Financial innovations can be dangerous to society and, in the short run, the apparent profitability of an innovation is a misleading way to measure the extent of its danger. Success must be measured across at least one full business cycle. Innovations that seem very profitable in the midst of a strong economic boom can and often do fall apart in the subsequent economic downturn.
For example, in the U.S. during the last decade, expansions in the menu of mortgage contracts that institutions offered to would-be borrowers and changes in the ways that lenders financed their mortgage activity only temporarily increased the homeownership rate. Pushing low-documentation, zero-equity, optional-payment and interest-only mortgage loans ended up hurting the very people they were supposed to help. Innovations that negated tried-and-true restrictions on borrower leverage and income stability encouraged millions of households to saddle themselves with payments they could not afford.
Regulations that allowed U.S. banks to make lightly documented loans were particularly pernicious because they undermined the ethics of the lending process. They invited borrowers to misrepresent their income and wealth and led lenders not only to tolerate misinformation, but to misrepresent the riskiness of poorly underwritten loans to regulators and other third parties. Lenders buried their weakest loans in hard-to-understand mortgage pools and pressured credit-rating organizations to overrate the quality of securities based on these pools. The big losers in U.S. and European securitized mortgage deals are dispossessed homeowners, unemployed workers, taxpayers who have to pay the bill for bailouts and trusteed investors such as universities and pension funds who cannot count on the bailout assistance that major issuers of defaulting mortgages and mortgage-backed securities have received.
Some Lessons
Reaching for yield within a risk class is an age-old investment strategy, but this strategy is only as sound as the risk measures and investment horizon one employs. Sponsors of defined benefit plans must recognize that credit ratings assigned to securitized instruments in good times are downwardly more volatile than those on corporate bonds and are rendered less reliable by nasty incentive conflicts under which credit rating firms operate. Sponsors must understand that if a AAA corporate bond earns only 4%, an innovative instrument that promises a 5% return cannot truly be a AAA investment, no matter how enthusiastically a credit rating organization or investment bank might proclaim otherwise.
In the modern era of global investing, sponsors need also to keep reminding themselves that in cross-border investing, the quality of the regulatory and supervisory system a country uses to maintain the safety and soundness of its financial institutions is an important risk factor. It is wise to avoid taking large positions in countries whose financial firms greatly influence the prudential standards its regulators enforce. A henhouse guarded by foxes is eventually going to run out of chickens.
During the last 20 years, guarding the financial henhouse is an activity in which Canada has outperformed other G20 countries. In 1998, Canadian officials protected taxpayers against too-big-to-fail politics by disallowing proposed mergers between two different pairs of its largest banks. Throughout the period, Canada’s financial regulators set and enforced tougher capital requirements than those established in multicountry agreements negotiated in Basel. Finally, in supervising mortgage lending, Canada held fast to traditional restrictions on borrower leverage and loan-to-income ratios when and as other countries foolishly abandoned them.