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Wall Street Business Model as Financial Origami

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One year after the most sweeping overhaul of financial market regulations in U.S. history, hundreds of rules mandated by the Dodd-Frank Act have yet to be written. And hundreds of thousands of U.S. taxpayers have yet to understand how the Wall Street business model collapsed in 2008 and why they were called upon to bail out the firms.

They've been told that difficult-to-understand financial instruments and complicated strategies lay at the heart of the financial crisis. Nothing could be further from the truth. The simplicity of Wall Street's business model is often masked by the supposed complexity of its innovations. And imposing the new regulations is apt to spawn more of what some people call financial engineering, and what I call financial origami -- the ancient Japanese art of folding paper into novel and intriguing shapes.

The late Merton Miller, winner of the 1990 Nobel Prize in economics, described the process this way: "The major impulses to successful innovations have come, I am saddened to say, from regulations and taxes.'' Given that regulations provide incentives for financial origami, regulators and legislators may be fighting a losing battle.

Start with the idea that Wall Street's job is to transfer risk from those who don't want it to those who do, using one or more of the three pieces of paper: stock, bond and derivative.

Stocks and bonds transfer risk from an entrepreneur to those who want to take a chance on a business's future earnings. Derivatives offer a type of insurance against financial losses.

The variations on these products aren't as complex as they sound or look. The firms simply fold and refold the attributes of these three core pieces of paper into intricate designs, sometimes to skirt regulations, sometimes to meet investor needs, always to make as much money as possible.

For example, the all-or-none proposition of owning a stock or a bond doesn't sit equally well with every investor. So Wall Street developed hybrid securities such as convertible bonds and convertible preferred stock, which mix attributes of the hierarchy of claims on a company's earnings and assets.

Today's derivatives are variations on three vehicles with even older roots: futures (used in medieval trading fairs), options (recorded in Aristotle's writings) and swaps (dating from when people lived in caves). All three are insurance-like contracts binding participants to perform specific transactions in the future if a specified event happens.

Investors can invest, trade, speculate, bet or gamble with these instruments, but the vehicles themselves are just pieces of paper, some with prettier shapes or more clever designs than others.

Wall Street's financial origami hasn't been limited to the products in which it traffics. In 1971, the largest firms began to refold themselves into public companies from private partnerships after the New York Stock Exchange dropped a rule prohibiting its members from using that corporate structure.

The trend accelerated in the 1980s and Wall Street migrated from being agents of risk transfer to principals of it, willing to take the other side of the trade in order to facilitate customers' orders. It used other people's money raised in the public offerings to finance the operation, but retained the compensation structure calculated off revenue.

Wall Street also began to refold the industry. Where once firms specialized, now they sought to offer one-stop shopping for all services. This vertical structure left the Street vulnerable to all manner of conflicts of interest to which it has periodically succumbed over the years, most prominently in the late 1990s during the Internet boom when Wall Street bankers and analysts used research to promote stocks of companies in order to get investment banking business from clients.

Wall Street also applied financial origami to the mortgage-lending process, unfolding the origination, funding and servicing components so they could be carried out by separate companies. For decades, banks and savings and loans had performed all three functions and kept the mortgages until they were paid off.

This financial origami created conflicts of interest and incentives to grant loans bankers previously might never have made. We now know some of them were low quality and didn't conform to the standards set by government-sponsored enterprises, such as Fannie Mae and Freddie Mac, which also bundled, insured and sold mortgages as bonds to investors.

The ultimate folding of paper wasn't credit default swaps, but what the Street did with them. Packaging what were effectively insurance premiums and selling that cash flow as though it came from an asset turned out to be one fold too far. Wall Street wasn't securitizing an asset; it was securitizing a potential liability.

Miller saw it all quite clearly: "The government is virtually subsidizing the process of financial innovation just as it subsidizes the development of new seeds and fertilizers, but with the important difference that in financial innovation the government's contribution is typically inadvertent.'' The Obama administration and congressional efforts to regulate the financial markets will only foster new forms of financial origami, not eliminate them.

Brendan Moynihan is an editor-at-large at Bloomberg News and the author of Financial Origami: How the Wall Street Model Broke, Bloomberg Press, 2011.