Engineering Lemons, Revise and Resubmit, Journal of Financial Economics
Banks engineer and sell to U.S. households complex securities with attractive yields but negative returns. I document this in a sample of over 20,000 yield enhancement products (YEP), which became a $20 billion market after the post-crisis fall in interest rates. YEPs carry a significant downside risk and, according to regulators, are frequently missold to inexperienced investors. The products lose money both ex ante and ex post due to their largely hidden fees: on average, YEPs charge 7% in annual fees and subsequently lose 7% relative to risk-adjusted benchmarks. The fees remain large even after the SEC mandated disclosure of product values.
The role of financial innovation is a subject of ongoing controversy. I offer new insights into this role by analyzing a global dataset of innovative (structured) retail products with an issuing volume exceeding $5 trillion. I show that demand is correlated with the salient quoted rates of the securities but inelastic with respect to their intrinsic value. Banks respond to the demand by making the quoted rates of the securities more attractive through value-decreasing "add-on" attributes, particularly at times when simple securities offer low upside potential. The "add-ons" decrease value to such an extent that the securities appear to be dominated by the risk-free asset. My evidence is consistent with banks innovating to enhance salient product characteristics while shrouding low security quality.