Origination Views

How Financial Innovation Went Wrong

By Frederic S. Mishkin

Mr. Mishkin, a departing Federal Reserve governor, spoke at the Caesarea Forum of the Israel Democracy Institute, Eliat, Israel, in July on how he believes problems with financial innovation and origination incentives led to the "subprime crisis." The following is an edited excerpt of his prepared remarks on these topics.

In the United States, financial innovation has recently manifested itself partly in the development of the market for subprime mortgages. While that market had serious weaknesses that eventually imposed large costs on many borrowers and their communities, it also brought considerable benefits to many others who were able to take advantage of responsible products never before available. As a result, they found themselves far better off financially than they probably would have been otherwise. As this recent experience suggests, financial liberalization and innovation bring many benefits but can also create information and incentive problems that lead to mistakes. When mistakes of this nature become evident, financial markets can seize up, with potentially significant adverse consequences for the economy.

Advances in information technology and financial innovations in recent decades encouraged new lending products and faster securitization of debt. This lowered transaction costs and contributed to a "democratization of credit" -- that is, the extension of credit to a wider spectrum of possible borrowers than in the past. In the United States, a potential customer with an Internet connection could quickly fill out an online form, and a mortgage broker could rapidly price a loan with the help of credit-scoring technology. The resulting mortgages were bundled together to produce mortgage-backed securities, which could then be sold off to investors.

All seemed well as long as the economy -- particularly, the housing market -- was booming, and credit became more and more available. But when the housing market turned down, substantial problems were exposed.

The subprime crisis exposed problems with the securitization of mortgages. In particular, it became painfully clear how poor the underwriting and credit-risk analysis were for a wide range of products. Some appraisers, brokers, and investment banks were motivated by transaction fees and had little stake in the ultimate performance of the loans they helped to arrange. Many securitized products were complex, and the ownership structure of the underlying assets was opaque. Investors relied heavily on credit ratings instead of conducting due diligence themselves, and credit rating agencies failed to fulfill their raison d'etre. The result has been rising defaults, particularly in the subprime mortgage markets, with losses to both investors and financial institutions.

The ultimate losses from the recent residential mortgage-market meltdown have been estimated by Wall Street analysts at about $500 billion -- less than 3% of the outstanding $22 trillion in U.S. equities. Why did a relatively small amount of losses on subprime mortgage loans lead to such broad-based financial disruption? After all, a 3% decline in stock market prices sometimes happens on a daily basis with hardly a ripple in the U.S. economy.

In part, the outsized impact of mortgage losses on broader financial markets probably stems from the fact that they exposed a more extensive set of problems in financial intermediation that were not limited to the original subprime loans. The liquidity shock that hit us in August has been described by one of my colleagues as a global margin call on virtually all leveraged positions. The liquidity shock quickly brought an end to the credit boom that preceded it, as a striking loss of confidence in credit ratings and an accompanying revaluation of risks led investors to pull back from a wide range of securities, especially structured credit products. Along the way, the inadequacies of the business models of many large financial institutions were exposed, and these models are now in the process of significant re-examination and rehabilitation.

As has happened in the past, the long-run benefits of financial innovations were easier to anticipate than the problems. The originate-to-distribute model of securitization, unfortunately, created some severe incentive problems -- or agency problems -- in which the agent (the originator of the loans) did not have the incentives to act fully in the interest of the principal (the ultimate holder of the loan). Notably, the incentive structures often tied originator revenue to loan volume rather than to the quality of the loans being passed up the chain. These agency problems resulted in lower underwriting standards, giving borrowers with weaker financial positions access to larger loans than they should have had. Investors in mortgage-backed securities apparently ignored the importance of these agency problems and did not adequately understand the risk characteristics of the securities they were holding. The practices in place to align the incentives of the originators, securitizers, and resecuritizers with the underlying risks proved to be woefully inadequate.