Wall Street's 5 Most Dangerous Financial Innovations

397913 01: Employees of the Houston-based energy trading firm Enron walk past the company's logo outside the corporate headquarters November 29, 2001 in Houston, Texas. The energy giant, which at one point handled some one-fifth of all US natural gas and electricity trade, is on the verge of bankruptcy after Dynery Inc. called off its proposed deal to buy Enron on November 28. (Photo by James Nielsen/Getty Images)
James Nielsen/Getty ImagesBy using special-purpose entities (No. 3 on our list of terrible Wall Street innovations), Enron was able to hide its massive debts for years -- until the house of cards collapsed and it was forced to file for bankruptcy.
A former chairman of the Federal Reserve once remarked that the ATM was the last financial innovation he could think of that actually improved society. For the record, the first such device was installed in 1969.

Although this might overstate the case, there's no question that Wall Street's financial engineers -- like the eccentric fictional scientist Victor Frankenstein -- have subjected society to more than their fair share of monsters. The resulting carnage has cost investors, employees, and taxpayers hundreds of billions of dollars.

What follows, in turn, are the five worst financial innovations that have been let loose on society over the past few decades.

1. Credit-default swaps

The real estate crash that triggered the recent financial crisis was the result of many factors. Wall Street bankers packaged faulty mortgages into bond-type securities that were sold to investors. Mortgage brokers eschewed underwriting standards to juice origination volumes. Property appraisers inflated home values. And homeowners used their properties as ATMs, withdrawing equity as values rose.

But underlying all of this madness was the credit-default swap.

Originally developed by financial gurus at JPMorgan Chase (JPM), the first CDS shifted the credit risk on a massive loan held by JPMorgan to a third party who agreed to assume the risk of default in exchange for premium payments, much as an insurer would.

In short order, bankers convinced themselves that they had stumbled upon the holy grail of finance: the complete eradication of credit risk. What followed was a lending boom (and bust) unlike any experienced since the Roaring 1920s.

2. Portfolio insurance

On a single day in October 1987, the Dow Jones Industrial Average (^DJI) dropped an astounding 22.61 percent. The plunge was nearly twice as deep as Black Tuesday, which triggered the Great Depression, and it remains leaps and bounds larger than anything we've experienced since.

The culprit? Portfolio insurance.

Developed to give investment managers a hedge against declines in the stock market, it turned an otherwise typical drop into a total rout, as computers programmed to execute the strategy flooded the New York Stock Exchange with orders to short the market.

3. Special-purpose entities

The Enron debacle wasn't an isolated incident. It was rather a byproduct of the accounting rules that governed publicly traded companies at the time.

One rule in particular, known as FAS 140, allowed companies to set up separate legal entities, which they continued to own virtually outright, and then offload copious amounts of debt onto them.
To the unwitting investor or regulator, it was as if the liabilities had evaporated into thin air.

But, then, of course, they had not -- as we came to find out in 2001, when Enron was forced to absorb its off-balance-sheet liabilities and file for bankruptcy. All told, it's estimated that shareholders lost $74 billion in the four years before the company's bankruptcy.

4. Stock-index futures

Whatever one thinks about Wall Street, there's simply no question that it serves the important purpose of making the capital of those with an excess (savers) available to those who need more (growing businesses, homebuyers, etc.). Stocks do this by giving investors equity in a business. Bonds do so by offering a claim on the underlying assets.

But not every financial product marketed by the gurus on the southern tip of Manhattan serves such a utilitarian purpose. One of the worst offenders in this regard is the stock-index future, which amounts to a zero-sum bet on the direction of stocks. It doesn't raise capital. It doesn't give the owner a stake in any business. It's a wager -- nothing more, nothing less.

It's for this reason that Warren Buffett tried to stem the proliferation of stock-index futures, arguing to Congress in 1982 that "We do not need more people gambling in nonessential instruments identified with the stock market."

5. The leveraged buyout

The leveraged buyout is perhaps the greatest financial travesty of modern capitalism.

Resembling a home mortgage, the tactic allows financiers, typically private-equity companies like Kohlberg Kravis Roberts (KKR) or the Blackstone Group (BX), to buy an entire company with a comparatively tiny down payment. The rest of the purchase price is financed by debt that is -- and this is the critical point -- collateralized by the assets of the company being acquired.

And herein lies the problem. The company that's acquired becomes so overwhelmed with interest payments that it's forced to cut back in other places. Thus, while a handful of financiers make off like bandits, employees become the unwitting beneficiaries of lower pay and unemployment.

The bottom line

At the end of the day, Wall Street is no different from any other industry. Pharmaceutical companies produce bad drugs. Car companies manufacture lemons. And restaurants serve bad food. As a result, what matters is the consumer's ability to distinguish between good products and bad.

Motley Fool contributor John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our newsletter services free for 30 days.

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Lonnie R McVaigh

Capitalism is a POOR replacement for a Democracy... And, the American Dream was NEVER to be Owned by a Capitalist and EXPLOITED on a JOB...

The real reason for POVERTY is CAPITALISM. Private Ownership should end at your Garage or Front Door because there is NO Pride in Ownership of your fellow Human Beings...

Corporations are NOT People too. They are nothing more than Entities that Possess Holdings, Never Live or Die and are concerned not with Human Values only Intrinsic Values. They may have been Founded with the good intentions to build the community of that Founder, but even those intentions died with that Founder. The Entity was then left as a mere Frame Work to be manipulated as a subsidy, with little regulation to a World Traded Multi-National Financial Concern...

A Pay Check for a Elite Capitalistic shell of a Human Being who has little concern for the Humanity who the now Ancient Founder cared so much and that Community that was built... Being Conservative is NOT being a Capitalist... Being Conservative is believing in long proven Values such as being Humane, no Dog required, just a God. That is simply, being and acting Human-Like... Kind of the same with Christianity is being Christ-Like!!! The guy who made himself a Servant, to the POOR, The Widowed and Disabled...

The Rich man was told to "GO!!!", give all you have to the Poor and then you could come follow me... Christ's Words, not mine!!! Still nothing, "Trickle Down", Capitalistic or about todays "Taxes for Big Government"... That's the Deadly Sin called GREED...

August 27 2013 at 11:50 AM Report abuse +2 rate up rate down Reply
johnguthrieyates

Organized crime, that's what this is ... pure and simple. And with the dollar amounts involved dwarfing anything our government has labeled organized crime or the enormity of the impact on the entire world's population ... you'd think the good old boys down in Washington could prioritize just a bit better as to who they spend so much time and money going after. The Gambino Family ... didn't bring us to the brink. And sadly, this is a conspiracy of grand proportions. Our government has not only looked the other most of the time, they allow it to happened. You want to make a difference, we don't need change. You can keep your change you filthy animal ... what we need is correction ... sink your teeth into that ... I honestly do not believe this country was supposed to wind up like this.

August 27 2013 at 9:07 AM Report abuse +2 rate up rate down Reply
joethightwad

Buffett warned long before the Great Recession that derivatives are financial weapons of mass destruction. Options and futures have a legitimate place in commerce. Manufacturers need to lock in the price of essential materials; producers of those materials benefit from locking in a sales price for future delivery. In both cases this eliminates uncertainty in planning decisions. It's the "exotic" derivatives used by speculators with no stake in either the production or use of goods that distorts markets. Similarly, trading huge numbers of stock options, puts and calls, not for the purpose of protecting a position or acquiring one at a favorable price but only to generate a quick profit by arbitrage is nothing more than manipulation of the market.

August 27 2013 at 8:49 AM Report abuse +3 rate up rate down Reply
Sherrie

Well, this article makes a start on listing the diseases. The patient, unfortunately 1. Doesn\'t believe he is very ill, just aches and pains. 2. Thinks the doctor should take the medicine AND foot the bill.

August 26 2013 at 9:37 PM Report abuse +2 rate up rate down Reply
betty_brock

Go ahead and print a few trillion more, FED. Make the money we have saved worthless.

August 26 2013 at 8:38 PM Report abuse +2 rate up rate down Reply
SPQR

And we have done what? to correct these devils?

August 26 2013 at 7:06 PM Report abuse +1 rate up rate down Reply
kimarkintl

Money Greed Power

August 26 2013 at 6:24 PM Report abuse +3 rate up rate down Reply
foxylynx

Wall St along with Gov officials have turned into the biggest Mafia ever invented and it has sucked the life out of 80% of the population. The top keep getting richer while the rest of us langor - there is no recovery - only for a precious, corrupt few.

August 26 2013 at 5:47 PM Report abuse +3 rate up rate down Reply
johndson

Until insurance companies go BACK to being insurance companies, banks go BACK to LOW RISK banking operations, conglomerate monopolies are disassembled into smaller components, and the SEC is returned to its former status that allowed constant real time OVERSIGHT, and ever present enforcement of working capitol levels always being on hand PRIOR to enormous risk trading, along with all dubiously valued faux securitiy trading instruments being disallowed completely, we have more than 5 dangerous situations ALL of which could cause a colossal collapse. Reform, regulate, oversee, and monitor Wall St!! Deregulation has FAILED and WILL FAIL AGAIN!

August 26 2013 at 5:07 PM Report abuse +1 rate up rate down Reply
flowkay3

Wall St is different than any other industry. Wall Street owns the government .

August 26 2013 at 4:59 PM Report abuse +1 rate up rate down Reply