What is the point of innovative financial instruments ?

Robert Waldmann
claims that, after the invention of the mortgage based security, which clearly served to diversify risk, there have been three main purposes : weakening the effects of prudential regulations, weakening the effects of prudential charters and making balance sheets look better.

I remain very ignorant about banking and real world finance. Some time ago, a commenter noted that while at first I said I was winging it I seemed much more confident and asked if I had learned a lot or if I was winging it louder. I am winging it louder.

I don’t know what innovative financial instruments have been invented. I tend to assume that the purpose of some is tax avoidance. For all I know, some are used to share risk, and might actually be socially useful.

A very short list of the financial innovations and their purposes follows after the jump

CDO.

Why pool and tranche ? A common argument is that different investing entities have different risk preference, so it is useful to provide them with tranches of different safety. This doesn’t follow at all. In a simple model with no transactions costs and no non-traded assets, all agents buy all risky assets. The more risk averse invest more in the safe asset (treasury inflation protected securities or TIPS). There is no agent who wants a slightly risky AAA tranche but not a mezzanine or equity tranche. If all agents buy equal amounts of all tranches, there is no point in tranching. An intermediary is only needed to pool if the final investors would have to buy odd lots to diversify their portfolio. Individuals did not invest much in CDOs, they were bought by institutional investors who could have diversified on their own.

However, for the purposes of banks’ capital controls, what matters is the amount of AAA, Aaa etc, and not the risk. A special purpose entity which pooled, tranched and sold to a bank reduced the risk adjusted assets of the bank. The purpose of relaxing capital controls was clearly served.
Also some institutional investors have charters which require them to invest only in investment grade debt instruments. CDOs gave them a way to bear the risk of, say, defaults on liars loans, without breaking this rule. CDOs helped neutralize the prudential charter.

I think it must have been about the rating and not overall porfolio risk (value at risk).

Interest rate swaps

Can be reproduced with long and short, spot and forward positions in bonds. However, total assets and total debt are extremely different if the same transaction has the form of an interest rate swap. I think they clearly existed to change the leverage reported on balance sheets without changing any obligations from one party to the other.

Trust-preferred Securities

See post below. They are a way to list debt as equity.

CDS.

A CDS can be reproduced with a REPO account. Consider firm A, firm B and AIG. Let’s go way back when AIG was AAA and assume that firm A is rated A.
First story, firm B buys a debt instrument from firm A and a CDS on the debt from AIG-FP. Firm B will be paid in full unless A and AIG both go bankrupt.
Second story Firm B buys firm A’s debt. Firm B opens a repo account at AIG-FP. It holds AIG bonds and a short position in Firm A bonds in it’s repo account. Firm B is paid in full unless Firm A and AIG both go bankrupt. Since AIG debt is rated safer as firm A debt, firm B has to send money to AIG to keep the repo account in the black and open. It is just like a CDS.

However, there are two differences. First some regulator might not count the repo account as making the debt safe – they definitely counted the CDS as making the debt safe. Second, and much more important, AIG has to issue a bond to make the second scheme work. To insure as much debt as it insured with CDSs AIG would have to issue $ 3 trillion in bonds. After doing that, AIG wouldn’t be rated AAA. The point of CDS is to make liabilities look small. They appear on the balance sheet at market value not at notional value.

AIG couldn’t make $3 trillion in debt instruments safe, yet, given accounting standards, debt rating practices, and Basel I capital controls, it was considered to have done so.

This made its balance sheet look better reasuring counterparties and top management.
Case_Shiller index bonds. Their purpose is neither to evade rules and regulations nor to buff balance sheets. They are useful to local governments trying to hedge risk. They were a total flop with trading volume around zero. They are the exception that proves the rule. Given the stated purpose and justification for financial innovation, they should have been a huge hit. They were a total wiff. This tends to make me more confident that the stated purpose and justification for financial innovation has little to do with reality.

I repeat I am ignorant. There may be other purposes to innovative financial instruments. Obviously I have only discussed the very few new instruments of which I am not completely ignorant. If anyone can describe an instrument which is used for a purpose other than the three I stressed (and, you know, is actually used unlike Case_Shiller bonds) please tell me in comments.