Moral Hazards of Financial Innovation

With home prices plunging, today the housing market is operating outside historical experience. Contracts that were written informed by the record of the last 50 years are proving impossible to fulfill. Financial institutions simply do not have the capital to meet their commitments.

A lot of commentators have pointed out that the current financial collapse has its roots in bad regulation. That is a bit like saying that juvenile delinquency comes from poor child rearing practices, but it does little for those who want to learn something about good parenting. A key lesson of the meltdown of 2008 is that financial innovation in itself carries the seeds of future crises. In the future, regulators must ask a question that has been routinely neglected in recent years: how is financial innovation changing the way finance is conducted; in particular, how are new contracts changing incentives that face buyers and sellers of securities.

 

Financial contracts and insurance always involves commitments to deliver in the future. Some financial contracts are not dependent on future conditions (for example, a fixed rate mortgage carries a repayment schedule that is set for every year until the mortgage is paid off). But most, from the return on share in a company to insurance against possible future losses, depend on what happens in the future. Finance (and insurance) professionals price their products and make their money based on forecasts of future outcomes. These predictions, in turn, are based on probabilities, as calculated from historical data. When forecasts prove wrong, someone bears unexpected costs. When the forecasts are way off, highly leveraged companies go bust. When nobody knows which companies will go bust, nobody wants to make a deal with anyone else. Welcome to October 2008.

Securitization of various contracts – the practice of bundling a number of them together and selling shares in the package – has made it possible for some institutions to specialize in writing contracts (for example, issuing mortgages) while others specialized in carrying risk. That sounds like a fine idea, but every bank or mutual fund that bought “collateralized debt obligations” was acting like an insurance company, assuming the risk of default on the underlying assets. As is now evident, they had no real idea of the risk they were assuming.

Nobody knew what the default risk was for these new financial obligations because everyone was using obsolete historical data to forecast the future.

What has become clear over the past few weeks is that the very process of financial innovation changes the probability of default. When underwriters knew that they could unload risk on others, through securitization, they shed inhibitions about writing dubious contracts. For the issuers of debt, the money was in writing the contracts, not the contracts’ long-term outcomes. More deals means more money, and if a bank in Iceland ends up with the risk, that was not the concern of the person who originated the debt.

What appeared to be a contract like millions before it – a standard home mortgage, say – was transformed by financial innovation into something entirely different. After securitization, neither the income nor the job of the person writing the contract depended on the outcome of that contract. Yet the financial experts who valued the securities acted as if the probabilities of default embedded in the historical data applied to the future.

People are not like dice, performing the same every time they are cast. People adjust to changing conditions by changing their behavior. So when it becomes profitable to issue trash paper, they do it.

The lesson for regulation in the future is that appraisal of the incentives, the “moral hazard,” created by new products and new contractual arrangements must be a central part of the regulatory process. Just as investments in new factories require environmental impact statements, creation of new contracts in finance and insurance should require “incentive impact statements.” Otherwise, we will be meeting here again.