My dream for the new year is that Wall Street will park its penchant for creating exotic securities. I’m talking about CDOs, CMOs, CLOs and the like — that alphabet soup of investment vehicles that has helped bring us to the brink of recession.
For years, Wall Street’s alchemists have been telling us these instruments — called derivatives because they are derived from other investment vehicles — are the greatest innovation since the internal combustion engine.
Consider housing. Package up scores of home mortgages into shiny black boxes, the Street’s financial engineers told us, then sell the boxes to investors all over the world. Spreading the risk in this way set the stage for credit to pour into the mortgage market. When home prices were soaring, everyone seemed to be winning.
Now that home prices are falling, this process doesn’t look so good. It turns out that a lot of the boxes contained shaky “subprime” mortgages. We still don’t know where all the bad boxes are or the value of what’s inside, but bit by bit they are surfacing at banks, pension funds, insurers, hedge funds and even money market funds. Worse, the once-booming market for alphabet soup securities has seized up, chilling the global financial system.
The markets will limp through to a better day, thanks partly to intervention from the Federal Reserve and other central banks. But what lessons can we take away from this crisis?
Should we slap regulations on the derivatives markets? Unintended consequences could make these fog-bound markets even more opaque.
How about requiring more disclosure? Great idea, but it might lead to even longer and more heavily lawyered financial reports.
No, my fondest dream is that somehow, Wall Street itself will shake off its addiction to financial engineering. I hope that’s not just another holiday fantasy.