The Failure of Financial Innovation

Abstract

This paper presents a review of the role of financial innovations in the global crisis that surfaced
in mid-2007 and which continues to the present time. We begin with a review of research on
financial innovations in order to arrive at a working definition of “innovation” in context. We
demonstrate the problem of innovative financial theories that were improperly implemented in
practice through a narrative description of one example of an innovation gone terribly wrong –
the securitization of mortgages. The paper concludes with a discussion of the specific problems
encountered in the implementation of derivative pricing models which were known at least since
the Crash of 1987, which contributed to the crisis of 2007 and which remain unsolved today.

About the Author

Susanne Trimbath, Ph.D.
Chief Economist
STP Advisory Services, LLC
4089 South 84th Street, #145
Omaha, NE 68127
(402) 923-8888 or cell (310) 266-1917
Susanne@stpadvisors.com

Dr. Trimbath is a former manager of depository trust and clearing corporations in San Francisco
and New York. She is co-author of Beyond Junk Bonds: Expanding High Yield Markets (Oxford
University Press, 2003), a review of the post-Drexel world of non-investment grade bond
markets. In addition to other works cited in this study, Dr. Trimbath is co-author of “Bond
Market Development in Select Asian Countries,” (Milken Institute Working Paper 2003-02). Dr.
Trimbath currently serves as an online adjunct professor of finance for the Bellevue University
(MBA) and University of Liverpool (MSc) programmes.
 The Role of Financial Innovation in Crises
“In recent years, financial innovators, seeking an edge in the marketplace, produced a
variety of new and complex financial instruments. These products, such as asset backed
securities, were designed to spread risk but ended up concentrating it. Loans were sold
to banks, banks packaged these loans into securities, investors bought these securities
often with little insight into the risks to which they were exposed. It was easy money.
But these schemes were built on a pile of sand.”
“This wasn’t just a failure of individuals. This was a failure of the entire system.”
“Instead of reducing risk, the markets actually magnified risks being taken by ordinary
families and large firms alike.”
Remarks of President Barack Obama on announcement of New Foundation
proposal for financial regulatory reform, June 17, 2009

We begin with a review of research on financial innovations. We demonstrate the problem

through a narrative description of one example of an innovation gone wrong – the securitization
of mortgages.

Prologue

One day in March 2009, the Program Director for the local Kiwanis Club, asked me to talk to his

chapter about the current state of the economy. Just one week before that, the Chairman of the

Federal Reserve System, Ben Bernanke, told Congress that he didn’t know what to do about the

economy; he couldn’t stop the repeated need for bailouts; and he wouldn’t be able to say how

long the economic turmoil would last.1 In the middle of what was looking like the worse

financial crisis in US history, the Kiwanis were expecting me to explain to a group of non-

financial business men and women where the economy stood and how we got there.

1
Chairman Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, Before the Committee on
Banking, Housing and Urban Affairs, U.S. Senate, Washington, D.C., February 24, 2009. Chairman Bernanke
presented identical remarks before the Committee on Financial Services, U.S. House of Representatives, on
February 25, 2009. The comments referenced here came during the verbal question and answer session in the House.
The Failure of Financial Innovation page 2

Actually, I wasn’t worried; I know what happened, and why. The truth is that I stood in front of a

classroom full of business students at the University of Southern California in August of 2007

and told them to expect exactly what we see now.

What I told them was neither overly-complicated nor the revelation of anything

particularly mysterious. It is a story of good intentions and bad implementations. It is also a story

about “naked greed,” as one bankruptcy judge put it. It’s the story of financial innovations that

were misused and abused to create what will possibly be the worst financial and economic

disaster in world history.

Introduction

Economists typically discuss stages of economic development as transitions. Economies begin

with agriculture, subsistence living. The first transition is from an agricultural economy – where

the majority of capital and labor are dedicated to the production of food – to industrial economies

– where food production has become mechanized (or chemically induced productivity has

increased yields) to the point that a minority share of the population is needed to produce all the

food required for a nation. The next step in economic development is service – a service-based

economy where the production of food and industrial goods is done by an increasingly smaller

portion of labor. Rather than spending their time in production, labor’s time is devoted to

services like accounting, management, education, etc. While there is no consensus that there

even is a “last stage” in economic development, it is sometimes believed that the next step is the

shift to a finance-based economy – one where the majority of labor is engaged in the servicing or

utilization of financial products.

The Failure of Financial Innovation page 3

That the U.S. had transitioned to an economy based on financial products – those most

ethereal of all services – made the financial collapse in the Fall of 2008 all the more tragic.

Attempts to stimulate a recovery may be hampered because we have transitioned so far away

from the underlying economic use of productive assets.

Defining Financial Innovation

By definition, financial innovation covers new processes, products and institutions. The earliest

volume I found dedicated to the definition and analysis of financial innovation was the product

of the 1975 conference at New York University (Silber, ed. 1975). The literature generally

divides the discussion of financial innovations into institutions, markets and products (or

instruments). This volume will focus on innovations in financial products. We will not delve

deeply into the markets and institutions with one notable exception – securities entitlements. The

innovation of providing securities entitlements in lieu of the delivery of actual securities for trade

settlement is a legal innovation developed to enable an institution – the central counterparty – to

provide for prompt clearing in financial markets. (More detail on centralized clearing and

settlement systems is provided in the chapters on settlement failures in Bond and Equity

markets.) Rather than discussing securities entitlements as either an institutional or a market

innovation, we will adopt Tuffano’s (2002) distinction and limit our discussion of entitlements as

an innovation in “processing transactions.”

Financial innovations come in two forms: circumventive and transcendental (Holland in

Silber 1975). Circumventive innovations are those that come about as a way to get around

regulations. Hedge funds are a good example of circumventive financial innovations: as an

institution, they were able to avoid certain regulations on registration and reporting. In the
The Failure of Financial Innovation page 4

present volume we are more interested in the second type. Transcendental innovations are those

sought by customers, in this case, demanded by investors. We will see that the demand for new

financial products and for more of them played an important role in building up the size and

scope of the 2008 financial crisis. As the financial system evolved, we should have seen more

technically perfect markets. Instead, the technology was used to hide information (Icard 2005)

and defy the laws of supply and demand by selling more financial products that there are

underlying assets and, in fact, more financial shares than are authorized and issued.

Silber (1975) extended the work of David and North (1971) on the impact of innovation

in the financial sector on performance in the real (macro) economy. The emergence of financial

products is, at least initially in the form of basic stocks and bonds, “an unambiguous financial

innovation.” Some entities, those with a deficit between spending and their current income, will

issue securities in the primary market that will be purchased by other entities, those with a

surplus of with income (or wealth) over their present spending needs. In this way, purchasing

power over real economic resources is redistributed through deep capital markets. If this

reallocation moves money from less productive uses to more productive uses, then the financial

sector is making a contribution to real economic activity.

Secondary markets, on the other hand, simply provide a way for the holders of existing

securities to dispose of the financial assets as their own discretion, without reference to the

original issuing entity. Therefore, none of the profits made (or lost) in the secondary market for
The Failure of Financial Innovation page 5

financial products has a direct economic impact on real economic activity of the entities that

came to the primary market for access to capital.2

The innovation of securities and financial markets emerged because they offer

comparative advantages over investment in individual real economic projects or single firms.

The plethora of financial products available was meant to help to distribute risk among economic

units. In case after case, however, we find that over the last decade these same financial products

were mis-used to an extent that consolidated and amplified risk rather than dispersing it. The best

way to outline what happened is to use an example centered on the one thing that most people

will forever associate with the 2008 financial meltdown: The Subprime Mortgage Crisis. Keep in

mind, though, that this same scenario played out in all other asset classes – from student loans

and credit card debt to syndicated corporate borrowing and commercial paper.

Paved With Good Intentions

Home mortgages make a good example for our purposes because the mortgages themselves are

considered to be financial innovations – banks created consumer loans in the 1928 in response to

weak loan demand and savings and loan associations created mortgage participations in 1957 in

response to rising yields (Silver, 1975). The rapid expansion of the market for residential

mortgages in the early 2000’s started out with very good intentions: provide opportunities for

homeownership to a segment of the population that was historically left out.

“… expanding homeownership opportunities for minorities is a fundamental aim of the

President’s housing policy. President Bush is committed to ensuring that opportunities
and benefits of homeownership are available for all American families. In June 2002,

2
Separate from this lack of direct economic impact, the price and popularity of a firm’s financial instruments in the
secondary market will have an impact on the firm’s ability to raise additional capital and the price of that capital.
The Failure of Financial Innovation page 6

President Bush announced a new goal to help close the homeownership gap by
increasing minority homeownership by 5.5 million by the end of the decade.”
Department of Housing and Urban Development, 2002, Benefits of Increasing Minority Homeownership

Yet, even in 2003, according to the NAACP:

“This assumption, that low-income and racial and ethnic minority Americans are less
likely to meet their financial obligations because they do not have the income, property,
education and employment history of their white counterparts flies in the face of several
studies that have been conducted as well as anecdotal evidence supplied by the NAACP
Financial Empowerment Initiative, which provides business, homeownership and
wealth-building counseling to low-income and racial and ethnic minority individuals.”
Statement of Mr. Hilary Shelton, Director, NAACP Washington Bureau, On the Fair Credit
Reporting Act and How It Affects Ethnic Minority Americans, Before the House Financial
Affairs Committee, July 9, 2003

In 2004, the U.S. Department of Housing and Urban Development launched a $161.5

million nationwide "American Dream Down Payment Initiative.” First-time home buyers could

receive the greater of $10,000 or 6 percent of a property’s price (after meeting established

income limits and home-purchase price limits). Other levels of government joined in the effort.

For example, in San Bernardino, California, a combination of state, county and city assistance

could add up to as much as 25 to 30 percent of the home price in grants to apply to down-

payments closing-costs.3

There had to be a way to measure the credit-worthiness so that immigrant and minority

buyers would not have to rely on the more aggressive (zero-down, interest-only, variable-rate,

etc.) mortgages which were the only option for borrowers designated “high-risk” by ordinary

3
Leslie Berkman. 2004. Through the roof; the inland housing frenzy,” The Press - Enterprise, August 8,
http://www.proquest.com.ezproxy.lapl.org/ (accessed July 24, 2009).
The Failure of Financial Innovation page 7

credit standards.4 To begin with, new credit rating systems had to be developed to take into

consideration the fact that, for example, some immigrant groups preferred to live with extended

families. The individual income of any one member of the household may not qualify for a loan,

but they would all be paying the mortgage. Yet, their social structure was such that assets are

only held by the male head of household. NAACP’s Mr. Shelton continued:

A second contributing factor to the existing bias against racial and ethnic minorities is
that credit reports and credit scoring may use variables that are, on the surface, neutral,
and these variables may be applied evenly to all applicants. However, closer inspection
of the variable may show that its use disproportionately adversely affects African
Americans or other ethnic minority Americans. One example may be education. Some
reports or scoring systems could conceivably take into account an individual’s
education level. While higher education in America is, in theory, equally accessible to
all, in practice it is still disproportionately available for white Americans.

Through the efforts of NAACP and other, banks and others came to realize that the existing

systems were excluding people who would actually be very good borrowers. The original

“subprime” borrowers were like the original junk bond companies. They didn’t fit the mold of

“creditworthiness” but MCI and Turner Broadcasting were among them. (Yago and Trimbath,

2003. See especially the case studies in Chapter 9.) Finding new ways to measure

creditworthiness was, in and of itself, probably the first innovation in finance that came to be

abused. While one in three minority borrowers received subprime loans, for example in

California in 2006, the rate was one in six for all home mortgages. As well as the problem of

predatory lending in minority neighborhoods, other borrowers were taking advantage of the

lending that included low-down-payment, no documentation, interest-only, etc. According to

Freddie Mac, about 10 percent of subprime borrowers could have qualified for a prime loan.

4
Center For Community Change, “Risk or Race: Racial Disparities and the Subprime Refinance Market,” May
2000.
The Failure of Financial Innovation page 8

Still, according to the Fannie Mae Foundation, homeowners in high-income black neighborhoods

are twice as likely to take subprime loans as homeowners in low-income white neighborhoods.

Altering lending standards was an innovative response on the part of mortgage lenders in

an attempt to generate demand for credit. These initially were aimed only at expanding balance

sheet constraints rather than in response to exogenous variability in investment opportunities or

in reaction to competitive market forces.5 Eventually, market forces induced banks to create

more mortgages with even lower lending standards. Those forces were in the form of increased

demand for mortgage backed securities. After thoroughly abusing credit ratings, the next step

was to move those bad debts off the balance sheets of the lenders. Securitization was the next

step.

Securitization Without Limits

At the end of 2002, the nearly $5 trillion of mortgage-backed securities were largely confined to

the “prime” mortgages – relatively low-risk, single-family home mortgages. (Van Order 2006)

The line between banks and brokers was blurred almost a decade ago when Congress repealed

the law that separated them. (The Glass Steagall Banking Law originally went into place as a

result of the Great Depression that started after the collapse of the stock market in 1929.)

Because they could, banks turned to their in-house brokers and sold the mortgage loans to Wall

Street in the form of bonds. This is called “originate and distribute.” The same bank wrote the

mortgage, packaged the loan for sale and distributed the bonds to their clients – collecting fees at

5
As mentioned earlier, there was an exogenous influence in the form of White House policy toward expanding
homeownership. While that was important for explaining why mortgage lending specifically expanded it is not
necessary for our illustration of the use and abuse of financial innovation and its role in the 2008 financial
meltdown. We deal more specifically with the contribution of home financing in the chapter on Structures.
The Failure of Financial Innovation page 9

every stage. The hunger for ever more and ever increasing fees drove the banks to write more

and more risky mortgage loans.

Structured securities, where a group of financial assets are repackaged into new

securities, is a relatively recent financial innovation. (Yago and Trimbath, 2003, see especially

Chapter 7.) Generally, a new company is formed – known as a special purpose vehicle (SPV) or

sometimes a special purpose entity (SPE) – which takes ownership of the assets and then sells

securities backed by the cash flow (principal and interest) generated by those financial assets.

By dividing claims on the principal and interest, and further separating claims on the first-in/last-

in cash flows, SPVs are able to issue the securities in several pieces (tranches), each with a

different risk profile and therefore capable of receiving a different credit rating.

Credit rating agencies played a prominent role in structured securities (U.S. House Of

Representatives 2007). According to internal documents that surfaced during congressional

investigations, staff at the rating agencies were pressured to give structure securities

(collateralized debt obligations, or CDOs), like the toxic mortgage backed securities, triple-A

ratings because they were being paid large fees by the underwriters and issuers of these bonds.

This exchange, between Public Broadcast Services’ Maria Hinojosa and Standard & Poor’s

Richard Gugliada, aired in late 2008 on the program NOW on PBS:

HINOJOSA: Okay, so how profitable were CDO's for Standard & Poor's?
GUGLIADA: Very profitable.
HINOJOSA: Give me an example. Throw out some numbers there.
GUGLIADA: A typically fee would be something like a quarter of a million dollars per
deal.
HINOJOSA: So—and you were starting to do now how many deals?
GUGLIADA: During the hey days, in the busiest months, we were doing as many as 20,
25 per month.
HINOJOSA: So if you do the math, the CDO division alone was bringing in at least five
million dollars a month in the busy season.
The Failure of Financial Innovation page 10

And the CDO's were spreading the wealth to Moody's and Fitch as well. Revenues at
the three top rating agencies went from three billion dollars in 2002 to over six billion
dollars in 2007.
So, was there pressure keep that money coming in?
GUGLIADA: Yes. All of us, Moody's, S & P, Fitch, we were constantly trying to bring
in new business.

In July 2009, The California Public Employees' Retirement System (CalPERS) – the

nation’s largest pension fund – sued Moody’s Investors Service, Standard & Poor’s and Fitch

Ratings – the top three credit rating agencies. Moody’s, S&P and Fitch are also the largest three

of only ten credit rating agencies accepted by the Securities and Exchange Commission (SEC) as

Nationally Recognized Statistical Rating Organizations (NRSRO). In the suit filed in San

Francisco Superior Court, CalPERS claims ratings agencies gave investments "wildly inaccurate

and unreasonably high" grades, leading to more than $1 billion in investment losses. Many

observers believe the agencies are at risk for lawsuits on a whole variety of cases. In September

2009, the SEC adopted amendments that would eliminate references to NRSRO credit ratings in

dozens of SEC rules, regulations and forms.

In our example, the securitization of mortgages is an attempt by lenders to generate

demand for their liabilities by modifying the existing assets in its portfolio. If the home

mortgages underlying the bond go into foreclosure then the bond goes into default. Because the

bond is more widely held than a particular group of local mortgages, the losses on the bond

default are more dispersed – no longer concentrated in the geographic area where the defaulted

mortgages and foreclosed properties are located. The way it’s supposed to work, the way the

theory on structured securities runs, this is a good idea. If a bank can sell the mortgages they can

use that cash to write more mortgages. It should disperse the risk, spread it around, so that some

economic problem in one town, like a factory closing resulting in job losses that send multiple
The Failure of Financial Innovation page 11

local mortgages into default, won’t cause the local bank to go out of business. Losses on those

mortgages would be spread out geographically, and spread out over a large number of investors

so that no one of them should suffer all the damage.

Structured financial instruments increase the liquidity of the lenders assets. By pooling

together a group of assets, they avoid the problem of the securities being too small to attract

sufficient trading volume for good liquidity. Removing loans from a bank’s balance sheet has the

beneficial effect of allowing the bank to free up expensive regulatory capital that it would

otherwise be compelled by regulation to hold. (Duffie and Gârleanu, 2001). Public and private

pension fund asset allocations favored holding structured securities that equities and Treasury

securities on the continuum of credit quality.

Mortgage-backed bonds had been issued by the government sponsored housing finance

institutions, Freddie Mac, since 1983. The structure here is to concentrate prepayment risk (the

risk that mortgages will be paid in full before the due date, shortening the duration of the loan

and causing the lender to find new investments for the cash proceeds) in one tranche which

behaves more like an equity than a bond. Because the mortgage-backed bond is publicly traded,

it provides liquidity to investors – making it more attractive than directly buying mortgage loans.

The basic structure is not atypical.

The problem multiplies from there. First, banks wrote more and more mortgages and

mortgages with less and less credit worthy borrowers, as they were generating fees every step of

the way – lending fees, mortgage insurance premiums, underwriting fees, trustee fees, etc., etc.

They became careless in their haste. Estimates are that between 30 percent to 60 percent of all

mortgage backed securities may lack the proper paperwork for the bond holder (SPV or Trustee)
The Failure of Financial Innovation page 12

to assert rights in a lien against the property. Since October 2008 evidence has been surfacing in

bankruptcy courts that the paperwork for the underlying mortgages wasn’t provided correctly for

the new bond holders, leading to delayed or denied foreclosure proceedings.

The story continues to unfold during the writing of this book. New York Times’ Gretchen

Morgenson reported on cases from Florida and California. A foreclosure judgment on a home in

Miami-Dade County (FL) was set aside on February 11, 2009 when the new mortgage holder

could not produce evidence that the original mortgage lien had been assigned. In one of the

California cases, the lender tried for foreclose on a mortgage that had previously been transferred

to Freddie Mac. That case was decided by Judge Samuel L. Bufford.

The earliest decision I’ve seen is from Judge Christopher A. Boyko in Cleveland.

Plaintiff Deutsche Bank’s attorney argued, “Judge, you just don’t understand how things work.”

In his October 31, 2007 decision to dismiss a foreclosure complaint, Boyko responded that this

“argument reveals a condescending mindset and quasi-monopolistic system” established by

financial institutions to the disadvantage of homeowners. The Masters of the Universe were

anxious to pump out mortgages into MBS so they could continue to earn fees – making money at

any cost.

On April 3, 2009, R. Glen Ayers a former bankruptcy judge, now with the law firm

Langley & Banack in San Antonio, Texas, spoke at the American Bankruptcy Institute in

Washington, D.C. In his speech, “Where’s the Note, Who’s the Holder”, written with Judge

Samuel L. Bufford, Judge Ayers dropped this bombshell: “A lawyer sophisticated in this area has

speculated to one of the authors that perhaps a third of the notes ‘securitized’ have been lost or

destroyed.”
The Failure of Financial Innovation page 13

According to research and interviews done by Matt Taibbi (The Great American Bubble

Machine, July 9-23, 2009 Rolling Stone), for a 2006 mortgage-backed security (MBS) issued by

Goldman Sachs, "58 percent of the loans included little or no documentation -- no names of the

borrowers, no addresses of the homes, just zip codes."

As of the end of 2008, there was $6,838.7 billion worth of government-backed mortgage

bonds outstanding. An additional $178 billion were issued in the first two months of 2009.

Despite the fact that the dangers of these “toxic assets” were well-known by 2007, nothing in the

bond market had changed. In fact, the average volume of failed-to-settle trades nearly doubled by

2009 (from an average of $48 billion to $86 billion, a 79% increase).

Failure to Deliver for Settlement
Mortgage‐backed Securities (MBS)
$350,000

$300,000

$250,000

MBS 2009
$200,000
MBS 2007

$150,000

$100,000

$50,000

$0
12/18/2008 2/6/2009 3/28/2009 5/17/2009 7/6/2009 8/25/2009 10/14/2009

Data source: Federal Reserve Bank of New York, Primary Dealers report FR2400. Values in $US Millions)
The Failure of Financial Innovation page 14

It wasn’t just home mortgages that were being abused through the newest financial

innovations. This same story played out in car loans, credit card loans, the borrowing of nations.

Although securitized mortgages provide a vivid and possibly the best-known example of the

abuse of financial product innovation, they were not the only asset to suffer this fate. In the

summer of 2009, a Montana bankruptcy court ordered a senior secured claim to be subordinarted

to the claims of all unsecured creditors because the lender’s conduct amounted to “naked

greed…driven by the fees it was extracting from the loans it was selling.”6

Entitlements Unfulfilled

The demand for these bonds completely outstripped the supply: senior management put pressure

on the troops to write more mortgages and sell more bonds. The demand was so great that in the

peak years 40% of the bond trades failed to settle for lack of securities deliveries – broker-

dealers were selling more bonds than were issued. (We present a complete analysis in the chapter

on Settlement Failures in Bond Markets).

Of course, the bond buyers were rarely notified that they did not receive their bond

purchases because the rules don’t require the broker-dealers to tell them. According to the

Uniform Commercial Code, the broker-dealers were allowed to make book-entries for securities

entitlements – basically an IOU for bought-and-paid-for bonds (and stocks).7 Developed as a

6
Credit Suisse v. Official Committee of Unsecured Creditors (In re: Yellowstone Mountain Club, LLC), cited in
“Commercial Loan Driven by ‘Naked Greed’ Warrants Equitable Subordination of Claim”, Mark G. Douglas,
Recent Developments in Bankruptcy and Restructuring, Vol. 8 (4) July/August 2009. Published by Jones Day, New
York.
7
We go more deeply into the legal innovations in equity markets in the chapter on Settlement Failures in Equity
Markets. For an overview of changes in Article 8 concerning securities entitlements, see Charles W. Mooney, Jr. et
al., An Introduction to the Revised U.C.C. Article 8 and Review of Other Recent Developments with Investment
The Failure of Financial Innovation page 15

convenience to solve the problem of guaranteed settlement in the early 1970s, on a peak-trading

day in 2004 securities entitlements for mortgage-backed securities stood at $410 billion or 58.9%

of all transactions in mortgage-backed securities that week.8 Securities entitlements are not

specifically a financial innovation, but an innovation in law that, while designed with good

intentions, became as abused as any of the financial innovations. Securities entitlements were

meant to be temporary (Mooney 1994) but were abused to the point of allowing more bonds to

be sold than had ever been created.

Credit Derivatives

Despite the triple-A credit ratings assigned to portions of the securities issuance, many tranches

were in fact risky investments and investors came to think of securities backed by subprime

mortgages as holding more than an ordinary amount of risk. Enter credit derivatives, another

abused financial innovation. Credit default swaps are quite simply a contract like an insurance

policy where the bond holder pays a small premium up-front for the guarantee of getting all their

money back if the bond goes into default, for example, if the home mortgages underlying the

bond go into foreclosure. The way it’s supposed to work, the way the theory on structured

securities runs, this was also a good idea – it made the bonds more popular and sent more money

back to the bank for mortgages.

Greed enters the picture again: instead of the swaps being sold only to the people who

owned the bonds and only in a quantity equal to the bonds an unlimited number of swaps were

Securities, 49 Bus. Law. 1891 (1994); James Steven Rogers, Policy Perspectives on Revised U.C.C. Article 8, 43
UCLA L. Rev. 1431 (1996).
8
As of week ending July 21, 2004 according to data from the Federal Reserve Bank of New York for primary
dealers only.
The Failure of Financial Innovation page 16

sold. This is as if you have a $1 million home and someone sold you $9 million worth of

insurance. The temptation to burn down the house was just too much. What you see now is

arson.

Bailouts And Stimulus: Necessary Evil

“Because government intervention transfers resources from one party to another, it

creates room for corruption. As corruption often undermines the purpose of the

intervention, governments will try to prevent it. They may create rents for bureaucrats,

induce a misallocation of resources, and increase the size of the bureaucracy.”

(Acemoglu and Verdier 2000, A&V)

Preventing corruption during government intervention has costs: bigger bureaucracy, rents for

public employees (gained with access to more information than their principals – taxpayers), and

misallocation of resources. These may be the “unavoidable price of dealing with market

failures.”

Unlike theories where corruption arises as an unpleasant side effect of necessary

intervention A&V’s analysis contains elements of principal-agent, regulatory capture, and

asymmetric information. Bureaucrats (e.g., Secretary of the Treasury) has access to more

information (e.g., through former-colleagues at regulated financial institutions) that is not

available to the government (e.g., Congress), which is attempting to allocate resources in their

efforts to stimulate the economy out of depression. According to their findings, there needs to be

more bureaucracy under circumstances where it is more difficult to monitory the agents’

behavior, like those in the US at this time.

The Failure of Financial Innovation page 17

Federal Reserve Chairman Ben Bernanke testified before the Senate Budget Committee

on March 3, 2009, the day after it was announced that AIG would receive an additional $30

billion in funding from the federal government. The generally subdued Senate was nonetheless

forceful in getting Bernanke to admit several things:

• The Fed and Treasury are using the same three rating agencies to help them select triple-
A collateral for bailout lending as were used to get triple-A credit ratings for junk
mortgage bonds;

• Neither the Fed nor the Treasury will tell us all the companies that are getting bailout
money;

• There is no “outer limit” to how much money the US government can print;

• No one knows the “outer limit” of how much money the US government can borrow;

• The “too big to fail” policy is a bigger problem than anyone thought it could be;

• No one was in charge of AIG – not bank regulators, insurance regulators or capital
market regulators.
When asked about AIG several times, Bernanke replied that it’s “uncomfortable for me, too.”

Through some hole in the regulations, the insurance regulators had no authority to monitor the

financial products activities of AIG. Explained simply and bluntly, the world’s largest insurance

company sold credit default swaps (CDS, insurance against default) on the junk bonds issued

from mortgages and consumer purchases. Many of those mortgages and consumer purchases

were made foolishly – when the borrowers failed to repay the loans the bonds also failed. The

people and companies that bought CDS on those bonds did not look too closely at AIG to see

what would happen if the bonds failed. As it turns out, they didn’t have to worry about AIG

failing – AIG was deemed too big to fail.

When the bonds defaulted and the buyers of CDS protection (“counterparties”) turned to

AIG for payment, AIG turned to the federal government for help. The AIG bailout has cost $180
The Failure of Financial Innovation page 18

billion so far for which the US government owns 80 percent of a company that lost $61.7 billion

in three months (for a total of $99.29 billion in 2008, an amount equal to all of their profits back

to about 1990).

Bernanke said, “AIG made me angry...This was a hedge fund attached to an insurance

company. We had to step in, we really had no choice. It’s a terrible situation, but we aren’t doing

this to bailout AIG, we’re doing it to protect the broader economy.”

Here’s how you connect the dots from AIG to main street: AIG is an insurance company

and insurance companies are among the “safe” investments that money market mutual funds are

allowed to invest their cash in – in fact most funds are required to keep some portion of their

assets in these supposedly risk-free investments.

Basically, this requirement is there to make sure that cash will be available to meet the

withdrawal requests from investors. Now, money market mutual funds and mutual funds are a

favorite investment for retirement money, including the 401k plans that many people have

through their employers. But also, your employer’s retirement plan money is likely also invested

in these funds. Pensions can hold stocks and bond directly, but as the size of these plans gets

bigger and bigger, it becomes increasingly difficult for one or a few investment managers to

handle everything. The California State Teachers Retirement System and the California Public

Employees Retirement System (Cal STRS and Cal PRS, for short), the largest pension funds in

the world, have $160 billion and $180 billion in assets to invest. So, propping up AIG means that

the investments made in the stocks, commercial paper, policies, etc. issued by AIG will not

collapse and take with them the retirement assets of many millions of Americans.

Derivatives Theory Poorly Implemented

The Failure of Financial Innovation page 19

Perhaps the most talked about financial innovation of the last 25 years has been the expansive

use of the options pricing model, used primarily in derivatives trading strategies. The

fundamental assumptions of the model required complex mathematics to institute large-scale

implementation of computer-programmed trading. The basic analytic formula for the efficient

solution (Black Scholes, 1973) is:

φt(x) = xN(d1) – exp(- r(T - t)) · c · N(d2),

Where

ln(x/c) + (r + σ 2 /2)(T - t)
d1 = , and
σ T-t

d2 = d1 − σ T − t

The solution requires the following assumptions:

• continuous trading (markets never close and there is no delay in execution)

• no transaction costs

• no penalty or fees for selling short

• no taxes

• the risk-free interest rate is constant and continuously compounded

• stock prices have constant expected rates of return that are proportional the their prices

• volatility is constant and proportional to the stock price

• options cannot be exercised before maturity

• stocks do not pay dividends

This last assumption is the most troubling since, in basic finance, the present price of the stock is

equal to the net present value of the future stream of income from the firm and that stream of

income is the dividend. In order to implement the iterative computer programs necessary to run

the options pricing model with dividends, “it is usual to assume that the dividends are fixed and
The Failure of Financial Innovation page 20

constant” which is unlikely to hold during times of market volatility like what happened in

October 1987 and September 2008.

The limitations of some of these assumptions could be overcome during programming.

But the computer language used by most financial firms (APL, a programming language) were

weakest at processing recursive calculations (Bookstaber 2007). Business computers simply

were not equipped to produce solutions to the multi-dimensional matrix equations necessary to

solve the model with great precision. The features in APL that introduced unaccounted for risk in

the most complex investment strategies from index-amortizing swaps to portfolio insurance and

from put options to credit default swaps.

The contemporaneous nature of events means that more details are now unfolding,

playing out in courtrooms across the country and, most likely, around the globe. Each week

brings news of examples similar to that described in this chapter. If the examples in the

remainder of the book have not played out by the time you are reading it, then you can use it to

understand the pitfalls that await investors and entrepreneurs in need of capital. If the examples

have already been reported in the press, then this book can serve as a compilation of research

into the various elements of global financial innovation that caused the Crisis of 2008 – and may

well cause the Collapse of 2018.

REFERENCES

Acemoglu, Daron and Thierry Verdier (2000). The Choice between Market Failures and
Corruption, The American Economic Review, 90(1), p. 194-211 [pursues the optimal mix of
market failure and government corruption]

Bookstaber, Richard (2007). A Demon of Our Own Design: Markets, Hedge Funds, and the
Perils of Financial Innovation, John Wiley & Sons, Inc. (Hoboken, New Jersey).
The Failure of Financial Innovation page 21

David, L.E., and D.C. North (1971.) Institutional Change and American Economic Growth,
Cambridge, Cambridge University Press.

Holland, Robert C. (1975) Tk in Silber, ed. (1975).

Icard, André (2005). “Risk measurement and systemic risk,” Speech by Deputy General
Manager of the Bank for International Settlements, at the Fourth Joint Central Bank Research
Conference on Risk Measurement and Systemic Risk, European Central Bank, Frankfurt, 8
November 2005.

Mills, Edward S. The Burden of Government. Stanford, CA: Hoover Institution Press 1986. [why
market failure is preferable to government interference]

Mooney, Charles W. Jr., et al. (1994). “An Introduction to the Revised U.C.C. Article 8 and
Review of Other Recent Developments with Investment Securities”, Business Lawyer (49), p.
1891.

Silber, William L. (1975). “Towards a Theory of Financial Innovation,” Chapter 2 in Silber, ed.
(1975).

Silber, William L., ed. (1975). Financial Innovation, Conference on Financial Innovation (New
York University), Lexington Books, Lexington, MA

Tufano, Peter (2002), “Financial Innovation,” chapter TK in The Handbook of the Economics of
Finance, George Constantinides, Milt Harris and René Stulz, eds. North Holland [review of
financial economics, history, law, and industrial organization literature on financial innovation]

U.S. House Of Representatives (2007). The Role Of Credit Rating Agencies In The Structured
Finance Market, Hearing Before The Subcommittee On Capital Markets, Insurance, And
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Representatives, One Hundred Tenth Congress, First Session, September 27, 2007. U.S.
Government Printing Office, Washington, D.C. (2008)

Van Order, Robert (2006). “Securitization and Community Lending: A Framework and Some
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Yago, Glen and Susanne Trimbath (2003). Beyond Junk Bonds: Expanding High Yield Markets,
Oxford University Press, New York.