Every thirty years the financial markets have a day of reckoning and get new regulations. Then the financial institutions set off afresh to invent new financial instruments that are unregulated.
We have four particularly dangerous instruments (and one accounting practice) that have been invented in the past 30 years that have come into wide usage. And failed.
1. Sub-prime mortgages bought by government agencies Freddie and Fannie and sold as bonds. The bonds, built up around these mortgages, are government guaranteed..in effect, as was proven last weekend when the government took over the two companies. Terrible idea to induce profit making companies to do anything guaranteed by the government. The same still remains true for student loans.
2. All sorts of bonds backed by mortgages have been cut into pieces with different risks (called tranches). These bonds are called CMO's or generally CDO's. Collateralized XXX Obligations. You can buy one with low risk with a 3% yield or another with lots of sub-prime in it for 9% yield. Bad idea if the risk is not properly calculated to include mortgages coming out of Las Vegas and Riverside where the whole market collapsed.
3. Derivatives, also called leveraged options, are an instrument invented by mathematicians (mathematicians on Wall Street are called quants) to guarantee safe investments. They used high level math to offset two different risk groups against each other. The guaranteed safety of the offsetting options allow the owner to borrow (leverage) the 'safe bet.' Bad idea unless you deeply understand the math, which always included a risk component. Long Term Capital found out about the tiny but perverse risk element when it went under because of the fall of the Russian ruble. Banks and other lenders got stuck with many of these leveraged options because the banks provided the leverage.
4. Hedgefunds. These are funds that are unregulated because they were supposedly such high risk investments that they would only be favored by the very rich. Available on to the very rich so he U.S. government didn't care who got burned by bad investments in derivatives and other exotica. Bad idea, hedgefunds invested in all of the above new financial instruments...consequence, when the investments went bad the rich investors demanded their money back and, surprise, the banks were left holding the bag.
5. Changes in accounting, intended to make assets on the books more transparent, have had a perverse effect as I've point out before. When a mortgage loan misses three payments it is totally charge-off and charged against earnings or a reserve is taken from other assets to offset the loan. This wildly exaggerates a slow down into a massive disaster for the company holding the mortgage.
All this because bad mortgages have risen, so far, from .5% of all mortgages to 1.3%. One hell of a lot of leverage has been piled on top of this hand-full of mortgages.