This article illustrates one point that I brought to the class discussion; whether the financial innovation leads to a financial crisis. I somewhat agree and disagree with Pual Krugman, the writer of this article.
I disagree with him about financial innonvation as a cause of the crisis. It is not the financial innovation itself that causes the crisis but rather the people who use them. For example, the aim of the mortgage-back securities is actually to reduce the risk of the mortgage holders by pooling many mortgages together to diversify the default risks on the loans. Nevertheless, many people purchase them for the sake of speculation.
However, I agree with him that one way to reduce the chances of misuses in such financial innovation is to always make the regulation about the financial systems up-to-date. This may be infeasible and require a massive cost on monitoring the whole financial system. The more possible way is to not allow the creation of new financial products at all. This may reduce potential problems in the future, but it also limits the use of good financial innovation as well.
Saturday, May 17, 2008
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3 comments:
It's true that those who are using financial instruments, not the instruments themselves, are ultimately responsible for the current crisis. That having been said, future problems can be reduced by limiting the speed at which new financial innovation can occur.
For example, continual retranched mortgage backed securities is recently developed financial instrument. The instrument’s tremendous initial popularity caused problems, as they were heavily packaged and traded before rating agencies learned how to rank them appropriately. If regulation allowed their use after an initial trial period, many of the rating problems would have been reduced.
Completely blocking financial innovation is, however, a terrible idea. Companies will not be able to adapt to changes in the industry and will not be able to take advantage of many profitable opportunities. Thus, slowing the adoption of financial instruments, not blocking it entirely is the best way to avoid future credit market problems.
I would disagree that the subprime mortgage frenzy is primarily driven by unchecked speculation. It is natural for investors to seek high yields for given risks. And most of the top trenched mortgage backed securities that pension funds or institution funds invested in had AAA ratings from the rating agencies.
I think the financial reform should target the rating agencies, and perhaps re-align their incentive structure so that they properly evaluate new financial instruments. That is, we need more transparency for the underlying value of the assets. Along this line, we might call into question the merits of fair-value accounting.
I think this article digresses from the bigger picture of the mortgage crisis problems: evaluation of risk.
The credit crisis is an interesting event that affected people from every end of the social spectrum. Thousands of lower-middle class families lost their homes for the same reason that top Wall street execs lost their jobs; they both underestimated the likelihood of a financial meltdown.
Our financial system was built on the Black-Scholes model- a model that has recently been a victim of much scrutiny and doubt, due to the fact that it grossly underestimates the probability of these financial panics. Unfortunately, we had to find this out the hard way.
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