Financial Innovation Is Taking Off Again

Includes: IYF
by: John M. Mason


More and more financial innovation is taking place in the world today and it is taking place in areas that are not regulated.

This drive to more financial innovation is driven by the government's credit inflation attempting to put people back to work again.

Smart investors have learned over the past 50 years that dealing in assets has produced greater wealth than producing more goods and services.

Sure, we have the Dodd-Frank Wall Street Reform and Consumer Protection Act on the books. It was signed into law on July 21, 2010. It was out-of-date before it even was totally put together. I wrote about this as early as 2009.

It was out-of-date before it was even signed into law for two reasons. First, it was out-of-date because the law was written to prevent the financial collapse of 2007 from happening again. Second, as I wrote many times, the financial industry, given the current state of information technology, had moved beyond what was being contemplated in the law.

Furthermore, credit inflation was still the name-of-the-game for the policymakers in Washington, D. C. and credit inflation always creates an environment in which financial innovation can thrive.

Credit inflation causes rising asset prices even though it may have a minimal impact on the consumer prices people consider to be connected with "price" inflation.

Credit inflation can impact stock prices, housing prices, commodity prices and the prices of other assets that are not included in such measures of "price " inflation like the Consumer Price Index or the index of consumer prices connected with the national income accounts. Thus, "consumer" price inflation can look moderate whereas the price inflation of assets can be rather aggressive.

Credit inflation has been going on in the United States since the early 1960s. People started to recognize this toward the end of that decade and it really began to take off in the 1970s as house prices, the price of gold, the price of paintings, and the prices of other "holders of wealth" became a source of wealth increase. And, it was the wealthy or the more connected individuals that took advantage of this inflation.

And, credit inflation, as I have written many times, has several consequences. First, people take on more and more risk; second, people take on more and more financial leverage; third, people tend more and more to mismatch maturities, borrowing short and lending long; and fourth, people begin to engage in more and more financial innovation.

In the past couple of years, investors have taken on more and more risk to get a higher yield. Also, they have been willing to increase their financial leverage, even with the experience of 2007-2008 fresh in their minds. With interest rates so low it seems foolish not to take advantage of the borrowing opportunities especially as the Federal Reserve continues to underwrite the whole financial system.

And, we have seen more and more financial innovation coming back into play. Tracy Alloway and Michael Mackenzie pay attention to this accelerating move to more financial innovation in the Financial Times: "Investors Dine on Fresh Menu of Credit Derivatives." They discuss two instruments that are "helping investors play booming corporate credit markets": the two instruments are called total return swaps (TRS) and options on indices comprised of credit default swaps.

The first of these, TRS, "enables an investor to receive a payment based on the performance of an underlying basket of assets. Such a strategy…enables an investor to leverage their exposure to the performance of credit, without owning an actual asset."

The other has carried with it the name of "swaptions." In this the options are tied to CDS, Credit Default Swaps, indices. The market has "grown sharply" because the instruments are not required to be centrally cleared.

"In the retail market "ProShares this month began offering an exchange traded fund that uses only swaps tied to CDS indices that allow investors to go long or short credit in a fresh way. Many ETFs already use TRS, options and other derivatives to juice up their returns or hedge portfolios.

In the article, the authors quote Janet Tavakoli, president of Tavakoli Structured Finance as saying, "We've reformed nothing. We have more leverage and more derivatives risk than we've ever had."

I can't emphasize enough that the financial world is changing rapidly and this change is not going to stop…it may even speed up as more and more advances in information technology come into play. I try to capture a little of this in my recent post "The Future of Banking: Once Again."

More and more financial innovation create an environment where there is less stability. People don't always know exactly how the instruments are going to perform in different environments and they don't know how people are going to react to the performance of the instruments in different environments.

The bottom line is that this financial innovation is going to continue…even accelerate…as long as the credit inflation is continued. And, it is a game that is played primarily by the financially sophisticated, the wealthy, or those wealthy individuals that are connected with the financially sophisticated.

And, the financial innovation remains primarily within the financial circuit of the economy and does little or nothing to spur on economic growth or higher employment.

As we have seen over the past fifty years or so, this is what the federal government has accomplished with its efforts to use credit inflation to achieve higher rates of employment and put more and more Americans in their own homes.

In terms of planning an investment strategy for the near term, I believe that one must incorporate this scenario into their strategies for I see nothing in the political environment to give any indication that anything else will be tried.

In this respect, we are seeing the quantitative easing has not produced economic growth anywhere near where it was in the later part of the last century and the labor force participation rate has fallen back to where it was in the 1970s. These short-falls are reflected in the production of real goods and services.

On the other side income inequality has grown immensely as those that are connected with the world of assets and technology fields have benefited from the way credit inflation has been administered over the past fifty years.

At this time, in terms of investment policy, I don't see the changing. The move into more and more financial innovation is just one indication of this.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.