What is the point of credit default insurance ?

I stress again that I am technically an economist, but I have focused on everything except for money and banking (OK everything but money, banking and Neo-Austrian theory) so I am ignorant on this topic.

I am interested in understanding why financial innovation is profitable. I can think of two key reasons for new instruments. One is that they make risk diversification possible, the other is that they enable regulated entities to evade prudential regulations.

I would tend to guess that the second is the more important.

My thoughts on Credit default insurance.
1) You can hedge against default on bonds by buying a diversified portfolio of bonds
2) Prudential regulations do not take account of this fact, but rather include restrictions on total assets as a function of capital and on the types of assets which entities can own.
3) Credit default insurance makes it legal for regulated entities to own bonds whose rating is low.
4) it is no more effective in avoiding risk than is plain diversification, because a nationwide crisis will bankrupt the insurer.
5) it exists as a means of evading prudential regulation.

If I am right, the smart guys on Wall Street are similar to smart corporate lawyers who made their money by finding ways of evading regulation. That lowers my opinion of them (I thought they were partly gambling and mostly fleecing individual fools who should blame themselves).

Thoughts on other innovations after the jump.

Does anyone else remember when money market funds were new ? Anyone else vague on the difference between a money market fund and a money market account ?

Now I understand that the point is that, theoretically (and not just theoretically any more) the balance of a money market fund is a number of shares each of which is always (almost always now) worth exactly $1, but which does not have a guaranteed price.

Thus, it seems to me, the balances do not count as liquid liabilities of the banks (deposits) for the purposes of reserve requirements, and the assets (commercial paper IIRC) does not count as an asset of the bank. Officially, the bank is just like a broker.

However, the instant that there is a significant risk of breaking the buck, the treasury jumped in to protect them.

The Treasury also said on Friday that it would siphon up to $50 billion from a fund established in the 1930s to conduct foreign exchange market intervention to backstop the rattled U.S. money market mutual fund industry.

This long-safe corner of financial markets, home to some $3.5 trillion of deposits, has increasingly appeared at risk of falling victim to the year-old credit crunch. Money market fund assets dropped by a record $169.03 billion in the week ended September 17 as jittery investors pulled money out.

The Treasury said it would back money market funds whose asset values fall below $1 a share. Separately, the Fed said it would lend money to banks to finance purchases of certain assets from money market funds

This means that banks have avoided paying dues to the FDIC and relaxed capital and reserve requirements in exchange for … an empty threat, since money market funds are too big to fail.

What is the point of pooling pools of mortgage bonds and making new tranches ? Much money was made by taking the middling seniority tranches of pools of mortgage bonds and reslicing them to make senior (AAA) tranches and equity tranches. Was there really any more diversification to be done ? Or was this a way to game the bond ratings ? If the original pools were already well diversified, they would be almost perfectly correlated so all tranches of the pool of pools would be middling risky (mezzanine). Were the original pools poorly designed or was the aim to get an AAA rating for a risky asset ? Even assuming the bond rating agencies are honest, they must work according to rules. I think it very likely that everyone knew that the senior tranches of pools of pools were risky (they paid higher than standard AAA rates) and that entities which weren’t allowed to buy risky bonds didn’t care.

That this was not a way of diversifying risk but a way to evade prudential regulations.

I suspect that financial innovators not only undermined the US financial system, but did it on purpose, creating instruments whose only role was to technically comply with prudential regulation while making a crisis inevitable sooner or later.