TCS Daily

Financial Innovation in Perfect Capital Markets

By Arnold Kling - August 8, 2005 12:00 AM

Editors note: this is the fifth in a series of essays on financial markets and the economy.

5. Financial Innovation


"A significant fraction of Fischer's work for the corporate finance side of Goldman concerned potential applications of one or another new derivative financial instrument. ... It was easy enough to see the immediate reason why someone might want to issue or buy some derivative or other. But from a deeper point of view, it was not so obvious why the need arises in the first place. A CAPM world without derivatives is entirely possible, so why do we have derivatives?

... Fischer came to see the proliferation of derivatives not as a deviation from his original ideal but as the road leading toward it."
-- Perry Mehrling, Fischer Black and the Revolutionary Idea of Finance, p 262


If all assets were liquid and tradable, then we might not need derivative financial instruments and other forms of financial innovation. However, financial innovation has a role in making assets liquid and tradable.


The previous essay described how the Capital Asset Pricing Model (CAPM) says that there is no reward for taking idiosyncratic risk. Everyone should hold the same market portfolio. No one should specialize in holding specific types of risk.


In practice, risk specialization is the rule rather than the exception. One way to understand financial innovation is that it serves to bring us closer to a financial system in which risks are spread and the advantages of diversification are achieved.


Local Knowledge


One reason for risk specialization is local knowledge. If some economic agents understand a particular risk better than others, then those agents may specialize in holdings related to that risk. In our Food Court economy, an expert in wine may be better able than the average person to evaluate the prospects of a new grape. Thus, the wine expert may do particularly well speculating in stocks that have projects related to wine.


From the economy's perspective, however, it would be better for wine companies to be able to sell securities to a broad range of investors. If only wine experts invest in wine stocks, then the risk premium on wine stocks will be unnecessarily high. The economy can benefit from financial innovations that can find a way around the need for local knowledge.


Thirty years ago in the United States, home mortgages were underwritten on the basis of local knowledge. Underwriters would know the characteristics of local borrowers, and appraisers would know the characteristics of the local housing market.


In the early 1970s, a mortgage bottleneck emerged in California. California Savings and Loans, which had the local knowledge to underwrite housing loans, did not have enough funds to meet the demand. Home buyers, particularly in California but also elsewhere, faced unnecessarily high interest rates and/or lack of availability of funds.


In theory, a number of solutions to this problem might have been developed. In the event, Congress chartered the Federal Home Loan Mortgage Corporation (Freddie Mac) with the goal of creating a "secondary market," which would allow mortgages originated in California (or anywhere) to be packaged into securities and sold nationwide. By breaking the bottleneck of local knowledge, this would reduce the premium that borrowers had to pay to get their mortgages.


Of course, local knowledge still mattered. In the mid-1980s, when I was working at Freddie Mac, the company incurred some significant losses on bad loans. In order to reduce the loss rate from fraud and other factors, Freddie Mac had to institute a number of changes. The most dramatic of these were the use of credit scoring and extensive data on previous housing transactions to compensate for Freddie Mac's lack of on-the-spot underwriters and appraisers.


My sense is that the net result of these innovations was to make mortgage risk more diversifiable and to reduce the premiums paid by home buyers. (However, I want to make clear that I am not suggesting that this history has any bearing on the regulatory issues that Congress is currently addressing with respect to Freddie Mac and its big sister, Fannie Mae. I am simply illustrating financial innovation using an example with which I happen to be familiar.)


Moral Hazard


Owning your own home is "the American dream." But in a CAPM world, owning your own home makes no sense! Your assets should be in a diversified portfolio, and you should not have such a large fraction of your wealth riding on your local real estate market.


The reason that home ownership makes more sense in the real world than in CAPM is that home owners take better care of their homes. If you could sell the equity in your home to a broad set of anonymous investors, then you would have little incentive to maintain your property. If you have sold your home equity, then you are insured against a decline in the value of your home.


When you are insured against a catastrophe that you otherwise would have an incentive to prevent, your incentive to prevent the catastrophe is minimized. This is what is known as "moral hazard."


Moral hazard is an important source of deviations from CAPM. In the housing market today, it is desirable for people to be over-invested in their own homes, because otherwise moral hazard would cause homes to be poorly maintained.


Venture capitalists are adamant about the importance of stock options as compensation. Entrepreneurs and employees who are paid with stock options are over-invested in the fate of their own companies -- from a CAPM perspective. However, venture capitalists want it that way. The last thing a venture capitalist wants is for the management team and their employees to be insured against failure. From the perspective of the venture capitalist, there would be too much moral hazard if key employees were insulated from risk and held diversified portfolios. (Note, however, that the question of whether stock options should be reported as compensation in accounting statements is another issue, beyond the scope of this essay.)


Room for Improvement


Whenever individuals or institutions are specialized in risk-bearing because of local knowledge or moral hazard, CAPM says that there is room for improvement. The trick is to discover and implement ways to harness local knowledge or mitigate moral hazard without requiring specialization.


For example, Robert Shiller has suggested that home owners could use futures markets in indexes of local home prices as a vehicle for hedging the risk in their homes. If I were to sell short an index of house prices in Montgomery County, Md., I would be protected against a market decline, but I would still have every incentive to maintain my own house.


I believe that financial innovations over time will reduce the segmentation in risk-bearing in financial markets. As more assets can be sold broadly, rather than held narrowly, the price of risk comes down and the economy becomes more efficient.


Financial innovation serves to free what development economist Hernando de Soto calls dead capital. Any asset that must be held by a risk-bearing specialist in that asset is less "alive" than it might be otherwise.


Perhaps one reason that the United States absorbs so much capital from around the world is that it requires little local knowledge to invest in U.S. assets. Our high rate of financial innovation may have contributed to this.


Financial innovation, like all other forms of innovation, is a trial-and-error process. Shiller's futures market in home prices may fail to attract sufficient interest. Other innovations can face tax or regulatory barriers. At the same time, many financial innovations serve no purpose other than to exploit tax and regulatory arbitrage.


In fact, the role of government in the financial system can be better understood using the perspective of modern financial theory. That will be the topic of the final essay in this series.


Arnold Kling is the author of Learning Economics.


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