The significance of financial innovation has been widely criticised and appraised. Numerous leading scholars, including Nobel prize winner Merton Miller and Robert C. Merton highlighted the importance of new products and services in the financial industry. They underlined that financial innovations are the backbone of any nations “economic growth”. With rise of modern and complex securitisation in the early 2000s, and the subsequent financial crisis of 2007/08; gives rise to questions about the role that they played in the crises. In this essay I will discuss the emergence and role that innovative financial products, which includes Mortgage-Backed Securities (MBS), Collateralized Debt Obligations, and Credit Default Swaps had on the Global Financial Crisis of 2007/08. I will additionally explore the importance of regulators in the financial market and their future role in financial innovation.
Lewis Ranieri is considered to be the “father” of mortgage backed securities during his tenure in Salomon Brothers during the 1970s. With a limited amount of mortgages in the market, mortgage backed securities (MBS) provided an opportunity for banks to transform relatively illiquid individual assets into liquid and tradeable market instrument. A mortgage-backed-security is defined as a type of asset that is secured by a mortgage, or collection of mortgages. This security usually pays periodic payments similar to coupon payments. MBS played a crucial role in the steps leading up to the crises itself. It can be considered as the first step towards more complex derivative products, which were later seen during the crises. By securitizing mortgages, banks were able off-load illiquid assets, thereby improving various financial ratios, allocate capital efficiently, and comply with risk-based capital standards. At the core MBS were originally sound financial products, with individuals who had high FICO scores and collateral in the case of default. However, as fewer sound mortgage borrowers were available, banks soon ventured into subprime borrowers. This resulted in a major contribution to the subprime mortgage crisis, and eventually the financial crises. A subprime mortgage is generally any individual with a weak credit score, little-to-no verification of income and assets, and high-debt to income ratios. Subprime MBS were extremely attractive to both banks and investors due to their high interest rate payments that derived from the high risk of default. The increase in subprime lending resulted in an increase in available mortgage credit, which by 2007 was valued at $1.3 trillion. Additionally, an approximate 80% of subprime MBS were made via private institutions (private label MBS) compared to the 20% from GSE’s (Government-backed). The overconfidence and easy access to liquidity fuelled the financial and already rising housing bubble. The majority of lenders did not consider that the US housing market would eventually collapse and result in a skyrocket of defaults. An eventual downward spiral would occur as banks try to sell of their assets, thus resulting in a downward spiral of assets. The necessity of easier and abundant credit fuelled the rise of Mortgage Backed Securities, which in turn led to the rise of subprime mortgages that carried significant risks. This would eventually affect the CDO market, which is explored in the next section of this essay.
A collateralized debt obligation (CDO) is a structured financial product that pools together cash flowing generating assets and repackages these assets in specific tranches. This allowed banks to repackage and sell unsold mezzanine and equity tranches from MBS deals. For example, a group of BBB, BB, and B tranches and other equity tranches from various MBS packages were re-bundled and divided into tranches exactly as MBS. The CDOs managed to receive high ratings as they were considered a diversified portfolio by the credit agencies. CDOs exacerbated the already rising issuing of subprime mortgages, by incentivizing lenders to further make subprime loans. Additionally, regulatory arbitrage played an important role in promoting and spreading CDOs in the financial market. This is defined as a practice whereby firms utilize loopholes in regulatory systems in order to avoid unfavourable regulation. Financial institutions were able to off-set such regulations by setting off-shore sponsor investment entities. These are known as Structured Investment Vehicles (SIVs). SIVs were significant buyers of Mortgage Backed Securities, CDOs, and subordinated debt. Their business model was very simple; they bought longer term debt instruments and funded them through short-term markets, taking a carry. SIVs were able to conduct risky transactions as they capitalized on regulatory arbitrage. This gave them greater liberty to sell CDOs and other securities in the market without complying to regulatory requirements. Numerous financial institutions sponsored off-shore SIVs, even when market indicators highlighted the amounting risks. As Citibank’s former executive stated, “As long as the music is playing, you’ve got to get up and dance” Investment banks such as UBS evaluated the risks that arose from the CDO market, and took protection via a Credit-Default-Swap. A CDS is a particular type of swap designed to transfer the credit exposure of fixed income products between two or more parties. In the case of UBS, the risk management team decided that it would be sufficient to take protection on about 2-4% of the total CDO investments. With a protection scheme in place, firms took on an even larger amount of derivative assets.
As financial innovation took charge of the market, regulatory bodies sat on the side-line. The aftermath and effects that innovative financial products such as MBS, CDOs, and CDS resulted in trillions of dollars lost to both investors and taxpayers. Securitization of assets brings forth cases of moral hazard and asymmetric information. The investment banks, SPVs, and SIVs that repackaged and sold the financial products were aware of the risks and structure of such products, yet they were continuously sold. Moral Hazard plagued the market as financial institutions were aware of the risks and knew that a bailout would be readily available by the government in case of bankruptcy. Based on the events of 2007/08, it is clear that regulatory actions should be at the forefront of every political agenda, however, the role should be to monitor and intervene but not limit financial innovation. Regulatory actions should be put into effect to discourage excess risk-taking. The extent of financial innovation largely depends from present day regulatory policies. Furthermore, future digital disruptions will naturally disrupt the financial industry, and bring forth financial innovation. The key is to maintain a balance between the two aspects of financial innovation, as it has had a crucial and positive effect on the world economy.
All in all, financial innovation was a significant factor that affected both the lead up and outcome of the 2007/8 financial crises. The numerous factors that evolved from the securitization of assets, especially when combined with subprime mortgages, resulted in risky products. However, it is important to note that financial innovation also brings forth positive outcomes to the financial and economic world. Therefore, in order to achieve a balance, it is imperative for regulators and government agencies to understand and control the complexity that follows with financial innovation.