Originally published 9/29/2008 at FiLife.
As Congress attempts to pass the bailout bill, it’s a good time to reconsider how we got where we are. Consider financial innovation - the introduction of new products and ideas - as both a blessing and curse.
On the back of this credit crisis were new and complex financial products that launched in rosy markets - they weren’t stress-tested for darker days. These products weren’t just the playthings of financiers ( in the form of credit derivatives, mortgage-backed securities et al.), they were also in our wallets (think option adjustable rate mortgages, high-yield checking and savings).
Bankers put together new products and unleashed them to the world. And we bit.
Yet, the true test of a product or even a market - financial, technological, agricultural - is its ability to endure. Many of the products currently going belly up worked well in a world where asset values (houses, stocks, commodities) only went in one direction - UP.
But innovation eventually finds its limit. These products found their limits when markets started to tremble, investors grew skittish and pulled back in order to protect assets and any available returns. Suddenly, the risk of these products outweighed their potential to realize returns.
Now, the U.S. government might swoop in and put the buyers of these products out of their misery.
Robert Merton, a professor of mine while at Harvard Business School and part of the team behind rescued hedge fund Long-Term Capital Management, put an interesting spin on these products at a conference last week.
“Is there a structural relation between innovation and crisis? I think there has to be,” Merton said. “Successful innovation will always outstrip the infrastructure to support it, at least for some considerable time. That’s true because most innovations fail, so it’s not practical to build a new infrastructure to support every innovation until you find out they succeed. So it’s inevitable they will be mismatched for some time. We have to have oversight. But if it is too strict we’ll never get innovation. There really is a tradeoff, and we have to be prepared for that.”
This observation is particularly insightful. Merton, whose own tangles with market innovation are included in Roger Lowenstein’s book about LTCM, When Genius Failed, is putting finance on the level playing field of all innovation.
Sometimes the first round of breakthroughs isn’t up to snuff or is just ahead of its time. Think Laserdiscs, the Newton, early electric cars. Unfortunately, in finance, these products were incredibly complex and only as good as the people selling them.
