Despite all that's gone down over the last few years, I'm an enthusiast of "financial innovation". I think it essential that we remake our financial system into something so different from what it has been that we would hardly recognize it. Doing so will require a lot of innovation.

But there's no question that the current financial crisis was abetted and largely enabled by many of the "innovations" that became ubiquitous in the financial sector earlier this decade — CDOs, SIVs, (arguably) CDSs, etc. To square the circle, I resorted to an old cop-out: the revolution hasn't been tried. There's good innovation and there's bad innovation. The stuff that didn't work was the bad stuff. Lame as that may be, it is what I think, and I did try to put some flesh on how we could distinguish good from bad going forward. Then Dani Rodrik came back with some fair questions:

OK, now that we have collectively gotten over our finance fetishism, and are willing to accept that some innovations can be bad, what does this mean for regulatory and supervisory approaches?

For example, it is one thing to say that good innovations are those that are transparent, and another to figure out how policy sorts out the degree of transparency of innovations and how policy makers treat innovations of different kinds. Does this line of thinking imply that some degree of paternalism in regulation is unavoidable ("no, you cannot issue this particular complicated derivative!")

I think we need to discriminate here between the structural and substantive terms of financial instruments. A contract is "structurally" transparent if, conditional on any set of observable real economic outcomes, it is clear what cash flows are compelled of all parties. A contract is "substantively" transparent if the economic outcomes that determine the cash flows are themselves susceptible to analysis. A mortgage-backed security, for example, might be structurally transparent but substantively opaque: Knowing the performance of the bundled mortgages, it might be easy to calculate the cash flows payable to all tranches. But as a practical matter, it might be impossible to estimate the performance of a thousands of heterogeneous loans in a volatile housing market. Common stock is arguably both structurally and substantively opaque: Even if one knows with certainty the long-term performance of a firm, the cash flows due a stockholder can be difficult to predict. And the future performance of a firm is itself very hard to estimate.

I think a strong case can be made for regulatory promotion of structural transparency. Contracts can be made arbitrarily complex, and there is little reason to think that skill at crafting and understanding challenging legal documents overlaps with peoples' ability to evaluate economic risks and outcomes. It would be useful to have standardized contracts so that those not expert in the law of finance can participate in financial markets without fear of getting screwed because their lawyers missed something. Also, I think regulators have a legitimate interest in ensuring that investors do not accept contingent liabilities foreseeably beyond their capacity to pay. To do so, regulators must be able to estimate the liabilities that counterparties could be called upon to bear. The potential extent of those liabilities should be evaluable without a lot of analysis or guesswork.

That said, I don't think the best approach would be to forbid nonstandard contracts. Instead, regulators could "bless" certain contractual forms as well-defined, while creating penalties for those who offer contracts that are structurally opaque or that serve to hide embedded leverage. Parties who have good reason to deviate from very standard contracts would have the ability to do so, but would risk of being punished if those instruments are deemed to have violated standards of clarity. In other words, instead of eliminating "bad" contracts, regulators should take on the role of organizations like ISDA and proactively define "good" contracts that meet needs they identify by monitoring "exotics" that gain prominence in the market. Unlike ISDA, however, regulators' primary mandate would be to ensure that the contracts they bless are well thought out from the public's perspective: that "catastrophic success" of those contracts would not create fragile networks of counterparties or other hazards. "Blessed" contracts might well include obligations to periodically report contract valuations notional and net, and collateralization to a public registrar. They would rely upon collateral much more than counterparty for security (to restrict embedded leverage), and provide for standardized means of termination or novation, to prevent the emergence of economically useless but systemically hazardous multilaterally offset positions. They might work proactively to encourage the formation of centrally cleared exchanges, to permit counterparty neutrality with less collateral or risk of early termination, as new forms of contract grow popular.

The case for regulatory promotion of substantive transparency is much weaker. Economic problems that appear inscrutable to distant regulators might in fact be quite tractable to those "in the know". (Pace Arnold Kling and Richard Serlin, it's important to point out that when I take "transparency" as desirable, I am not suggesting that people should be compelled to reveal hard-won information without compensation. People who can predict economic outcomes should be paid for doing so. But contracts should generally be structured so that the relationship between economic outcomes and contract cash flows is clear. How much "inefficiency" is desirable, meaning how slowly contract prices should respond to information revelation, creating opportunities for the informed to profit, is a complicated question. We need to balance the interests of uninformed investors, whose capital may be required for large projects, and information workers, who need incentives to evaluate competing projects.)

Suppose a group of people learned that, in the near future, there would be an incredible economic need for COBOL programmers, and looked for a way to monetize this. Noting that former COBOL programmers are much more creditworthy than their FICOs suggest, they might wish to buy up the loans of this dispersed, obscure population. Knowledgeable individuals would not want to buy up individual loans: instead they would want diversified exposure to the pool of COBOL programmer loans, since individual circumstances vary widely. Our cabal only knows that on average COBOL programmer loans are underpriced.

So, our insiders should hire up some financial engineers, and construct an asset-backed security containing a pool of consumer loans to COBOL geeks. They could each take diversified shares of the pool, with some assurance of having bought undervalued assets. Once the ABS is established and divvied up, they would have every incentive to reveal their information, explain to the world why COBOL is the next big thing (and how their ABS was structured), and sell to the world at fair-ish value for a quick profit.

This chain of events is informationally idyllic: Knowledgable people are compensated for revealing hard-won information, and economic assets become more accurately priced, which should feed forward into better decision-making. But if regulators are empowered to evaluate the "substantive transparency" of investment contracts, they would certainly have nixed an ABS made up of loans to an eclectically selected population of individuals without justification. Up-front revelation of the justification to regulators, however, might leak and allow a larger player to buy up the whole pool, eliminating the opportunity.

Also, consider common stocks. No rational regulator concerned with substantive transparency would approve of common stock, if it were a novel investment vehicle. It guarantees no cashflows whatever, its "control rights" are so weak for most purchasers that representations thereof should be viewed as fraudulent. Empirically common stock behavior is very weakly coupled to the performance and health of the firms that stocks fund. The only instrument in wide use more substantatively opaque than common stock is fiat money.

I think common stock is a deeply imperfect instrument, one that we should work to improve upon and eventually replace. But, there's little question that over the several hundred years between the invention of joint stock companies and the advent of information-technology that might make more fine-grained claims practicable, common stock served a useful purpose, both in terms of pooling capital and risk, and promoting information discovery and revelation.

Still, much of our current catastrophe was caused by investors investing overeagerly in securities whose structures were clear enough, but the economic substance of which they were entirely incapable of evaluating. Rather than banning such securities, we should turn our attention to understanding why they did this. A lot of very opaque securities (both substantively and structurally) were invented, sure. But how did they vault from idiosyncratic experimentation to widespread implementation? This had to do with the structure of financial intermediation, and it is there that I believe that regulatory energy should be focused, rather than on evaluating the terms of contracts.

Flawed financial instruments only become policy issues when people responsible for investment on a significant scale decide that what they don't know won't hurt them. This can happen by virtue of fads and fashion, the madness of crowds: consider internet stocks, or blind faith in diversification and "stocks for the long run". But most poor investment, in dollar-weighted terms, is not taken by foolish individuals placing their own money. Bankers and institutional investors are on the one hand granted the power to control investment on a very large scale, and on the other hand make consistently awful choices. Delegated money, rather than trading off return and safety, often trades return for safe-harbor. Absurd contracts that appear to offer high returns are very attractive to money managers of all stripes, if they offer a veneer of safety and "prudence", or better yet, if they become conventional.

Getting regulators in the habit of banning some classes of contracts (or worse, requiring them to approve novel contracts) would have the perverse effect of certifying the instruments that are permitted. A better approach would be to eliminate safe-harbor for intermediaries by insisting that they be substantially invested in the funds they manage, and on the hook — financially, not just reputationally — for losses as well as gains. (Obviously, we should eliminate safe-harbor that derives from rating agency certifications or statistical risk models. But that won't be sufficient — professionals will always manufacture "best practices" and find safety in numbers, or hide behind consultations with experts and representations by prestigious sources.)

Fundamentally, the agency problems associated with financial intermediation are deep, and it will take a lot of reform — and innovation — to find good solutions. Regulation to promote structural clarity in investment contracts and manage leverage and counterparty risk may help limit the damage, but won't be nearly enough. I think we need a fairly wholesale restructuring of financial intermediation, one that limits the scale and leverage of intermediaries, segregates transactional balances and noninformational savings from informational risk investment, and ensures that those who do manage large quantities of wealth land in penury or in prison before the taxpayers are on the hook to make private losses whole. But having regulators review and restrict the substantive terms of financial contracts strikes me as a bad idea.

Steve Randy Waldman — Sunday November 23, 2008 at 8:13pm permalink
tom brakke (mail) (www):
Great food for thought.

Most of what I work on is at the organizational level, and there is a striking lack of innovation at most investment firms. What does constitute innovation is focused on the creation of new instruments that (a) are profitable to the firm and (b) can be sold easily. While you would think complexity would work against (b), it turns out that many of these creations seem benign, even if they are not.

Firms need to also look at how they do what they do. Organizational structure, information flows, incentives, etc. Leaders need to break new ground on those fronts, as I argued in a post I did about Putnam's recent changes.

For a look at discriminating good innovation from bad, you can read about the investment business as being .
11.24.2008 9:10am
tom brakke (mail) (www):
Here's the last part of the sentence that got cut off in the previous comment:

in formaldehyde
11.24.2008 9:12am
Benign Brodwicz (mail):
Yes. And...

Thesis: Loosening leverage constraints are the major culprit.

First, the Federal governement binge: Ronnie hoodwinked American people with "supply side economics" ruse to cut taxes on rich people. (For those who defend his record in Califnornia--California couldn't print money, Fed government can--so when you "cut 'em off at the ankles" [cut spending] in a state, they have to balance the budget or lose their credit rating and go bankrupt].)

Private sector binge #1: instigated by Democrats, put into mass production by Republicans, gross violations of age-old mortgage underwriting standards in the name of promoting home ownership implicitly guaranteed by the Feds and making investment bankers billion-dollar bonuses led to a consumer binge of home buying and home price appreciation, leading to...

Private sector binge #2: American consumers, flush with paper wealth from their rapidly appreciating home values, are encouraged to borrow against their equity to spend like there's no tomorrow, leading to an unsustainable bubble in consumption demand....

Unless you worked on Wall Street this past 15 or 20 years, you don't get something for nothing. The loosening of leverage constraints generally seems the most culpable liberalization getting us where we are.

I submit that the loosening of leverage constraints has produced most of the fiscal burden our children will bear, and that it was sold to the public more or less consciously as a "get rich quick" society paradigm ("You can get rich too by investing in [insert bubble--Dot Com, Real Estate, Commodities, etc.] that has wound up fleecing the unsuspecting responsible majority who didn't participate when the biggest bubble finally burst and Wall Street fast buck plutocrats pulled their political strings to dump the losses on the public.
11.24.2008 10:36am
chew2 (mail):
"Knowledgable people are compensated for revealing hard-won information, and economic assets become more accurately priced, which should feed forward into better decision-making."

2 objections:

1. Too much cost and risk for the supposed benefit of price discovery. Too many pointy headed geeks gambling and mentally masturbating about the potential of someone else's real or intellectual capital, instead of learning cobol and making something useful. Really what is the economic benefit of this "price discovery". If as many claim, 25% of corporate profits were "earned" by the financial sector in recent years, I would claim that "price discovery" is taking up way to much of our economic efforts.

2. What real "economic assets" have become more accurately priced? The derivatives created by the pointy headed geeks? These are not real economic assets. Companies that train cobol programers, the cobol programmers themselves? Really, all this effort to create artificial markets in derivatives get's us what? Information revelation, risk reduction? Uh, yeah. There seem to be less costly and risky ways of doing this, for example, the labor markets for programmers.

To paraphrase Shakespeare, let's kill all the financial economists. Or how about making investors personally liable for their debts, maybe that would lessen the free lunch of excessive risk taking.
11.24.2008 1:05pm
JIMB (mail):
Let's have free market money (start with gold) and let the chips fall as they may. The entire problem-set is because of non-market money.
11.24.2008 1:48pm
I don't see a reason to ban any kind of financial contracts if the volume of them is relatively small and if they are not prediatory against individuals whose basic well being depends on the money.

however, it's necessary to protect the system against systemic failure, and that can make some kinds of contracts "bad" if they are done too much.


hey, is it possible to delete my email information from the previous post -- i don't want to invite spam.

[done, and comments merged -- SRW]
11.24.2008 7:45pm
horn (mail):
WE don't need more regulation, we need people to write 'Caveat Emptor' in black ink above their computer screen.

One of the main problems is most of the garbage that was sold was sold to public-sector employees who basically can't get terminated. They just get re-assigned, and even that may take 5 years. [Probably less now, but still...]

I work on the buy-side, and once you say 'No thanks' 1 or 2x they stop calling you with crap deals and junky structures. It's pretty simple.
11.24.2008 8:25pm
Murph (www):
Hey I know COBOL! Can I get a loan? :)

Steve what are your ideas for an evolution from common-stock?

Clearly the concept failed the shareholders of every Wall Street firm - their shift, starting the Solomon Bros in 1980's, from a partnership-model to publicly-traded companies simply allowed the partners to reap the rewards (>50% of profits to compensation and bonuses) but transfer all the risk to others.
11.24.2008 10:53pm
While greater transparency is certainly desirable, I don't think that any legislative measure toward that end will solve the problem. As Benign states above, the problem is leverage. But how do you regulate leverage? As Hyman Minsky pointed out decades ago, metrics like Debt/Equity ratios are useless, because asset prices are procyclical - the DE ratio looks conservative today precisely because the boom has inflated asset prices, tomorrow the asset prices cliff dive and all of a sudden the DE ratio skyrockets, but it's too late.
11.25.2008 9:48am
Steve --

I have read this post several times now. Each time I become more
aware that it backs up against what is probably the most central
most important contemporary issue having to do with finance and
markets: whether we conceive that markets should apply decisions
made by other processes in the society, or whether we imagine
that markets have their own imperatives to which the society must
adapt and follow; whether markets are architects or
carpenters, whether they are best to design structures or whether
they should be just pounding nails once they have read the

"Market fundamentalism" among other things is the belief that
markets are proper social architects of the first order. I am
not a market fundamentalist, among other reasons because I think
money is verey informationally limited, and cannot adequately
model social quesitons in order to create structures of
sufficient social quality. (So, when somebody says price
"discovery" I have a little mumph thought to myself whilst I hope
he really means price "implementation" or some such. It is far
too grand to suppose that prices would be "discovered" like
scientific truths and leads us toward the common fallacy of
"anthropomorphizing" the market itself, as in "the market
knows...." Characteristic human psychological behavior gets us to
put the focal plane of our attention right at the surface and
then to imagine intentionality when we need explanation. We do
the same thing, for example, with computers. We attend to what
the machine prints or puts on the screen, use phrases such as
"the computer says...." or "the computer knows..." while we tend
not to thnk a lot about the program structure operating on the
machine. In fact, of course, the computer doen't "know" dink; it
changes state according to a set of rules too limited and
inflexible fairly to characyterize as really "knowing."

So, along with commenter chew2 who says that we are overpaying
for price discovery, I say that's right. But I also say that
markets should, can only be expected to, have a different (and
lesser), role in the social scheme. It would be biological and
medical science that would tell us that certain substances treat
infection -- that's a "discovery" -- and the markets a method for
allocating resources and attention in the manufacture of

To which we might add one more little bit of honesty: common
stock may be both structurally and substantively opaque as a
financial "contract" but it is not unreasonable to say that at
least some large part of its practical use is as a political
instrument. It has been the central vehicle for a kind of second
half of the twentieth century "financial democracy" (not
especially democratic, true -- but that isn't the issue) purposed
to give a kind of legitimacy to those who hold and manage
corporate interests. (Boards and executives are "serving the
best interests of their shareholders..." Corporations are
actually taken over by buying up all the stock...)

Which then does lead to the beginnings of a kind of theory of

a) Transparency is very important, quite helpful. Good
transpaency is rather like "open source" software in which the
functional structure is disclosed rather than just the "screen
image." (This is somehwat your strucrural/substantive, but lies
along a different axis -- this is less trying to predict the
future and more to get initial disclosure of anything that would
otherwise have to be "reverse engineered."

b) Standardization can be helpful, but in and of itself it does
not solve the problems of knowing whether something that is
claimed to accord with the standard in fact does, or what happens
if and when it doesn't.

c) The real issues having to do with information do not have to
do with its being "won" as in "hard won", they have to do with
who gets to create it, according to what terms, and that it will
be held up to what standards.

d) A part of what is really wrong with common stock is like what
is wrong with campaign contributions to congressmen, one suddenly
can get realtively too much selection and exclusion for it, great
big structural results for a relatively little bit of money.
And, on the other hand, it can be serviced by a mere appearance
of "growth (as long as that appearance can be further transacted

e) "Innovation" as such is not the issue. Without it things
would go very wrong. And innovation that is, among other things,
not innovative will kill us all as well.

f) It becomes hugely important to have any informational
structure wich contains information that needs to be evaluated
point toward larger informational capacity and analytic capacity.
This is the real key to successful "regulation." Rules aren't
particularly "strong." Informational depth is strong.
11.25.2008 10:03am
reason (www):
Rue the day is on the right track, I'm not convinced it is the nature of the contracts of the problems. You are taking a micro-economic look at a macro problem.
11.25.2008 10:04am
reason (www):
should read
... nature of the contracts that is the source of the problems.
11.25.2008 10:05am
horn (mail):
Salomon didn't start the trend. DLJ started the trend of public investment banks back in the early 1960s.

Quis custodiet ipsos custodes?

'New Jersey's pension fund, already in the spotlight thanks to losing investments this year in large banks, is under fire again, this time over a series of controversial hedge-fund investments that initially swept below the public radar.

New Jersey made the investments last month, ...

In effect, the funds, which had borrowed money for investments, either faced or anticipated facing demands from lenders for cash as the value of those investments fell.

State legislators, upon learning of the investments, are questioning both the wisdom of the decisions as well as the process: At $49.5 million each, the investments came in a hair below the $50 million threshold that requires the fund to explain an investment to an oversight board before moving forward.'
11.25.2008 10:07am
reason (www):
I think maybe we need to think about this differently. The problem is that people who thought they were investors ended up in the (re-)insurance business.

Insurance is a business that I don't like from any aspect. As a customer you are always subject to counterparty risk, often you pay now and hope to receive a long time ahead in an unknowable and uncertain future (and often there is no independent referee apart from a very expensive court). As an insurer you are subject to competition by competitors who may be taking excessive risk. And my general rule on insurance, if you really need it, you can't afford it.

And I haven't even talked about adverse selection!
11.25.2008 10:15am
Reason, I think you're being a bit tough on insurance

* Insurance is just a pool of diversified liabilities of an uncertain size supported by a pool of assets smaller than the notional size of the liabilities (the difference? leverage!).

* The reason the insurance company exists is that most of us can't generate enough diversification by self-insuring and so can't get any leverage.

* RISK NEVER GOES AWAY - it's just put into a vehicle that can apply leverage to it. Counterparty risk replaces fire risk, hurricane risk or whatever other risk you're insuring.

* You alraedy did talk about adverse selection - people who "really need" insurance are the people who are trying to poison the pool by shoving a load of crappy risk into it.
11.26.2008 1:38pm
I should add that the only legitimate criticism of insurance is the same one that SRW has already made. Opaque contracts and dressed-up shell games can really ruin your day. No different than any other financial contract.
11.26.2008 1:40pm (mail) (www):
Transparency is a deeper subject than contracts. While contracts are important to transparency, new technology in many aspects of the market make it difficult. Unregulated computer modeling disallows a standardization of asset values and promotes risky lending.
11.26.2008 5:28pm
There is a need for innovation but...

...a lot of innovations are snake oil.

...innovations are not complex.

...complexity is often used to hide ugly details and create an air of innovation. Examples: CDOs and a lot of patents.

...robust systems are simple and observable.
11.27.2008 7:42am
DCW --

HUGE disagreement re risk, esp "risk never goes away." Risk is a product / consequence of the operations of systems, to climb a tree is to create / construct the risk that you'll fall out of it. Changes and goes away as other systems are engaged, substituted, different to use a bucket truck. Which then requires insurance, so that there is some compensation when it gets driven down an embankment, true. BUT the idea that risk is basic and essentially fixed and just passed around the financial system pales compared to the notion that the way the financial system is operated, what firms are permitted to do and what they do in fact, greatly changes the type and level of risk that might be shunted about the system.
11.28.2008 1:31pm
RueTheDay (mail):
BR - I believe that what DCW is saying is that the mere introduction of insurance does not reduce the level of risk, it merely moves it around. That is correct. Obviously legislative and institutional changes apart from insurance can alter the total amount of risk in a system though.
11.30.2008 4:50pm
RueTheDay -- Understood BUT calling particular transactions insurance is significantly arbitrary (that was part of the point in the first place when reason began the "they thought they were investors, but they were insurers..." theme) AND as transactions /events they have a risk effect. FWIW I am pushing against the idea that there is risk (there -- contained within a box) and there is insurance (in another conceptual box glued onto the "risk" box), etc.
11.30.2008 5:57pm
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