Financial Innovation and Swindlers

The meltdown wiped out and bankrupted famous investors. Evidence even surfaced of involvement by some politicians. The new, clever financial innovations suffered horrible mispricing; investors who believed they were holding solid, liquid assets were left holding empty bags when the markets crashed.
I am, of course, referring to the 1720 British bubble in the South Sea Company, fueled by the new financial innovation known today as common stock. This metaphor is not yet complete, because the British government responded to the financial meltdown aggressively, essentially banning most stock issues for roughly a century. Yet, most of us would agree that the invention of common stock created value in industrializing economies. The initial bad experiences with the financial security in Britain caused concern, fear... and the previously mentioned long-standing ban.
Here's hoping that something similar does not happen with a primary source of our current crisis: the CDO (collateralized debt obligation) and her offspring. Closely related are securities that exist in derivative markets, like credit-default swaps. Although they justly receive blame in the current crisis, in many cases debt securitization can create value. In a simple case, a large number of loans are bundled, carved up by risk exposure, and sold as an equity instrument to investors. In this simple case, default risk is being held by investors who want it.
In the simple case, CDOs make the market more efficient by allocating capital and risk exposure to those who desire it.
So what exactly is the problem? As mentioned above, the same loan may be carved into different tranches based on risk exposure. The highest risk securities are known as “toxic waste”. Who in the hell would purchase these?

Let me step back to a previous post for a moment, one that deals with hedge funds. Hedge funds are notorious “black-boxes”; investors cannot immediately remove their investment, there are few reporting requirements, and investment strategy is not transparent. In short, investors can generally view (reported) returns, but not risk. Additionally, a hedge fund manager's compensation is structured so that the manager receives a portion of upside profits, but no downside penalties. Because high-risk investments carry high potential payoffs, hedge funds are naturally attracted to these types of investment. Here are your “toxic waste” customers.

Due to mistakes with interest rates in the early part of this decade, and the market-making power of hedge funds (as well as other problems), the quality of CDO issuance swiftly deteriorated. It is almost identical to the deterioration in quality of junk bonds from the mid 1980s to the late 1980s. The parallels with junk bonds and the South Sea bubble are not accidents. Nearly every financial innovation results in a financial meltdown of some degree; investors initially tend to underestimate the risks associated with such instruments. This does not mean that the innovation does not have value.
Today, there is a clamor in Washington for more regulation. Much of it is justified. But any sort of ban on financial innovation, in my opinion, is misguided. Focus on the fraudsters and swindlers, not the newfangled shiny derivative instrument they peddled.