Financial innovation pioneer Rick Bookstaber predicted the meltdown in his 2007 Demon of Our Own Design: Markets, Hedge Funds & the Perils of Financial Innovation. Recently he debated the value of “financial innovations” in an Oxford-style debate at The Economist’s Buttonwood Gathering in October 2009. Nobelist Myron Scholes, the chairman of Platinum Grove, and Putnam’s CEO Robert Reynolds argued for “financial innovations.” Jeremy Grantham the CEO of GMO was on the other side with Bookstaber. Afterwards, Bookstaber summarized his message on SeekingAlpha. Here are three of his strongest criticisms:
Market Efficiency. Q: “Do innovative products promote growth by increasing market efficiency? A: The objective in the design and marketing of innovative products is not market efficiency, but profitability for the banks. And market efficiency is the bane of profitability. The last thing a bank would want is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it. How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand a price. And the second is by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.”
Risk Management. Q: “Do innovative products promote growth by allowing us to manage risk better? A: Hardly. They create risk, or, if you don’t want to go that far, they hide risks. They put risks off balance sheet, obfuscate them through complex schemes, create non-linearities and correlations that only become evident in times of large market changes. They also push more risk into the tails, so that in the day-to-day world things look more stable, but in an extreme event the losses are accentuated.”
Capitalism or Socialism? Q: ”Do innovative products promote capitalism? A. The answer to this is yes and no. We get capitalism when things are going well, and socialism when things are going poorly. … Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, … lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot [then] lose more than everything’, and viola, at some point the taxpayer is left holding the bag.”
Systemic meltdowns are increasing in frequency in recent decades, with “financial innovations” playing a key role. The conflict: Short-term profits vs long-term risks. So ask yourself: Since the 2008 meltdown left taxpayers ”holding the bag” with an estimated $23.7 trillion new debt … can Americans really handle trillions more debt when the next meltdown comes? Probably sooner than expected? Triggered by a bigger, badder Black Swan?
For more on “financial innovations:” see Bookstaber’s June testimony before the US Senate. Also my November 10th MarketWatch.com column, “Financial Innovation: Wall Street’s new Soul-Sickness.” Some good news. The New York Times reports that since the Buttonwood Gathering, Henry Hu, new director of the SEC’s newly created Division of Risk, Strategy and Financial Innovation hired Bookstaber and two other experts to “help it keep closer tabs on developing risks in financial markets.” Next, they need Congress to give them some new laws with teeth.