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January 14, 2008
Will the credit revolution continue
Wolfgang Munchau has an interesting take on the current financial mess in his recent Financial Times column The credit revolution looks to the long-term:
So what about the long-term prospects of securitised credit? In A Short History of Financial Euphoria, John Kenneth Galbraith made the depressing claim that finance does not lend itself to innovation, full stop. What masquerades as innovation, he said, boils down to nothing more than credit secured on some asset. You can repackage it, slice it horizontally or vertically, repackage it, call it a different name, but at the end of the day, somebody owes money to somebody else. If this market booms, you can bet your securitised dollar that this is due to exuberance. This is worth discussing in some detail.
The macroeconomic function of a modern financial market is to provide liquidity, pool information and share risk. During the credit boom, proponents argued that products such as collateralised debt obligations would help distribute credit risk through the economy. While that was technically correct, they distributed it in a perverse way. Instead of channelling risk to those best able to absorb it, they channelled it to those who amplified it the most – banks.
Nor did the pooling of information work according to plan. Most of the credit market products are notoriously opaque. And the liquidity argument appears to have worked only during periods of exuberance. We must therefore conclude that the securitised markets, as they have been operating until today, could not have brought many macroeconomic benefits. Since boom-bust episodes are hugely damaging to an economy, the net macroeconomic effect of the modern credit market may well have been negative until now, and be about to get more so as this year progresses.
But I still suspect that Galbraith is wrong in the long-term. A properly functioning financial market with proper risk-sharing and information flows should be positive. Without it, there would be less finance for venture capital and private equity. Nor is there anything wrong in principle with the idea of a subprime mortgage, a product that allows poor families without a credit record to finance their homes, as long as all sides in the transaction understand the risks in full and as long as the mortgage distributor shares some responsibility in case of default.
While none of these conditions existed during the credit boom, these problems are fixable.
I have to agree with 90% of this. I am especially heartened with his conclusion that the problems are fixable. The real problem in the current melt-down has been the repackaging of debt (as I've noted in earlier postings). But, while Galbraith was correct that much of the "innovation" is re-slicing of the same baloney, there is some true innovation out there (again as I've noted occasionally on this blog). Case in point is the vast expansion of the asset classes used as collateral. That is true innovation. One can always find historical evidence that almost everything under the sun was once used as collateral for a loan (including a pound of flesh). My own research on the monetization of intangible assets pointed out to me that patents were used to back loans since the late 1800's. But the regularization of certain classes of assets at part of the credit markets is the real innovation. The ubiquity of the 30 year fixed rate mortgage in the US is a true innovation. 60 years ago, the idea of lending to students on the promise of future income would have been absurd to many. Auto loans, accounts receivable, credit card receivables -- all of these are credit market innovations. A little over a decade ago, a crusty old local banker in my neighborhood refused to provide mortgages for condo's ("where's the dirt").
So, I am happy to hear that the current problems are fixable. That gives us plenty of room for a new boom. In part, that boom will be fueled by new asset classes (such as intangibles and intellectual property). As Bill Gross, Managing Director of PIMCO Bonds says in his latest Investment Outlook: "Pyramids Crumbling":
Financial innovation will inevitably march forward, if not in distinctly new forms, then into new asset markets . . .
However, Munchau's point is that these true financial innovations will not trigger the type of boom that we have seen recently. He may be right. True long term financial innovations may be more incremental in their impact, rather than create a huge (and unsustainable) boom. It may be the slicing and dicing that creates the exponential changes.
I'm not sure that there is anyway to prevent that - at least come of that. With a new financial innovation, there may just be a layer of froth. What really worries me is that any growth founded on true innovation will quickly turn into a bubble. That seems to be the history.
Here we come to the role of financial regulation. Unfortunately, the political economy of such regulation is usually reactive. Not because the regulation is inherently reactive, but because the politics makes it reactive. During the boom, laissez faire advocates put up a strong fight against any government "interference" -- usually by pointing to how well everything is going and warning not to "kill the goose that laid the golden egg." (Ironically, having pre-empted any proactive government actions, they can then claim that government is only reactive and non-innovative.)
I don't know if the next wave of financial innovation (based on intangible assets) will follow this same course. But there may be a chance now to get ahead of the curve and put in place sensible policies and regulations that promote the use of intangible assets as an asset class while trying to head off any speculative bubble. That may not be possible. At least it is worth a try.
Posted by Ken Jarboe at January 14, 2008 8:32 AM
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