New York Times op-editorialist and Princeton Professor Paul Krugman has a point when he talks about how financial innovation created the current credit crisis. (Credit is derived from credere -- the Latin word for belief -- and the absence of belief in the ability of lenders to pay back their loans is the result of this crisis). As he argues, lack of transparency in the pricing of complex financial instruments is partially to blame. But Krugman does not address the most important source of the problem -- how the players get paid.

The financial innovation that Krugman blames for the credit crisis is called securitization, a complex system of connected industries:

• Originators make loans mostly to consumers who want to buy houses, cars, or charge things to a credit card;
• In the case of home loans, mortgage brokers encourage people to borrow based on whatever type of loan the originator will pay the broker the highest commission;
• Investment banks buy bundles of mortgages and other asset-backed securities (ABSs) from the originators;
• Rating agencies compete to get fees from investment banks in exchange for the highest rating; and
• Institutional investors such as hedge funds, pension funds, money market funds and insurance companies buy the ABSs to goose their returns at what they thought was low risk.

Continue reading Krugman misses the boat on how financial innovation caused the credit crisis

Krugman misses the boat on how financial innovation caused the credit crisis originally appeared on BloggingStocks on Mon, 03 Dec 2007 10:49:00 EST. Please see our terms for use of feeds.

MarketWatch reports that General Electric Co.'s (NYSE: GE) General Electric Asset Management (GEAM) Trust Enhanced Cash Fund will offer investors the option to redeem holdings at 96 cents on the dollar. I wonder whether this will look like a relatively good deal when we look back on the problems that money market funds are likely to experience due to their exposure to asset-backed securities (ABSs).

The GEAM fund sustained losses due to mortgage-backed securities (MBS) investments and has already let institutional investors exit the fund. No word on the terms these investors received, but if they had other business dealings with GE, I would be very surprised if they got out below 96 cents on the dollar. Meanwhile, GE plans to withdraw $250 million of its own money from the fund.

As I posted yesterday, GEAM is far from the only money market fund in trouble due to investing in MBSs. One thing's clear -- those who get out first will be better off than the small fry that wait until the end to try to redeem their money from these uninsured funds.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns GE stock.

GE bond fund to offer 96 cents on the dollar signaling more money market woes originally appeared on BloggingStocks on Thu, 15 Nov 2007 10:10:00 EST. Please see our terms for use of feeds.