Thursday, February 14, 2013

Robert Shiller: Capitalism and Financial Innovation

At the 2012 CFA Institute Financial Analysts Seminar, Yale professor Robert Shiller laid out his views on capitalism and financial innovation.

Professor Shiller channeled his inner Gary Gorton, another Yale Professor whose work on informationally insensitive debt and safe assets your humble blogger has previously debunked, and talked about the benefits of financial innovation, in particular securitization.

According to Professor Shiller,
The ideas I posit are basically an appreciation of financial innovation. Today, cynicism and skepticism regarding financial innovation abound.
Your humble blogger is neither a cynic or a skeptic.  I simply subscribe to Yves Smith's maxim:  nobody on Wall Street is compensated for creating low margin, transparent products.

Financial innovation is primarily about how to create opacity so that the bankers can extract excess rent from investors who are gambling on the value of the opaque innovation rather than investing in a transparent investment.
Even former Fed chairman Paul Volcker contributes to these views. A couple years ago, he famously said that he couldn’t think of any useful financial innovation within recent memory besides ATMs. 
What Volcker says gets a big audience, but I couldn’t disagree with him more.
Which puts the burden on Professor Shiller to show a financial innovation that is actually useful for something other than extracting excess rent from investors (we'll get to that when he talks about securitization).
Our civilization is built on financial innovation. Finance begets and supports almost all activities; it makes the world turn in a modern and civilized way. 
Innovation is necessary if finance is to remain relevant as a means of achieving society’s goals. Perhaps what I have to say will help the finance community defend itself better and encourage finance professionals to assume personal responsibility for their role in making markets more efficient....
This is quite a statement as most people would think that it is the real economy and its inventions that built our civilization.

Finance certainly has a role in supporting the real economy, but it is not at all clear that it is financial innovation that lead the real economy and its inventions and built our civilization.
Securitization was an innovation that blew up in the latest crisis because the process was fraught with errors. 
The most notable error in securitization was in real estate—the subprime loan securitization, which blew up because people didn’t appreciate the risk that home prices would fall. 
It is misleading to say that people didn't appreciate the risk that home prices would fall as a drop in home prices is not what caused the losses on these securities.

What caused the losses was that the borrowers were not making payments on their mortgages.

Since the value of these securities is based on the ongoing payments on the mortgages, so long as the borrowers are paying on their mortgages, the security is performing regardless of what is happening to the price of the house the mortgage is secured against.

Perhaps Professor Shiller never heard the expression "opaque, toxic sub-prime mortgage-backed securities".

What made these securities so dangerous to investors' wealth was that opacity hid their true toxicity.

Specifically, the lack of observable event based reporting on all activities like a payment or delinquency on the underlying collateral before the beginning of the next business day made it impossible for market participants to know what they were buying or know what they owned.

Your humble blogger has demonstrated this numerous times using a Brown Paper Bag to represent a security using current industry disclosure practices and a Clear Plastic Bag to represent a security using observable event based reporting.

As a concept, however, securitization will survive because it is a means through which a large number of people benefit.
I happen to agree with Professor Shiller that securitization will survive.  The question is whether it will survive in its current opaque form that allows bankers to extract excess rent from investors or in a transparent form where it supports society.
Securitization is an innovation designed to solve an asymmetric information problem.
Actually, as Wall Street uses securitization, it is an innovation designed to create an asymmetric information problem.

The asymmetry is that Wall Street has the information on the current performance of the underlying collateral (they see these securities as if they are Clear Plastic Bags) and the rest of the market place has out of date performance information (they see these securities as they truly are, Brown Paper Bags).

This information asymmetry effectively lets Wall Street trade on tomorrow's news today.

As the financial crisis showed, Wall Street is more than willing to take advantage of this information asymmetry at the expense of the investors.
In the case of the mortgage market, mortgages and thus mortgage-backed bonds require a lot of analysis that many investors are unable to do, so without securitization, those investors would forgo investing in this market.
By securitizing mortgages, tranches of similar credit quality are created, allowing a large swath of the general investing population to buy mortgage-backed bonds that they otherwise would not buy. 
Professor Shiller's observation about the need for analysis reminds me of Professor Gorton's theory on informationally insensitive debt.

Professor Gorton cited bank deposits as an example of informationally insensitive debt.  There is one small problem with this example.  Bank deposits are insured and depositors are very sensitive to this fact.  Confirmation of this can be seen in Greece and Spain where doubts have arisen about whether deposit insurance will be honored and depositors have pulled their money.

Regular readers know that our financial system is based on the FDR Framework under which the government is responsible for ensuring that all useful, relevant information is disclosed in an appropriate, timely manner and investors are given the incentive to use this information as they are responsible for all losses on their investments.

Investors know this.  As a result, if investors cannot assess the information on the mortgages themselves, rather than forgo making an investment they simply engage third party experts who can assess the information.

Individuals hire portfolio managers.  Portfolio managers, if they or their organization cannot do the analysis themselves, hire third party experts.

The simple point is that if there is transparency and all the useful, relevant information is disclosed in an appropriate, timely manner, it is used by investors so they can make a fully informed investment decision for any type of investment.

Unfortunately, current securitizations are opaque and there is no information for investors to analyze.  As a result, buying or selling these securities is nothing more than gambling on the contents of a Brown Paper Bag.
Thus, mortgage securitization creates a financial market that allows many people to buy homes that they otherwise might not be able to buy, and it also lowers mortgage rates. 
Isn't one of the problems we have is that people bought houses that they couldn't afford?
The theory of finance involves asymmetric information as one of the elements that financial professionals have to engineer and design around. 
Please re-read the highlighted text again as Professor Shiller has effectively praised Wall Street for creating high margin, opaque products where Wall Street has an asymmetric information advantage.

What is good for society is when financial products are designed to eliminate asymmetric information.

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