• By
  • Justin Lahart

Financial innovation gives investors new tools for diversifying portfolios and sharing risks, so it should make markets safer. But the theory that new financial products will make markets less dangerous doesn’t always stand up.

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The 2008 financial collapse taught us that in spectacular fashion, when the very mortgage derivatives that were supposed to limit risk instead blew up. And one needn’t stretch too hard to think of other crises to which financial innovation contributed: There’s the 1998 Russian debt crisis, for example, the saving and loan crisis of the late 1980s and the 1987 stock market crash.

But that still leaves open the question of why innovation has at times made the financial system riskier rather than safer. An economist at the Massachusetts Institute of Technology named Alp Simsek may have come up with at least part of the answer. To do so, he tapped what has been a rich vein for behavioral economists trying to understand why financial markets can behave so irrationally: How differences in opinion among investors can create distortions.

Most difference-of-opinion research has centered on prices. If investors vehemently disagree on a stock, for example, but the costs of shorting the stock are high, bears may simply opt not to be involved in it — leaving the bulls in control and pushing the share price skyward. Mr. Simsek has taken the further step of examining what happens to investors’ portfolios when they disagree and some new financial product comes along. He finds that can increase the amount of risk investors take on in two ways.

First, it gives them something new to wager on, and the creation of new bets in the context of broad disagreement can add substantially to portfolio risks.

As an extreme example, consider the synthetic collateralized debt obligation Goldman Sachs put together in 2007 called Abacus 2007-AC1. There was plenty of disagreement on how the risky home loans included in the CDO would fare, with some banks happy to buy it while hedge fund Paulson & Co. (which controversially helped pick some the CDOs underlying securities) took the other side of the trade. Both the banks and Paulson & Co were taking on risks they couldn’t have absent the development of synthetic CDOs. Paulson & Co. bet right, making about $1 billion.

Second, says Mr. Simsek, financial innovation can give investor the opportunity to amplify bets elsewhere.

Consider two investors who in the early 1980s had widely divergent views on Mobil and Standard Oil of Indiana. Because both companies’ share price varied with the price of oil, the investors would be reluctant to trade boldly on their views. But once oil futures began to trade on the New York Mercantile Exchange in 1983, it became easier to hedge bets on the fortunes of those companies against changes in oil prices — allowing the investors to more precisely home in on their area of disagreement, and take on more risk.

“When investors can purify their bets, they’re going to amplify them,” says Mr. Simsek.

Of course, while the introduction of oil futures probably did amplify risk-taking as in the above example, they also provided investors with more opportunities for diversification and made it easier for companies to hedge against swings in oil. On net, one would probably say they ended up reducing risk. Similarly, synthetic CDOs like Abacus 2007-AC1 were used for hedging purposes and the like, though in this case one would say the excessive risks banks took on outweighed such positives.

The model Mr. Simsek has developed shows that every new financial asset helps mitigate risks in some ways and increase them in others. Which dominates depends on how deep investor disagreements surrounding the asset are.

He further notes that while many of the products that Wall Street’s financial engineers come up with are made in response to investors’ demand for assets that reduce risks through diversification and risk sharing, others are aimed at areas where there’s a lot of disagreement. After all, and as previous research has shown, where there’s a lot of disagreement, there’s a lot of trading — and, therefore, fees.

Of course Wall Street markets pretty much every new product it sells as a way to reduce risks. But before biting, investors should ask if it’s telling the truth.



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