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Nye Lavalle

November 6, 2007

The financial crisis has become Shakespearean comedy.

An audience would surely roar at the comeuppance delivered to Wall Street's impeccably credentialed mortgage-makers. A group of subprime knaves got the better of them, leaving the Ph.D.s choking on their own hubris.

The subprime realm has thus become a vital portal onto Wall Street, helping us understand just how upside-down the place has become. In this world, risk management is applied retroactively. CEO succession planning is, too.

Don't let those on Wall Street fool you by saying "this is the natural cycle of things." Does it really have to be? Unlike virtually any other industry, Wall Street shakes, twists, and hammers on its innovations until they break. What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?

Ratings downgrades -- defects, really -- have hit about 10% of the subprime related derivatives, known as collateralized debt obligations. The number is expected to rise in the weeks ahead. By random comparison, the Food and Drug Administration allows defect rates of about 3% for surgical gloves. Semiconductor manufacturers produce defect rates of about .05%.

"That's the thing about Wall Street that amazes me. They keep making the same mistakes" says Jim Keegan, who oversees a $20 billion fixed-income portfolio for American Century Investments, and who foresaw this spring that credit markets would convulse. "They can't seem to get out of their own way.

Of course, plenty of this financial innovation is good and sensible, as noted by Harvard Business School professor Peter Tufano. Securitization, for example, "has done lots of things in the economy for lots of years," he says, be it helping underwrite more student loans or greater home ownership. And it would be silly to think that risky activities don't come with the potential for losses.

Yet as the innovations are pushed further and further, it's hard not to focus on the foul-ups. That's largely because the tests are not carried out in an isolated airplane hangar, but in the real-world venue of the markets. "It's pretty hard to simulate in a laboratory," Dr. Tufano notes.

One example: Collateralized debt obligations began life inside the shop of junk-bond king Michael Milken, during the last debt crisis of the late 1980s. Stuck holding a collection of corporate bonds in such companies as the infamously failed Campeau Corp., Mr. Milken's Drexel Burnham Lambert fused a number of lagging issues into what were then known as "collateralized bond obligations."

Over the ensuing years, the structure was stretched ever further, and eventually came to embrace a way of securitizing home mortgages. We'll leave it to assistant U.S. Treasury Secretary Anthony W. Ryan to describe what happened next, as he did before Congress in September: "Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others."

It is, of course, the nature of markets that capital should flow to where it is most needed. But the subprime market eventually pivoted on a quirk of need. It was lenders -- not borrowers -- who most needed the loans.

Without a production-line of mortgages, the inventory for all those fee-paying derivative securities would dry up. Merrill Lynch went so far as to buy mortgage-originating banks to keep up its supply. Whether scoundrels or simply opportunists, the subprime borrowers took what was available, preferably something with a nice lawn.

Consider another sector of this upside-down world. Over the last few years, standard bank deposits became less desirable. It was too costly building branches and bidding for deposits, especially when more flexible wholesale funding could be created at a moment's notice via fresh short-term paper. That was the reasoning of Countrywide Financial, and a slew of other players such New Century Financial and Northern Rock PLC of the United Kingdom.

It was great, as long as the paper could be repeatedly rolled over. When it couldn't, the companies would be well out of business. But how could that possibly happen?

The markets are best served when they "do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have," writes Richard Bookstaber, in his latest book, "A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation."

As a hedge-fund manager himself, Mr. Bookstaber acknowledges that in the real world of "normal accidents and primal risks, limitless trading possibilities might cause more harm than good."

Financial cycles are natural, we're told. Of course they are. But they also make a wonderful excuse for lots of bad, or downright dumb, behavior. Does it really have to be?

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