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Frenzied Innovation

The two factors of extraordinarily low interest rates and surging global investor demand combined with the growth of Internet technology to produce a period of intense financial innovation. Designing new ways to invest had long been a Wall Street specialty: Since the 1970s, bankers and traders had regularly unveiled new futures, options, and derivatives on government and corporate debt—even bonds backed by residential mortgage payments. But now the financial innovation machine went into high gear. Wall Street produced a blizzard of increasingly complex new securities.

These included bonds based on pools of mortgages, auto loans, credit card debt, and commercial bank loans, sliced and sorted according to their presumed levels of risk. Sometimes these securities were resliced and rebundled yet again or packaged into risk-swapping agreements whose terms remained arcane to all but their authors.

Yet the underlying structure had a basic theme. Financial engineers start with a simple credit agreement, such as a home mortgage or a credit card. Not so long ago, such arrangements were indeed simple, involving an individual borrower and a single lender. The bank loaned you money to buy a house or a car, and you paid back the bank over time. This changed when Wall Street bankers realized that many individual mortgages or other loans could be tied together and “securitized”—transformed from a simple debt agreement into a security that could be traded, just as with other bonds and stocks, among investors worldwide.

Now a monthly mortgage payment no longer made a simple trip from a homeowner’s checking account to the bank. Instead, it was pooled with hundreds of other individual mortgage payments, forming a cash stream that flowed to the investors who owned the new mortgage-backed bonds. The originator of the loan—a bank, a mortgage broker, or whoever—might still collect the cash and handle the paperwork, but it was otherwise out of the picture.

With mortgages or consumer loans now bundled as tradable securities, Wall Street’s second idea was to slice them up so they carried different levels of risk. Instead of pooling all the returns from a given bundle of mortgages, for example, securities were tailored so that investors could receive payments based on how much risk they were willing to take. Those seeking a safe investment were paid first, but at a lower rate of return. Those willing to gamble most were paid last but earned a substantially higher return. At least, that was how it worked in theory.

By mid-decade, such financial innovation was in full frenzy. Any asset with a cash flow seemed to qualify for such slice-and-dice treatment. Residential mortgage loans, merger-and-acquisition financing, and even tolls generated by public bridges and highways were securitized in this way. As designing, packaging, and reselling such newfangled investments became a major source of profit for Wall Street, bankers and salesmen successfully marketed them to investors from Perth to Peoria.

The benefits of securitization were substantial. In the old days, credit could be limited by local lenders’ size or willingness to take risks. A homeowner or business might have trouble getting a loan simply because the local bank’s balance sheet was fully subscribed. But with securitization, lenders could originate loans, resell them to investors, and use the proceeds to make more loans. As long as there were willing investors anywhere in the world, the credit tap could never run dry.

On the other side, securitization gave global investors a much broader array of potential assets and let them precisely calibrate the amount of risk in their portfolios. Government regulators and policymakers also liked securitization because it appeared to spread risk broadly, which made a financial crisis less likely. Or so they thought.

Awash in funds from growing world trade, global investors gobbled up the new securities. Reassured by Wall Street, many believed they could successfully manage their risks while collecting healthy returns. Yet as investors flocked to this market, their returns grew smaller relative to the risks they took. Just as at any bazaar or auction, the more buyers crowd in, the less likely they are to find a bargain. The more investors there were seeking high yields, the more those yields fell. Eventually, a high-risk security—say, a bond issued by the government of Venezuela, or a subprime mortgage loan—brought barely more than a U.S. Treasury bond or a mortgage insured by Fannie Mae.

Starved for greater returns, investors began using an old financial trick for turning small profits into large ones: leverage—that is, investing with borrowed money. With interest rates low all around the world, they could borrow cheaply and thus magnify returns many times over. Investors could also sell insurance to each other, collecting premiums in exchange for a promise to cover the losses on any securities that went bad. Because that seemed a remote possibility, such insurance seemed like an easy way to make extra money.

As time went on, the market for these new securities became increasingly esoteric. Derivatives such as collateralized debt obligations, or CDOs, were particularly attractive. A CDO is a bondlike security whose cash flow is derived from other bonds, which, in turn, might be backed by mortgages or other loans. Evaluating the risk of such instruments was difficult, if not impossible; yet investors took comfort in the high ratings given by analysts at the ratings agencies, who presumably were in the know. To further allay any worries, investors could even buy insurance on the securities.

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