Financial Innovation and the Definition of Insanity

We're all likely more familiar with Mortgage Backed Securities (MBS) and Credit Debt Obligations and their effect on the financial crisis than most of us ever wanted to be. Both of these very sophisticated financial instruments had an important role to play in creating the crisis we are still battling through. One of the biggest problems for both MBS and CDS was that they would take financial instruments of varying degrees of risk and package them together into one bond that would then be given on risk profile by Moody's and other bond rating firms. In other words, varying degrees of risky mortgages would be put together into one MBS and all of them together would be given one rating. CDS were even trickier and that's because those combined several debt vehicles like car loans, mortgages, and even credit cards together into one financial instrument.

To add to the problem, the bond ratings companies did a fairly poor job of measuring their risk and often gave far too risky a loan package the highest, or at least far too high, ratings.

Now, it appears that Wall Street wants to repeat the process all over again.

Wall Street may have discovered a way out from under the bad debt and risky mortgages that have clogged the financial markets. The would-be solution probably sounds familiar: It's a lot like what got banks in trouble in the first place.

In recent months investment banks have been repackaging old mortgage securities and offering to sell them as new products, a plan that's nearly identical to the complicated investment packages at the heart of the market's collapse.

"There is a little bit of deja vu in this," said Arizona State University economics professor Herbert Kaufman.

Essentially, here's what's happening. Banks are desperate to sell their "toxic" MBS and CDS so that they can free up money presumably to lend. Of course, they are so toxic that no one wants to buy them. Se, many banks are taking some of the toxic portions of the instruments, the really bad loans, and rearranging them to go with loans in their portfolios of good loans. By so doing, they can essentially hide these toxic loans among a basket of good loans. (I did an expose of just such a scheme in which fraud was involved last year)

Essentially, what we have is banks rearranging their assets in order to hide the toxic ones and make their financial instruments look good. Only this time there is a twist.

We're back to financial engineering, absolutely," he said. "But I think it's being done at least differently than it was before the meltdown."

The sweetener at the heart of the deal is a guarantee: Investors who buy into the really risky pool agree to also take some of the risk away from those who buy into the safer pool. The safe investors get paid first.

The risk-taking investors lose money first. That's how the safe stack of bonds gets it AAA rating, which is crucial to the deal. That rating lets banks sell to pension funds, insurance companies and other investors that are required to hold only top-rated investments.

"There's no voodoo going on here. It's just math," said Sue Allon, chief executive of Allonhill, which helps investors analyze such hard-to-price investments.

Financial gurus call it a "resecuritization of real estate mortgage investment conduits." On Wall Street, it goes by the acronym Re-Remic (it rhymes with epidemic).

"It actually makes a lot of fundamental sense," said Brian Bowes, the head of mortgage trading at Hexagon Securities in New York. "It's taking a bond that doesn't necessarily have a natural buyer and creating two bonds that might have a natural buyer for each."

If your head is spinning, join the club. This is financial innovation on steroids. Not only are you able to rearrange financial instruments but you can then peel away the new instrument into its parts so that, theoretically at least, those with the most risk get that risk realized. It remains to be seen if this twist turns a risky and flawed investment into the pot of gold or it turns it into an even greater nightmare.