Financial Innovation

I remember when I first heard about CDOs, I didn't understand them--or maybe I should say I did. They were explained to me as being tranched securities of tranched securities: that is, they took subordinated debt pieces, wrapped them together, and then tranched them again, so there were senior pieces of subordinated tranches.

But these really weren't senior pieces--they were "mezzanine " pieces--pieces that got paid after the original senior piece got paid, but before the sub of the sub got paid. In any event, it was pretty risk stuff, and it is now taking a beating.

Nevertheless, just because people invested stupidly in innovative securities, innovations in securities are not per se bad things, and on net (in my view) contribute benefits. The development of the mortgage backed security market in the 1970s was an important and welfare enhancing innovation that brought liquidity to the mortgage market everywhere in the United States, and perhaps preserved the 30-year fixed rate mortgage as an instrument for American consumers. Even now, the conventional conforming mortgage market continues to cook along just fine.

Perhaps the most important thing the Fannie/Freddie MBS market did was bring standardization to mortgages, so that they could be underwritten, packaged and sold as commodities. The mortgages creating the problems we are facing now are anything but standard.