Are our financial products flawed?

Author Gregory Walker Published 28 September 2009

Imagine trying to build a house or a motor vehicle when the metrics you use for design and construction (centimetres, litres, etc) continuously change! But have you ever considered how difficult it must be to design financial products when its metric – money – is constantly changing?

Money changes in value over time due to inflation and deflation. Yet the overwhelming majority of our financial products are denominated in nominal currency values with nominal interest rates. Following the global financial crisis we must ask: is there a fundamental flaw in financial product design that may have contributed to this and other financial crises [i] ?

Consider the most common of financial products, the home loan. There are two basic types: the variable rate loan and the fixed rate loan, both of which are usually secured by a mortgage over the housing asset.

It is not hard to identify the risks with these two loans. If you take out a fixed rate loan and inflation increases, the real value of your interest repayments and your outstanding loan declines. This benefits the borrower and leaves the lender carrying the loss incurred by the change in currency value, interest rate and maturity mismatch. If you take out a variable loan, however, the bank is able to pass on the loss in currency value to the borrower by increasing interest rates.

Of course the opposite occurs if inflation decreases. You would think that most lenders would opt for variable rate loans so that they can pass the risk onto the borrower, but variable rate loans are not the dominant loan type everywhere in the world. Fixed rate housing loans are the most popular in the USA – something like 90% of US home loans were fixed rate in 2005 – whereas variable rate loans dominate in the UK and Australia.

It is perhaps surprising that fixed rate home loans continue to dominate the American market after the US Savings and Loan Crisis of the 1980s and 1990s, which saw banks faced with interest rate mismatches (borrowing with variable rate funds to finance fixed rate funds) and maturity mismatches (borrowing with short-term funds to finance long-term loans).

So why does fixed rate lending continue to dominate in the USA? A widely held belief is that the US housing market is underpinned by long-running government policies to assist and promote home ownership (see Chambers et. al. 2008). These policies created a secondary market for banks and mortgage lenders to sell their mortgages and pass on their risk. The process is called securitisation (the bundling of multiple individual mortgage loans in to a pool and the selling securities as claims on the mortgage pool). Mortgage insurance is a similar support mechanism for the US housing market. The two biggest and best known mortgage securitisation and insurance institutions are Fannie Mae and Freddie Mac. Both started as government enterprises, were privatised and have now had to be effectively renationalised to prevent their collapse in the current crisis. The subprime crisis had as its root cause the huge supply of securitised mortgage securities with complex structures and opaque risk characteristics that were sold into the global financial market.

Based on this experience the USA policy of promoting fixed rate loans and risk management via securitisation has failed. However does this mean we should support the adoption of variable rate loans?

Geoff Gloster (2009), an experienced Australian banker, suggests neither product should be supported. He criticises the use of nominal value financial products and calls on bankers and governments to support the development of real value savings and loan products to prevent a future repeat of such crises.

In hypothesising improved financial products we must ask ourselves the following questions:

• Whose role is it to manage the transfer of funds from savers to lenders?
• If there was a demand for real value financial products wouldn't the market supply it?
• Is there a government impediment to real value financial products, such as a taxation system predicated on nominal rates?

Australia does experience with real value taxation and real value financial products: it used to have a capital gains tax on real values and until 2003 it issued Indexed Treasury Bonds!

[i] A recent example is Geoff Gloster, (2009) “Facing up to dysfunctional finance products”, JASSA, The FINSIA Journal of Applied Finance, Issue 2, pp. 16-19.