Has Any Good Come From Financial Innovation?

Is financial innovation good for society? In a speech last week, Federal Reserve Chairman Ben Bernanke gave a qualified yes. Financial innovation really picked up after 1980, and "I don't think anyone wants to go back to the 1970s," he said.

Ryan Avent, the new blogger-in-chief over at Portfolio's Market Movers, thought that statement rather funny:

According to Bernanke, no one, "wants to go back to the 1970s," but neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in...the 1970s.

Have there been any beneficial financial innovations since then? Interest-rate swaps and currency swaps gained traction in the 1980s, and these are generally considered positive advances, because they let companies unload some of their risks to places like hedge funds that are happy to roll the dice.

Credit default swaps are trickier. They act like insurance on a bond in case a borrower goes bankrupt, and in doing so, they expand access to credit. After all, I'm more likely to buy a home if I know I can get reasonably priced insurance on it, because that lessens the risk of being a homeowner. The logic is similar if I'm a big pension fund considering whether to make a loan to an auto parts manufacturer. If I know I can buy insurance on all or part of the loan, I'm more likely to make it in the first place.

But now there are signs that credit default swaps are encouraging bankruptcies. Last week General Growth Partners, the nation's second-largest mall operator, declared bankruptcy. Lawyers dealing with the bankruptcy say that "credit default swaps are the problem -- mainly, bondholders who have purchased CDS on this debt have little incentive to negotiate or play ball, since the CDS, if the counterparty honors the agreement, makes them whole."

This is our old friend moral hazard at work. To extend the analogy I used before, if I know I can get fire insurance at a decent price, I'm more likely to build my home near a hill full of dry brush, and less likely to clear that brush before the dry, hot winds hit in September.

Here's a key line in the Bernanke speech:

We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience.

The story of General Growth Partners shows that it's not at all easy to determine who the "intended audience" is. In this case, the swaps may work perfectly fine for the counterparties: the bondholders will (presumably) get paid according to their contracts. But the results are worse than they otherwise would be for GGP and, arguably, for the economy at large. As the Fed sets about regulating the derivatives market, we should probably have a wider definition of "intended audience."