Did Innovation Trigger This Financial Meltdown With Fannie Mae And Freddie Mac And Cause A Recession?

I've been sitting on the beach pondering what one senior European banker told me in January in Davos at the World Economic Forum--

I’ve been sitting on the beach pondering what one senior European banker told me in January in Davos at the World Economic Forum—“you always talk about the benefits of innovation Bruce, but innovation in the financial markets has gotten us into this mess.”

Of course, I disagreed with him at the time but now I think we need to seriously examine what he was saying. Innovation assumes the creation of positive value, whether it’s revenue and profits in business or a better experience for consumers or patients or students. This, I believe, is different from invention or technology, which is neutral in its design. High-tech advances can be used to make life better—or worse. Think nuclear.

So the question is whether or not all the innovation in structured finance—the slicing and dicing of mortgages—that went on in Wall Street and ultimately exploded, leading to the current financial crisis was good or bad. Put another way, what went wrong with financial innovation?

I don’t have the answers and truly welcome your analyses. I think those in the innovation/design field should really think about the meta question of the impact of innovation in society. And in fact, lots of us are doing that in terms of sustainability and making life better in Third World countries. But thinking about financial innovation is very important because it gets to the issue of what can go wrong in innovation.

My initial thoughts are these: 1) Innovation and design methodology use prototyping to test new concepts, reduce risk and improve chances of success. This is where financial innovation failed. The intentions were good. Slicing and dicing mortgages and selling them

around the world was intended to reduce risk to the mortgage lenders, increase mortgage lending and allow many more people to buy homes. Home ownership did rise, especially for lower income folks.

Two things went wrong in the prototyping of the structured finance products. First, they weren't transparent. No one really knew what they were because banks and credit rating agencies mixed and matched good and bad, low risk and high risk, stuff in products that really couldn't be seen or evaluated. Proper prototyping didn't take place and the financial products sold in the marketplace were seriously deficient.

Second, the prototypes that were designed were improperly tested. The credit rating agencies used their traditional methods of evaluation for mortgage related financial products--credit history of losses on mortgage payments. They have always been very low so the credit rating agencies gave the new financial products high ratings. But the real issue turned out not to be losses on mortgages but liquidity in the mortgage market. And they didn't test for that. They should have because the opaque nature of the structured finance products made them hard to price and sell once trouble began. In fact, even today, banks are having a hard time putting a price on them. That's why the housing and financial crises continue.

It's a little like people buying something that seemed OK when they opened the box and took it out but wasn't what was advertised when they turned it on.

These are my beach ruminations about the failure of innovation. I'm back now and would really like to know what you think on the issue.

Before it's here, it's on the Bloomberg Terminal.