Speech

Financial Innovation: Engine of Growth or Source of Instability? UniversityofIllinois–Springfield Springfield,Illinois March6,2008 Distress in home mortgage markets, dynamicprocessof“creativedestruction”that falling new home construction and drivesmarketeconomiesforwardandraisesliving falling home prices in many areas standards.Mymessagetodayisthatweshould havebeenafocalpointintheoutlook notfearfinancialinnovation,butthatwemust for the U.S. economy for at least the past nine becareful,bothindesigningourpublicpolicies months. When rising mortgage defaults led to andinmakingourpersonalfinancialdecisions, broaderfinancialturmoillastAugust,forecasters tounderstandthelessonsoftherecentsubprime began to downgrade their estimates for U.S. eco- mortgageturmoilandofpastinnovationsthat nomic growth in 2008, and some predicted an ledtoinstability. imminent recession. Many analysts blame the TodayIwilldiscusswhyfinancialinnovation distress in mortgage markets on a proliferation isanimportantsourceofeconomicgrowth,but of exotic home mortgage products, including alsowhyfinancialinnovation,whenitgoesawry, adjustablerateandinterest-onlyloansthat canbeasourceofmacroeconomicinstability.I exposeborrowers to more interest-rate and willdescribethesourcesoffinancialinnovation house-price risk than conventional fixed-rate anddiscussseveralexamplesofhighlysuccessful mortgages. Others cite a lowering of underwritinnovations.Iwillalsopointoutwhysomeinnoing standards that drew people into mortgages vations,includingsomeassociatedwiththesubthat they could not afford. Still others point to primedebacle,ledtoinstability.Finally,Iwill increased securitization of mortgages, especially offersomelessonssuggestedbythoseexperiences. of non-prime mortgages, and lapses in the eval- Beforeproceeding,Iwanttoemphasizethat uation of mortgage-backed securities and derivtheviewsIexpressherearemineanddonot atives by rating agencies and investors. A common theme hasbeenthatinstabilitywasthe necessarilyreflectofficialpositionsoftheFederal productofinnovations in the mortgage market ReserveSystem.Ithankmycolleaguesatthe that went awry. FederalReserveBankofSt.Louisfortheircom- Ihavesaidelsewherethatthereisreally ments.DavidC.Wheelock,assistantvicepresinothingfundamentallynewabouttherecentsub- dentintheResearchDivision,providedspecial primemortgagedebacle.Historyisfullofexam- assistance.However,Iretainfullresponsibility plesofinnovationsthatledtoinstability,atleast forerrors. initially,asfinancialmarketparticipantssought toexploitaninnovationandfailedtotakeadequateaccountoftherisksinvolved.Onthewhole, THE SOURCES OF FINANCIAL however,economistsareinagreementthatfinan- INNOVATION cialinnovationplaysanimportantroleinsupportingeconomicgrowth.Financialinnovation, Financialmarketsarealwaysinnovating. likeinnovationinotherindustries,ispartofthe Someinnovations,suchascreditcards,reflect 1

FINANCIALMARKETS technologicaladvances.Thefirstcreditcards ratesonbankandthriftdepositswerecappedby appearedinthe1950s,butcreditcardsdidnot law. comeintowidespreaduseuntiladvancesin Thelong-termamortizingmortgageisanother computerandcommunicationstechnologymade innovationthatgotaboostfromgovernment. thehigh-speedprocessingofcreditcardtransac- BeforetheGreatDepression,homemortgages tionsfeasible.Creditcardsarenowubiquitous— wereoftenshort-term,non-amortizingloanswith itishardtoimaginelifewithoutthem.Theyare aballoonpaymentduewhentheloanmatured. aconvenient,relativelysafemethodformaking Lenderswereusuallywillingtorefinancemortpayments.Theyarealsoanefficientwayofpro- gageswhentheycamedue,butthatwasnextto vidingshort-term,unsecuredloansthatenable impossibleduringtheDepressionwhenbanks householdstosmooththeirconsumptionover andotherlenderswerefailingindrovesand time.Clearly,somepeopleborrowmorethanthey unemployedhomeownerswereunabletoqualify canafford.Creditcards,however,likemanyother asgoodcreditrisks.Fallinghouseholdincomes paymentsandcreditinnovations,havelowered resultedinasharpspikeindelinquentmortgages. transactionscosts,improvedresourceallocation, Accordingtooneestimate,asofJanuary1,1934, andthuscontributedtoeconomicgrowth. nearlyhalfofallurbanhomemortgageswere Otherfinancialinnovationssimplyreflect delinquent.1 quickthinkingandtheopportunitytomakea Thefederalgovernmentrespondedtothe profit.A.P.GianniniwasaSanFranciscobanker logjambyacquiringsomeonemilliondelinquent homemortgagesandrefinancingthemas15-year who,attheturnofthelastcentury,broughtretail fixed-rateamortizingloans.Congresscreatedthe bankingtothemassesandmademillionsforhim- FederalHousingAdministrationtooffergovernselfandhisshareholdersintheprocess.Giannini mentinsuranceonlong-termamortizingmorthitthegroundrunning—literally—aftertheSan gagesthatmetspecificstandards.Later,the Franciscoearthquakeof1906.Giannini’sBank FederalNationalMortgageCorporation—“Fannie ofItalyquicklyresumedoperationsafterthe Mae”—wasestablishedtopurchaseFHA-insured earthquakeeventhoughitsbuildinghadbeen mortgages,whichgaveafurtherboosttothelongdestroyedandotherbanksremainedclosed. termamortizingloantypethatbecametheindus- Gianninimadecharacterloanstoindividuals trystandard. andsmallbusinesseswhenmostbanksshunned suchclientele,andhelaterbuiltanetworkof retailbranchesthroughoutCalifornia.Giannini’s AN HISTORICAL EXAMPLE conceptwashighlyprofitableandhelpedestablishhisbank—renamedtheBankofAmerica— Financialinnovationshaveoccurred asoneofAmerica’smostsuccessfulbanks. throughoutrecordedhistory.Fractional-reserve Manyfinancialinnovationsariseinresponse bankingwasanearlyfinancialinnovation,aristoregulationorothergovernmentpolicyactions. inginEuropeseveralcenturiesago.Infractional- Moneymarketmutualfunds,forexample,arose reservebanking,banksholdreservesinready inthe1970swheninflationdrovemarketinterest cashagainsttheirdepositsofonlysomefraction ratesfarabovetheregulatedratesthatbankscould ofthedeposits.Thesystemarosenaturallyfrom paytheirdepositors.Moneymarketmutualfunds marketforces.Manyoftheearliestbankerswere werewildlysuccessfulbecausetheyofferedsmall goldsmithswhoaccepteddepositsofgoldbullion saverstheopportunitytoearnamarketrateof andcoin.Thereceiptstheyissuedtotheirdeposinterestontransactionsbalanceswheninterest itorscirculatedamongthepublicasamediumof 1 Bridewell,DavidA.TheFederalHomeLoanBankBoardanditsAgencies:AHistoryoftheFactsSurroundingthePassageoftheCreating Legislation,TheEstablishmentandOrganizationoftheFederalHomeLoanBankBoardandtheBankSystem,TheSavingsandLoanSystem, TheHomeOwnersLoanCorporation,andtheFederalSavingsandLoanInsuranceCorporation.FederalHomeLoanBankBoard,1938,p.172. 2

FinancialInnovation:EngineofGrowthorSourceofInstability? exchange,beingmoreconvenientthanmaking settlepaymentsamongtheirmembers.Clearingpaymentswithcoinorbullion.Theacceptance houseassociationsworkedtolimitcrisesby ofgoldsmithreceiptsasamediumofexchange demandingconservativepracticesamongtheir allowedgoldsmithstoevolveintobanksasthey memberbanksandbypoolingtheirresources discoveredthattheycouldissuemorereceipts whenpanicsdidoccur.Governmentsalso thanthevalueofthegoldtheyheldintheirvaults. attemptedtopreventcrisesthroughregulations, Solongasagoldsmithheldenoughgoldtosatisfy suchasrequiredreserveratios,andbycreating occasionalredemptions,hecouldprofitbymak- centralbankstoserveaslendersoflastresortto ingloansintheformofreceiptsbecausethose thebankingsystem. receiptswerewidelyacceptedasamediumof Theinnovationofpapermoneysometimes exchange.Theuseofgoldsmithreceiptsasa ledtoanotherproblem—inflation.Theproblem mediumofexchangegreatlyeconomizedonthe ofinflationbecameespeciallyacutewhengovernuseofgoldandotherpreciousmetalsformaking mentstookovertheprintingpress.Governments payments,whichencouragedeconomicactivity thatissuedcurrencytofinancewarsorother andtrade.Atthesametime,thedevelopmentof adventuresoftenfoundthatthemorecurrency fractional-reservebankingpromotedeconomic theyissued,thelessitwasworth.Extremeinflagrowthbyfacilitatingtheallocationofcapitalto tion—hyperinflation—hasneveroccurredexcept productiveoutlets. whenacountryprintsmoneytofinanceamassive ThestoryIjusttoldinvolvestwoimportant budgetshortfall.Governmentshaveneverabanandcloselyintertwinedfinancialinnovations— donedpapercurrencyorrevertedtoapurelygoldpapercurrencyandfractional-reservebanking. basedmonetarysystembecausethebenefitsofa Bothweretremendouslyimportantforthedevel- modernfiatmoneysystemaretoogreat.However, opmentofmoderneconomies.However,both todiscourageexcessivegrowthoftheirmoney havealsobeenasource,attimes,ofextreme stocks,countrieshaveincreasinglysoughtboth instability.Inevitably,somegoldsmithbankers toinsulatetheircentralbanksfrompoliticalinterissuedtoomanynotesagainstthegoldtheyhad ferenceandtomandatepricestabilityasthe intheirvaults,eitherintentionallyorbecauseof paramountobjectiveformonetarypolicy. badjudgment.Then,inatimeoffinancialstress, thebankersfoundthattheydidnothaveenough goldtomakegoodontheirpromisetoredeem MORE RECENT EXAMPLES theirnotesforgoldondemand.Suchafailure couldtriggerapanicifthepubliclostconfidence Let’snowconsidersomemorerecentfinancial inthenotesofmanybanks.Ifsufficientlywide- innovations.OneistheEurodollarmarket,which spread,arushtoredeemnotesforgoldcouldshut developedinLondonintheearly1960s.Atthat downanentirebankingsystem,withsevere time,theUnitedStateshadagrowinginternational repercussionsfortheentireeconomy. paymentsdeficitandfacedamountingstockof Overthecenturies,numerousmechanisms short-termofficialdollarclaims,someofwhich evolvedtoprovidestabilitytothebankingsystem wereconvertedintogold.Tostemfurtheroutandpreventthedeleteriouseffectsofbanking flows,theKennedyandJohnsonAdministrations panics.Mostbankerswereconservativeintheir imposedanumberofcontrolsandtaxestolimit noteissuancebecausetheycaredabouttheir theflowofdollarsabroad.U.S.banksresponded reputationandhadapersonalstakeintheirbusi- bysettingupsubsidiariesinLondon,whichthey ness.Still,crisesoccasionallyhappenedwhen usedtotakedepositsandmakeloansinU.S.dolbadbehaviororsimplybadluckonthepartofa lars.AEurobondmarketalsodevelopedwhere fewbankscausedthepublictoloseconfidence borrowersissuedbondsindollarsandothercurinbanknotes.Duringthe19thcentury,banksin rencies.TheEurodollarmarkethascontinuedto U.S.citiesformedclearinghouseassociationsto existlongaftertheUnitedStateseliminatedcap- 3

FINANCIALMARKETS italcontrolsandremainsanimportantglobal variouscategories,ortranches,withdifferent financialmarket.Themarkethascontributedto maturityorriskcharacteristics.Investorscan theglobalizationandintegrationofworldfinan- thenpurchasetheobligationthatbestsuitstheir cialmarketsandpromotedefficientallocationof appetiteforriskorduration. capitalacrossinternationalborders. TurningbacktotheUnitedStates,another exampleoffinancialinnovationistheso-called BACK TO THE SUBPRIME junkbondmarket.Thejunkbondmarket DEBACLE expandedrapidlyinthe1980s,primarilyasa Withthatbriefintroductiontomortgagesourceoffundingforcorporatemergersand backedsecurities,letmeturntosomeofthe acquisitions.Beforethedevelopmentofaliquid problemsinherentwithsubprimelendingand junkbondmarket,corporatetakeoversweretypisecuritizationthatmayhaveplayedaroleinthe callyfinancedwithloansfrombanksorother recentmortgagemarketdebacle. financialinstitutions.Thejunkbondmarket Subprimemortgagelendingbegantogrow attractedmuchofthisbusinessbyprovidinga rapidlyinthemid-1990s,spurredbytechnologilessexpensiveandlessrestrictivesourceoffunds. calinnovationsthatloweredthecostofcollecting Thecapitalmarketswerebetterabletoabsorb informationaboutthecreditworthinessofpotentheseriskyloansthanwerebanks.Withoutdoubt, tialborrowers.Frequently,subprimeloanswere thetakeoverwaveofthe1980swasdisruptive soldbytheiroriginatorstofinancialintermediformanymanagersandemployeesofcompanies aries,whichinturnformedmortgagepoolsand thatweretargetsofcorporateraiders.Ontheother soldthecashflowsfromthosepoolsasCMOs. hand,manyofthesecompanieswerepoorlyrun CMOswereboughtpredominantlybybanks, firmswithentrenchedmanagementandineffihedgefundsandotherinstitutionalinvestors. cientoperations.Takeoverscouldmakesuch Defaultratesonsubprimemortgagesbegan firmsmorecompetitive. torisein2006,whenthegrowthinhouseprices Wecanthinkofthejunkbondphenomenon begantoslow.Asdefaultratesrose,someholders asanexampleofabroadertypeoffinancial ofmortgage-backedsecuritiestooksubstantial innovationknownas“securitization.”Securitizalosseswhenpromisedcashflowsfailedtomatetionistheprocessofconvertingnonmarketable rialize.Investorsthencalledintoquestionthe creditinstrumentsintopubliclytradedsecurities. valuesofasset-backedsecuritiesingeneral,pre- Mortgage-backedsecurities,ofcourse,arean cipitatingtheflighttoqualitythatbeganlast exampleofasecuritizedcreditinstrument.Other August.TheFederalReserveandothercentral typesofcreditinstruments,suchasautoloansand bankshavebeenworkingeversincetorelieve creditcardreceivables,havealsobeensecuritized. financialmarketstrainsandminimizetheimpact Mortgage-backedsecuritiescantakemany ofthefinancialdistressontherealeconomy. forms.Acommonformisthemortgagepass- Inarecentspeech,Ireviewedfivemajor throughsecurity.Thesearesecuritiesbackedby mistakesthatledtothesubprimemeltdown. apoolofmortgageloansinwhichmonthlypay- Thereisplentyofblametogoaround.Manybormentsofprincipalandinterestarepaidbythe rowerstookonmortgagesthattheycouldnot mortgageoriginatororservicertothesecurity’s afford.Mortgagelendersputtoomanyborrowers holders. intounsuitablemortgages,inmanycaseswith- Inthe1980s,mortgage-backedsecurities outadequateverificationofborrowerincome.In knownascollateralizedmortgageobligationswere particular,mortgageoriginatorsmadetoomany created.Typically,theunderlyingcollateralfora adjustablerateloanswithoutanadequateassess- CMOiseitherapoolofmortgagesoramortgage mentoftheborrower’sabilitytoservicehisloan pass-throughsecurity.CMOsarecreatedbycarv- aftertheinterestrateontheloanreset.Underingthecashflowfromtheunderlyingassetinto writingstandardsslippedbadlyinmanyinstances 4

FinancialInnovation:EngineofGrowthorSourceofInstability? wheremortgagelenderssoughttocollectfees morecapitalthatafinancialintermediaryhasat fromoriginatingloansthattheythenre-sold. stake,themoreprudentlyitwillbehave.Wesaw Itappearsthatmanypurchasersofmortgages inthe1980sthatsavingsandloanassociations andmortgage-backedsecuritiesinthesecondary assumedgreaterandgreaterrisksastheirnet marketalsofailedtoadequatelyassessthequality worthdeteriorated—thatis,astheleverageof oftheunderlyingassetsorunderstandtherisks theirportfoliosincreased.The“zombies”that associatedwiththesecuritiestheypurchased. hadnorealcapitalandwerekeptaliveonlyby Informationproblemsaboundincreditmarkets. regulatorforbearancetookextremerisksthat Lendersgenerallyhavemoreinformationabout ultimatelyaddedbillionstothecostofcleaning thecreditworthinessoftheirborrowersthando uptheS&Ldebacle. secondarymarketparticipants.Thisinformation Thereisaroleforgovernmentinregulating asymmetrygiveslendersanincentivetohold thecapitalpositionsofbanks.However,alesson thelowest-riskloansintheirportfoliosandsell ofthesubprimeepisodeisthatthefirstlineof offthosewithhighdefault-risk.Recognizingthis defenseagainstexcessiverisktakingismarket incentive,investorssometimesdemandthatloan discipline.Mortgageoriginatorsthatselltheir loanswithlittleornorecoursehavelessincenoriginatorsmaintainastakeintheloanstheysell, tivetomaintainprudentunderwritingstandards orotherwiseguaranteethecreditqualityofthose thandooriginatorsthatputtheirowncapitalat loans. stake.Marketparticipantsneedtounderstand Toooften,however,itappearsthatinvestors theincentivestheirtransactioncounterparties insecuritiesbackedbysubprimemortgagesfailed haveforlayingoffriskanddemandappropriate toappreciatetheinherentrisksofinvestingin riskpremiumsandcreditenhancements.Further, assetssecuredbysubprimemortgages.Perhaps theepisodehastaughtusthatratingagencies investorstrustedtoomuchtheratingsassigned don’talwaysgetitright. tomortgage-backedsecuritiesbytheratingagen- Underlyingmanyepisodesoffinancialinstacies.TheratingagenciesplacedAAAratingson bilityaremismatchesinthematuritiesofthe manysecuritiesbackedbysubprimemortgages. assetsandliabilitiesinlenderportfolios.Mortgage Apparentlytheagencieslookedintherear-view loansarelong-termassetsthatalltoooftenare mirrorandassignedratingsbasedonthelow fundedwithshort-termliabilities.S&Lssuffered defaultratesonmortgage-backedsecuritiesbefore heavylossesinthe1970swheninflationandris- 2006,ratherthanonaforward-lookinganalysis inginterestratesdrovethecostoffundsabove ofthelikelyabilityofborrowerstorepayinaless thereturnonthefixed-ratemortgagesthatcomfavorablemarketenvironment. prisedtheportfoliosofmostS&Ls.Adjustableratemortgagesthenbecamepopularbecausethey reducetheexposureoflenderstointerest-raterisk. LESSONS FROM THE SUBPRIME However,aswehaveseenrecently,adjustable- DEBACLE AND OTHER ratemortgagesexposeborrowerstointerest-rate FINANCIAL INNOVATIONS GONE riskthattheymaynotbeequippedtohandle.In thesubprimemarket,alltoomanylendersand AWRY borrowerswereextremelyshortsightedasthe Whatarethelessonswecandrawfromthe verycommon2/28mortgagewouldresettoa subprimedebacleandotherepisodesaboutthe muchhigherrateinonlytwoyears.Theseinterunderlyingcausesofinstabilityassociatedwith est-rateresetshaveincreasedpaymentamounts financialinnovation?Onelessonconcernsthe beyondthemeansofmanysubprimeborrowers. roleofcapitalinovercominginformationprob- Atthesametime,fallinghousepricesarewiping lemsandincentivesforexcessiverisktaking. outhomeownerequityand,inmanycases,push- Capitalbothservesasacushionagainstfinancial ingthecurrentvalueofthehousebelowtheoutlossesandencouragesprudentbehavior.The standingmortgagebalance. 5

FINANCIALMARKETS Whatshouldwelearnfromallofthis?For designedtoendtheabuseswilldosobutonlyat theindividualorthefirm,thelessonsareclear— thecostofmakingsubprimelendingsocostly educateyourselfaboutthepotentialrisksofany andriskytolendersthattheywillhavenointerinvestmentorfinancialtransaction;understand estinrestoringthismarket.Weshouldnotforget theincentivesofcounterpartiesinthosetransac- thatmarketdisciplineimposedbylenderswho tions;avoidputtingatriskmoneythatyoucannot havesufferedextremelylargelossesisalready affordtolose.Ifaninvestmentseemstoocompli- makingitverydifficultforanyonetooriginate catedtounderstand,itisprobablytoocompli- subprimemortgages.Intime,ifnewregulatory catedtoown.Thepublicpolicylessonsare burdensdonotbecometoogreat,weshould perhapsmorevariedandcomplex,butthey expecttoseenewpracticesbecomestandard. includetheimportanceofeconomicandfinan- Mortgageoriginatorsmight,forexample,retain cialeducation,adequatedisclosureoftheterms aninterestinthemortgagestheyissue,providing ofloancontracts,andregulationsthatminimize someassurancetothecapitalmarketabsorbing conflictsofinterestinfinancialtransactions. securitizedmortgagesthatincentivesareproperly Weshouldnotforgettheimportanceoffinan- alignedtoassuresoundunderwriting.Mortgage cialinnovationinpromotingeconomicgrowth. brokerswithagoodrecordofsoundunderwriting Successfulfinancialinnovations—thosethatmeet shouldbeabletogetapremiuminthemarket themarkettestoverthelongterm—promotethe whentheysecuritizetheirmortgages.Afterrecent efficientallocationofcapitalandcontributeto experience,thereputationofafirst-classmortraisingourstandardofliving.Thechallengefor gagebrokershouldmattermorethantherating policymakersistowriterulesthatpromotefinan- assignedbyaratingcompany. cialstabilitywithoutdiscouragingproductive Inanyevent,myviewisthatweshould innovations. regardrecenteventsinthemortgagemarketas reflectingthenormalprocessofinnovation.The lessonshavebeenexpensiveandpainful,andthe LOOKING AHEAD painisnotyetover.Aswiththedot-combust, wheremanyfirmswentbankruptbutsomesound Mortgagesecuritizationisanimportant businessmodelssurvived,weshouldexpect financialinnovationandwillsurvivethecurrent thatsuccessfulinnovationsbehindthesubprime financialturmoil.Thesubprimemarketisatrisk. marketwillalsosurvive.Intime,Ibelieve,we Atpresent,lendersareoriginatingpracticallyno willfindthatthesubprimesectorofthemortgage subprimemortgages.Thatisunfortunatebecause marketwillbeasnormalasanyotherpartofthe manyofthosewithweakcreditratingscanservmortgagemarket.Someoftheinnovationsin icemortgages.Someareyoungpeoplejustbeginunderwritingautomation,whichreducelabor ningtheircareers.Theirlowcreditscoresmaybe costs,willsurvive.Thesubprimemortgagemarmoreareflectionoftheirlimitedborrowinghisketwillbecomeasacceptedasfractionalreserve torythantheirinherentcreditworthiness.Others banking,moneymarketmutualfunds,credit mayhavespottyborrowingrecordsbutwithdiscards,equityindexmutualfundsandahostof ciplinecanbecomeprimeborrowersinduetime. otherfinancialpracticesandserviceswenow Weshouldnotwantthemortgagemarkettobe takeforgranted. permanentlyclosedtosuchborrowers. And,Icanassureyouthatpolicymakerswill Thepublicpolicyproblemisthedangerthat, beverypleasedwhenthisinnovationisthorwiththesadrecordofsomanymistakesand oughlydigested! abusesinrecentyears,regulatoryburdens 6