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

Posted by: Bruce Nussbaum on July 16, 2008

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.

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Reader Comments


July 16, 2008 03:12 PM

Check out Paul Virilio's idea of the "integral accident". Essentially it is the notion that with the creation of each 'invention', that invention's 'accident' is also simultaneously created. A common example is: the invention of the train was also the invention of derailment. Of course, this can go on: the invention of rope was also the invention of hanging; the invention of electricity was also the invention of electrocution, etc. So, what is innovation's accident?


July 16, 2008 04:15 PM

What went wrong with financial innovation? It can be reduced to basic human behavior. People's actions are primarily based on fear and greed. Many people knew at the time that they were packaging these mortgage backed vehicles up to be sold at a much lower expressed risk than the reality. But they went along with it because they made a ton of money doing it. What's worse is that they did it under the guise that they were helping lower income folks by lowering the entry bar on homeownership. If you give mortgages to millions of people who couldn't in their wildest dreams afford to pay it back, there is only one outcome. Disaster.

Tom O'Brien

July 16, 2008 04:26 PM

Hi Bruce:

Nice post. I generally agree with your thoughts - but I don't lay the blame on the innovation.

It's more like a herd mentality fueled by greed. Everyone else is lending on no money down, so can I. I can lend to an even worse credit risk.

Liquidity is assumed on the other side - but when there are large events, liquidity breaks down and someone gets left holding the bag. Happened with the old Pension Portfolio Insurance instruments.

Happened with dot coms. When your neighbors are all day traders, the market is about to collapse. When your neighbors are all real estate developers, the market is about to collapse.


Scott Berkun

July 16, 2008 04:39 PM

I think the primary problem you have here is in not identifying what the innovation involved is. Was it NINA (No asset) loans? Was it the bundling of mortgages into funds (CDOs)? Until you're clear on what the specific creation is we're talking about, the question you've phrased in the title is entirely vague.

You're also not clear on your use of the word innovation. Does it mean change? Does it mean doing something new? Or does it mean something that has a positive effect on the world?

By most definitions of the word I know, an innovation alone can't trigger a meltdown. But greed, lack of maturity, denial of accountability among banks, the Fed and the national government can. There were many people who knew this was set up to fail from the beginning and did nothing, and that has more to do with ethics and leadership, than creativity and innovation.

Taylor Davidson

July 16, 2008 04:41 PM

It is not innovation that failed. It a was simple misguided focus on copying tactics; tactical thinking masquerading as strategic thinking.

Copying tactics without testing, without learning, without iterative design. That's simply not innovation.


July 16, 2008 05:14 PM

This was innovation, alright, probably the most destructive innovation the global economic system has ever known. We, as designers, business managers and analysts and global citizens, have to stop using “innovation” to try to get something for nothing.

What happened is that from the early 70s on, as America stopped being an industrial giant and became a net-oil-importer, we became a financial services and consumer giant – it pays to be the first to industrialize as we got to set the pace of the global economic order.

To pull this paradigm switch off, the rest of the world had to feel that investing in Wall-Street was a positive return on investment, and one of the ways to do this was to turn Wall-Street into a gigantic-bubble-blowing-debt-based-Ponzi-Scheme-Casino where everyone could win at least some of the time; the Maestro, Greenspan, performed admirably in this role as Casino Cheerleader and Market Manipulator. Using exotic financial instruments and tactics (Credit Default Swaps, Asset-Backed Securities, Naked Short Selling (an egregiously destructive and inherently greedy practice well-documented at, along with increasingly “creative” lending practices (Liar’s loans, NINJA loans, ARMS, Negative-Amortization loans, etc) along with the increasing deregulation of Wall-Street (with the repeal of the Glass-Steagall Act – thanks Clinton!) and the bail-out option available to all the Too Big to Fail!!! elite banks, the world threw a gigantic gambling party as big and little money chased bubble after bubble and profited on the way up, and big money even managed to profit after each bust.

The disaster unfolding was decades in the making; money has failed to serve its society or in the creation of things and services of real value. Aggressively parasitic hedge funds and other big-money investors were able to make money off the “notion” of money…to profit on the slicing up of debt that will not be repaid and short selling the stocks of well-managed smaller companies (many of which were destroyed) through obscure loopholes in the system. Banks will fail, taxpayers will pay, careers will be lost, pensions and 401ks will be gone, and recovery will be…well, I’ll let you decide.

If you want positive innovation, try reforming the way money works in this country to serve the country and the communities, not to serve those who want something for nothing at the expense of everyone else. Design and innovation are but tools that can be used for good or bad.


July 16, 2008 05:27 PM

I agree with your comment that the lack of transparency contributed to the the problem i.e. people did not know what they were buying and what the risk was. However, I think the real underlying problem is that mortgages were given to people who did not have the ability to make the payments. Lending standards were tossed out the window in the interest of making the loan which could then be sold and repackaged into a structure secuity. Lenders got all their money today, as opposed to over time which is how it use to be before structured finance products came to be.


July 16, 2008 06:20 PM

I understood that it had more to do with corporate greed than anything else. Put together a dodgy product that looks ok, then sell it on and don't worry about the consequences as you have your commission and profits keep going up beyond the dreams of avarice. Until it all collapses like a pack of cards, that is. As always, social evils await only the opportunity to grow without anyone noticing, until it is too late and we have to wake up and do something.


July 16, 2008 06:58 PM

When did dumping CFCs in rivers go from cost-saving convenience to inexcusable pollution inspired by greed?

The players and materials and means change. The motive rarely does. Same tune here.

Pete Mortensen

July 16, 2008 07:04 PM

Maybe it's that rapidly prototyping something as intangible services is dramatically harder to do than mocking up a rapid succession of physical products? How exactly do you prototype the reaction of an impossibly complex financial market to new services? This was one issue where the idea was interesting on paper, worked well in small doses, and is catastrophic in mass-implementation.

This is an issue Barry Katz of Stanford calls "Anticipatory Design."
Katz spoke at Jump about this problem not long ago. In other words, designers and other innovators consider themselves problem-solvers, but they're also problem-creators. And, unfortunately, designers are notoriously bad at anticipating and preemptively solving the new problems their work creates. So, for example, Motorola's introduction of the mobile phone has led to car crashes attributable to cell phones. Did the product's creator see that coming? Probably not. High-fructose corn syrup made incredibly cheap sweets possible -- it also dramatically increased obesity in the United States. Did the marketers of corn syrup anticipate this problem?

In the same way, the creators of these financial innovations need to excel not in prototyping, but in anticipatory design. They were unable to anticipate the chaos their short-term gains would bring about. Worse, perhaps, they might have seen the potential for trouble and gone on ahead regardless. This is not new to the financial markets. Investing on margin, as introduced in the 1920s, opened access to the stock market for millions who had never touched the stuff. It also precipitated the Great Depression.

Now, as then, we need to be particularly mindful not just of the benefits our work can create, but of the unanticipated harm it can bring about. And that goes doubly when it comes to financial markets.


July 16, 2008 07:26 PM

Ooops, PCBs, not CFCs. So many pollutants, so little time.


July 17, 2008 12:19 AM

Bruce, the short answer is yes...

Designers and innovators are like F1 pilots, always neurotically positive and pie in the sky optimistic. They never want to know the down side realities as they will foil the momentum of development or the will to win. These financial institutions ran into several things that foiled their plans to provide the middle-class dream of owning a home and they making a profit on their lending. However, deeper forces were at play in corrupting this innovative momentum.

Pie in the sky hope lead to people, and mortgage lenders thinking they could afford a mortgage, but the deeper forces of wage stagnation, inflation, offshoring of jobs, fat CEO pay packages, deregulation and the cycle of housing bubbles created by the Federal reserve lead to where we are now.

Innovation is how we grow as individuals and as a group or organization. Design school is and should be tough as it teaches designers to defend their designs through the process of critique. A good design school will teach the designer to stand up and defend their design in the face of adversity by forcing them to think of and refute as many constructive criticisms as possible. Testing their prototype can be beneficial given the rigor and objectivity of the testing group. There are several new design programs in the US that have not yet grown or innovated enough on themselves yet to be able to stand up to the rigor of the real world. They rely on media to prop them up as innovators while their designers fail to consider the markets they are creating with their innovations. Given time they will improve however.

Companies in the product world used to have Quality testing labs before a new launch. Those have been removed now due to cost cut backs and the move of manufacturing offshore. Digital prototypes of financial instrument designs still cannot handle the scale and complexities of all of the variables that exist in the launch of a new product. Will all of this technology we still cannot predict the outcomes of innovation.

We need F1 pilots in the driver seat of innovation, but I would add that taking a look at the how those F1 crews innovate, implement, maintain and operate their launch of new designs might tell those i-bankers on wall street a thing or two about discipline of a temper mental and high performance, constantly evolving thing that can at any moment spiral out of control and crash into innocent bystanders in the stands.


July 17, 2008 03:48 PM

Perhaps the analogy of a bridge is fair. Each bolt holding a structural element on a bridge is like one individual mortgage. The bridge is like our economy. A bridge is redundant - the failure of one bolt won't compromize the bridge. However, a bridge's integrity is compromised once a critical number of bolts fail. Nobody designs a bridge to accomodate fradulent components. Building infrastructure using bad parts only results in predetermined disaster (see the "Big Dig"). Financial institutions loaded our economy with bad mortgages (bolts) assuming that America's economy (bridge) was resilient enough to accomodate this dubious practice. If only a few institutions exploited the strength of our economy, our resilient economy would cover the liability. Once everyone engaged in this sketchy (but profitable) practice, the economy was loaded with too many predetermined failures. The destructive ethos at work within the financial sector it puts us all at risk. If I intentionally sold flawed bolts to be put into a bridge, I would be liable for fraud. Hopefully, packaging and selling compromised fianncial instruments will have similar legal consequences to the "brilliant" individuals who do great harm to our overall economy.

Steve Wunker

July 17, 2008 06:38 PM

I agree that transparency was a huge problem. With unfamiliar products, having little track record over a variety of circumstances (e.g. interest rate and credit environments in this case), you must provide loads of transparency if you’re to surmount buyer skepticism. OR, you rely on skewed incentives, which is the other key problem I’d identify in this case. People in this market made money if deals got done, bonds got issued, etc. Funny enough, they overlooked transparency failings that would have turned off the financial spigot. Either transparency or proper incentives should have stopped the run-away process, but the lack of both these factors caused the current implosion.

Mister Mister

July 29, 2008 04:33 AM

Innovation in mortgage backed securities provided a false assumption and reliance that splicing and dicing the risk somehow made the risk more manageable. The problem with that theory is there was no one at the helm assessing the qualitative risk or the assessing the risk en masse for their organization, or for the system in its entirety. Also, the prevailing notion that the "invisible hand" would somehow smooth out irregularities in risk management left corporate leaders, lenders, investment bankers, mortgage bankers and government entities and quasi-entities (Freddie Mac and Fannie Mae)with a false sense of "where the cracks in the system were, and whose responsibility it was to deal with them, especially regarding liquidity." The Great Depression was, indeed, more manageable. God Help Us in this time of crisis.

Annalie Killian

August 16, 2008 02:44 PM

Hi from Downunder Bruce, and Innovation Leader in a large Australian Financial Services corporation. Thanks for a sober and reflective conversation. Bruce, I am attending the Business Innovation Factory Conference in October- maybe this will be a great question to throw open for a debate given the audience you have attending? I would especially be interested to see how we can test better without over-bureaucratizing and stifling speed to market and spirit.

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Want to stop talking about innovation and learn how to make it work for you? Bruce Nussbaum takes you deep into the latest thinking about innovation and design with daily scoops, provocative perspectives and case studies. Nussbaum is at the center of a global conversation on the growing discipline of innovation and the deepening field of design thinking. Read him to discover what social networking works—and what doesn’t. Discover where service innovation is going and how experience design is shaping up. Learn which schools are graduating the most creative talent and which consulting firms are the hottest. And get his take on what the smartest companies are doing in the U.S., Asia and Europe, far ahead of the pack.

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