about how the payment structure is much more convenient as a result of credit and debit cards. I agree it’s convenient, but it doesn’t come free. It’s worth noting that the interchange fee on credit and debit cards runs from 1-3% plus a fixed cost per transaction. This rate is increasing, though the technology has matured and had significant market penetration, which should lead someone to believe something has gone wrong in the market structure. (I’ll have an interview about this tomorrow, but a problem is that competition works to increase fees, not lower them, since the real competition is for banks, not storeowners.) Challenges to the business model online, notably paypal, have really just become UI front-end for the credit card model, reinforcing the duopoly structure without disrupting it.

So there’s a 2% tax that goes into the real economy for getting people’s money from point A to point B carried out by the banks and credit card companies. I’m not sure what should be done – the Federal Reserve eventually absorbed the clearing risk of the inter-bank checking system the last time this sort of thing existed. Certainly more transparency would help.

4) I also think there’s a benefit to index funds, and in general getting consumers of mutual funds to be more cautious of fees in the long run. I did note this: “On the other hand, because there is some stock market premium associated with membership in the more exclusive indexes, the strong demand for indexed funds provides incentives for firms to grow.” Is this true? I know there are studies about anomalies surrounding stocks that enter and leave the index, they blip behaviorally, but I’d be curious more generally if there’s research here.

5) As for home equity lines of credit: I think the arguments will eventually converge to the argument that HELOCs were primarily used to synthetically create household earnings growth over the 2000s, where the middle and working-classes used a derivative-like structure to push out the full realization of stagnant earnings growth after all other options (working more hours, in their case) had been maxed out, in order to buy themselves some breathing room, just like any other number of failing companies. And countries now, if you include Greece.

It seems like some moderate restrictions at the state level saves major, major headaches with housing bubbles, so I support limiting them in a general way. I also think, as of this writing, that the originator of a HELOC should only be the originator of the first mortgage, because of ownership issues. I could be convinced in either direction on this. I think the idea, pushed by many, that you should use home equity to pay off credit cards since mortgage interest is tax deductible is evil, and reason alone to kill the mortgage interest rate deduction.

6) Though hedge funds get 0s across the board, it is worth noting if you work for a hedge fund you’ll often pay a 15% tax rate, since your income is reported not as income but through investments. That’s why you see the average tax rate for the 400 richest people averaged 16%, and you get things like Warren Buffet paying less of a percent in taxes than his secretary. It’s one thing if you think this is crucial work benefitting the country to have our tax code “nudge” people into working for hedge funds; if you think it is a bunch of zeros in benefits we should probably revamp that.


Anyone who wants to talk about financial innovation in the past 20 years needs to address the following question: Was the subprime home loan a good innovation, independent of the fact that it help mess up the economy? I’m going to define a subprime home loan as a mortgage with a low down payment, an initial rate above prime, with a 2 or 3 year jump, and some sort of prepayment penalty.

I’m going to say no, quoting a smart line I’ve heard Julie Gordon, from the Center for Responsible Lending, say: “I’m in favor of home ownership, not home buyership.” Subprime was a fantastic way to increase buyership. I don’t think a subprime loan was a good way to build home equity, in fact I think it is quite the opposite.

So what’s “access” here? That more people can buy? Or that more people can build wealth? This is crucial, since who has access to financial services is dependent on what we mean by access, and so we need to contest the uses of this definition. I don’t think subprime loans increased access for anyone, since I don’t think of “buyership” as a net good for anyone other than those collecting the transaction costs. This is what will guide me as I start to explore what it means for consumers to have access to financial services more formally soon.


So a more general question. The share of GDP that comes from the FIRE industries (fire finance, insurance, and real estate) has doubled over the past 50 years, and the share of business profits that go to financial industry has been steadily climbing for some time now, reaching almost 45% right before the crash. There’s been a “financialization” of the real economy, with major power over the real economy directed from Wall Street. So to the extent that this all increases GDP, it also comes as it takes up much more of the overall economy’s energies.

And what has this huge financialization of the economy brought us? I’m reminded of the simple fact, pointed out very well by Steve Waldman, that for all the energy, time, brainpower and capital put into the financial market, it is not even a little bit easier for me to help invest in small businesses.

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11 Responses to Financial Innovation II: Much, But Not All

  1. Matt Frost says:

    That’s a great interfluidity post. Have you seen ?

  2. Pingback: Thursday links: nuanced voices Abnormal Returns

  3. Z. says:

    “The share of GDP that comes from the FIRE industries (fire, insurance, and real estate) has doubled over the past 50 years”.

    I think you meant “finance, insurance, and real estate”, no?

  4. Pingback: tabla du jour: Impacto de las innovaciones financieras « Quantitative Finance Club

  5. Pingback: Joe Stiglitz On The Crisis, EMH And Suchlike « Chasing Fat Tails

  6. joey says:

    don’t worry with the smokescreen debate on heathcare by the time anyone wakes up the BIGGEST HEIST IN HISTORY will have been completed by those controlling these financial instraments.

  7. PK says:

    In terms of “liquidity not being there in a crisis”, I think the comment is a bit off base – there is plenty of liquidity in the markets where high frequency traders usually operate; for instance US/euro equities and futures. During the financial crisis the reason why people were able to even unwind their positions is because high frequency trading algorithms were taking the other side of the trade. Now – as high frequency trading gets into other exchanges, there will be liquidity in a crisis as well on those exchanges. The liquidity needed during the financial crisis was in the credit markets – high frequency traders are not trading much credit these days since the market is not very electronic.

    Most serious HFT shops have market maker status which means that they are FORCED to provide liquidity to the market – a good thing in people’s eyes besides human click traders.

  8. Pingback: Financial Innovation, Again « The Baseline Scenario

  9. Jim Caserta says:

    If you integrate FIRE’s cumulative profits/loss for the full naughties (include Fannie’s recent $72B in the red), how does it come up? A problem that doesn’t get mentioned is that much of the profits were phantom profits that quickly disappeared – consider AIG booking profit from CDS premiums, while not setting aside reserves for losses. Bad accounting seems more prevalent in FIRE industries than everywhere else (it showed up at Enron).

  10. The Ancient says:

    1) “There’s been a “financialization” of the real economy, with major power over the real economy directed from Wall Street. ”

    It would be interesting to know how this compares to, say, 1890 or 1920. What share of business profits went to the financial industry back then?

    2) Bob Litan’s estimation of the value of risk-bearing innovations seems to be the exact opposite of Paul Volcker’s. (I would trust Volcker over Litan eight days out of seven.)

    3) Insofar as “small businesses” need additional investment, it’s those new, small businesses that have the potential to grow dramatically. Most small businesses are created as a way for the owners to avoid tax, or employ relatives, or work to their own clock. Only a minuscule fraction have potential to generate real innovation and large numbers of jobs.

    4) Buffet’s claim is somewhat misleading, as he also incurs the burden of the corporate tax, as a principal owner of Berkshire Hathaway.

    5) I completely agree with everything you say about “home buyership.” But would Barney Frank? I don’t think so.

  11. Adam Jones says:

    Barney Frank does. His views on this are easy to find and admirably realistic for a politician. I don’t know how you became confused about his views, but I suspect you were delibrately misled by people you trust.

    Consider reading this:

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