It looks like it's time for everyone's favorite whipping boy, "financial innovation," to come in for another round of mockery in the blogosphere. Simon Johnson and James Kwak make all the familiar arguments about CDS and CDOs, neither of which they seem to understand in the slightest. Their discussion of CDOs is particularly specious:
The magic of a CDO, as explained in the research paper "The Economics of Structured Finance" by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in how CDOs can be used to manufacture "safe" bonds (according to credit rating agencies) out of risky ones. Investors as a group were willing to buy CDOs when they would not have been willing to buy all the assets that went into those CDOs. We don't have to decide who is to blame for this situation—structurers, credit rating agencies, or investors. The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value.This is usually how CDOs are portrayed these days: they're obviously voodoo finance, because—get this!—they claimed to take a bunch of risky bonds and transform them into a super safe bond. What a ridiculous idea, right? Now do you see how useless financial innovation is? Of course, this isn't a remotely accurate description of CDOs. Notice how they conveniently leave out the explanation of how CDOs transform risky bonds into a safe bond. They do this through subordination and various other credit enhancements. Say we have a CDO with a $100 face value, backed by a pool of BBB-rated mortgage-backed securities. The CDO sells three classes of bonds: an equity tranche, a mezzanine tranche, and a senior tranche. Investors in the equity tranche will take the first 10% of the losses; investors in the mezzanine tranche will take the next 15% of the losses; and investors in the senior tranche will take the rest of the losses. Investors in the senior tranche wouldn't suffer any losses unless and until the total losses on the CDO exceeded 25%, so we'd say that the senior tranche has a subordination level of 25%. When Johnson and Kwak say that CDOs "manufacture 'safe' bonds out of risky ones," the "safe" bonds they're referring to are the senior tranches. But as you can see, the idea that the senior tranche would be "safe" isn't at all ridiculous—after all, there's almost always some level of subordination that will make the senior tranche a safe investment. The problem, in very broad terms, was that the lending standards on the underlying mortgages significantly deteriorated, while at the same time the rating agencies were handing out AA and AAA ratings to tranches with lower and lower subordination levels. I can't find a similar chart for CDOs, but this chart of CMBS subordination levels is instructive (the trend for CDO subordination levels was similar):

Securitization absolved lenders from sensible underwriting, since they knew they were just going on onsell that debt anyway.This is just not true. I know most people think this is true, and that it's some profound insight, but it's not. Securitization doesn't necessarily absolve lenders from sensible underwriting. In theory, if investors in securitizations do the proper due diligence and are sufficiently discriminating, then they wouldn't buy securitizations with bad quality loans in them; lenders who make bad loans wouldn't be able to sell them on, and thus wouldn't be "absolved" from sensible underwriting because they'd have to hold them on their own balance sheets. The weak link in this chain was, again, the rating agencies: investors in securitizations have long outsourced their due diligence to the rating agencies, who got it colossally wrong in 2004-2006. It was the rating agencies that absolved the lenders from sensible underwriting by slapping AAA ratings on securitizations with laughably bad mortgages underlying them. Once it became clear that pretty much any securitization, regardless of the underwriting standards on the underlying loans, could get rated, all bets were off. Conduits—which package together and securitize mortgages—revised their origination guides that they circulate to banks and other loan originators, which essentially gave them the green light to ignore underwriting standards, since the conduit knew it could place virtually any loan in a securitization and still get it rated. Because underwriting standards didn't matter anymore, the mortgage business became all about volume. Independent mortgage lenders like Countrywide and banks like WaMu originated as many loans as humanly possible, confident that they could sell them on to a mortgage conduit. (Of course, Countrywide owned its own conduit, which probably presented absolutely no conflict-of-interest whatsoever. Or something like that.) Far from showing that securitization absolves lenders from sensible underwriting standards, what this shows is that the securitization market of 2004-2006 absolved lenders from sensible underwriting standards. So yes, let's have a serious discussion about the costs/benefits of financial innovation. I'm all for it. But to have that discussion, you have to be willing to not play to the crowd for a few posts. So far, the entire debate over financial innovation seems to have taken place among people with little or no experience in financial markets, and thus little understanding of how certain financial innovations have translated into real-world benefits. Unfortunately, the only defenders of financial innovation have been people like Niall Ferguson, who—let's be honest—is a total joke. Now, I definitely wouldn't characterize myself as a "defender of financial innovation" (though I guess a lot depends on how you define "financial innovation"), but I've been around long enough to know that the last 30 years, contrary to popular belief, have seen plenty of beneficial financial innovations. I've been meaning to write a post about financial innovation for a while, but I obviously haven't had time. In the interest of having a serious discussion of financial innovation though, here are some of the beneficial financial innovations of the last 30 years:
- Zero-coupon bonds
- Project finance
- Treasury STRIPS
- Medium-term notes
- Puttable bonds