I went to a session today on financial innovation. The panelists were:
- Michael Milken, Chairman, Milken Institute; Chairman, FasterCures / The Center for Accelerating Medical Solutions
- Lewis Ranieri, Prime Originator and Founder, Hyperion Private Equity Funds; Chairman, CEO and President, Ranieri & Co. Inc.
- Richard Sandor, Chairman and CEO, Chicago Climate Exchange; Senior Fellow, Milken Institute
- Myron Scholes, Nobel Laureate, 1997; Chairman, Platinum Grove Asset Management
- Moderator: Andrew Rosenfield, Managing Partner, Guggenheim Partners LLC; Chairman, Guggenheim Investment Advisors
These are some of the architects of the mortgage backed securities and other innovative financial instruments.
The people on stage still very much believe in financial innovation. They see financial innovation as a means of solving the world's major problems, e.g. making it possible to trade property rights for water and air, as a way to save endangered species, as a way of lifting the poor out of poverty, as a solution (rather than a cause) of the problems we are having today in mortgage markets. It is very much in their own financial interests to believe these things, and these are people who know how to sell an idea or product or they wouldn't be where they are, and it was clear from a variety of sessions they were there - in part - to argue against regulation that would inhibit their ability to create new financial instruments. So all of their comments should be taken in that light. They have convinced themselves that they hold the keys to the drivers of world growth and the solutions to the world's problems, and they do not want anything standing in their way. In fact, one of their biggest regrets from the crisis is that other countries will no longer hold our financial system in such high esteem and will shy away from financial innovation that could be very helpful to their development (and the panelist's pocketbooks). Their creations are now viewed as imperfect, and that seemed to bother them.
In their defense of financial innovation, they said something I've said too, so I have some sympathy for the argument. They said that it wasn't the financial vehicles themselves that were the problem, it was the way that they were used, and the way that warnings of impending trouble were ignored. And the biggest problem in the way they were used was to give people free (zero price) options. People could purchase a house with zero money down, realize the gains if the price goes up, and since the loans are non-recourse, walk away relatively unscathed if the price turns downward. Giving people free options was the problem, it wasn't the financial instruments themselves (in fact, they thought that since they distributed the losses all over the world, the new financial instruments probably saved US banks who could not have absorbed the losses on their own).
Another problem that was cited was bond agencies, though Milken argued that any investor ought to do their own rating and not trust anyone else (to which Scholes replied why should we duplicate the same effort thousands of times - wouldn't it be better if the market could do this for us and save the duplicated effort?), so his was another area they cited as needing attention. But notice that, once again, it's not the financial instruments, it's the lousy ratings agencies.
What is their solution to our financial market problems? They say, unsurprisingly, that this is not something the government needs to solve, or can solve, the government needs to get out of the way and let the private sector solve the problem. I'm supportive of the idea that we should be careful about getting in the way of financial innovation, but I don't think the solution is for the government to get out of the way, there are market failures (e.g. moral hazard from lack of capital requirements) that will not correct themselves.
But you should watch it yourself - click on the link "Financial Innovations: Complexity Isn't Innovation, Leverage Isn't Credit" in the list below the video player (starts at 3:45 min):