Financial Innovation is a Fallacy

When the lending industry developed exotic loan products, they touted them as “innovation,” and they sold these toxins far and wide. Since these loans achieved the highest default rates ever recorded, it is apparent the “innovations” of the bubble rally were not entirely successful. The cutting edge is sharp. Innovators often pay a heavy price for attempts at advancement. Sometimes these advances lead to quantum leaps in human knowledge and understanding. Sometimes the time, effort, and money are merely thrown into the abyss. The financial innovations of the Great Housing Bubble are of the latter category.

It is amazing that a group of assumingly intelligent bankers came up with these exotic loan programs and expected a positive outcome. The “innovation” meme is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.

Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing.

The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common). This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans.

A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.

To be financially conservative is to accumulate wealth and to be risk adverse. It requires managing equity, paying down a mortgage loan, and allowing net worth to accumulate rather than depleting it via consumer spending through mortgage equity withdrawal.

Many people do not realize the risk they take on when they use some of the innovative loan programs developed during the bubble. Exotic financing terms are not exotic anymore. Interest-only, adjustable rates and negative amortization have become so ubiquitous that nobody seems to remember why 30-year fixed-rate mortgages are used. A home should be financed with a fixed-rate conventionally-amortized mortgage and a sizable downpayment. The reason for this is simple stress management: nobody wants to spend the next several years worried about a loan reset or the need for increasing house values or future salary increases.

People should not buy with the desire to make a fortune in real estate. Instead, they should purchase with the intent to have a stable housing payment, and a stress-free life.