The Role of Financial Innovation in Crises
“In recent years, financial innovators, seeking an edge in the marketplace, produced avariety of new and complex financial instruments. These products, such as asset backedsecurities, were designed to spread risk but ended up concentrating it. Loans were soldto banks, banks packaged these loans into securities, investors bought these securitiesoften with little insight into the risks to which they were exposed. It was easy money.But these schemes were built on a pile of sand.”“This wasn’t just a failure of individuals. This was a failure of the entire system.”“Instead of reducing risk, the markets actually magnified risks being taken by ordinaryfamilies and large firms alike.”
Remarks of President Barack Obama on announcement of New Foundation proposal for financial regulatory reform, June 17, 2009
We begin with a review of research on financial innovations. We demonstrate the problemthrough a narrative description of one example of an innovation gone wrong – the securitizationof mortgages.
One day in March 2009, the Program Director for the local Kiwanis Club, asked me to talk to hischapter about the current state of the economy. Just one week before that, the Chairman of theFederal Reserve System, Ben Bernanke, told Congress that he didn’t know what to do about theeconomy; he couldn’t stop the repeated need for bailouts; and he wouldn’t be able to say howlong the economic turmoil would last.
In the middle of what was looking like the worsefinancial crisis in US history, the Kiwanis were expecting me to explain to a group of non-financial business men and women where the economy stood and how we got there.
Chairman Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, Before the Committee onBanking, Housing and Urban Affairs, U.S. Senate, Washington, D.C., February 24, 2009. Chairman Bernankepresented identical remarks before the Committee on Financial Services, U.S. House of Representatives, onFebruary 25, 2009. The comments referenced here came during the verbal question and answer session in the House.