Wall Street’s 5 Most Dangerous Financial Innovations

397913 01: Employees of the Houston-based energy trading firm Enron walk past the company's logo outside the corporate headquarters November 29, 2001 in Houston, Texas. The energy giant, which at one point handled some one-fifth of all US natural gas and electricity trade, is on the verge of bankruptcy after Dynery Inc. called off its proposed deal to buy Enron on November 28. (Photo by James Nielsen/Getty Images)
James Nielsen/Getty ImagesBy using special-purpose entities (No. 3 on our list of terrible Wall Street innovations), Enron was able to hide its massive debts for years — until the house of cards collapsed and it was forced to file for bankruptcy.

A former chairman of the Federal Reserve once remarked that the ATM was the last financial innovation he could think of that actually improved society. For the record, the first such device was installed in 1969.

Although this might overstate the case, there’s no question that Wall Street’s financial engineers — like the eccentric fictional scientist Victor Frankenstein — have subjected society to more than their fair share of monsters. The resulting carnage has cost investors, employees, and taxpayers hundreds of billions of dollars.

What follows, in turn, are the five worst financial innovations that have been let loose on society over the past few decades.

1. Credit-default swaps

The real estate crash that triggered the recent financial crisis was the result of many factors. Wall Street bankers packaged faulty mortgages into bond-type securities that were sold to investors. Mortgage brokers eschewed underwriting standards to juice origination volumes. Property appraisers inflated home values. And homeowners used their properties as ATMs, withdrawing equity as values rose.

But underlying all of this madness was the credit-default swap.

Originally developed by financial gurus at JPMorgan Chase (JPM), the first CDS shifted the credit risk on a massive loan held by JPMorgan to a third party who agreed to assume the risk of default in exchange for premium payments, much as an insurer would.

In short order, bankers convinced themselves that they had stumbled upon the holy grail of finance: the complete eradication of credit risk. What followed was a lending boom (and bust) unlike any experienced since the Roaring 1920s.

2. Portfolio insurance

On a single day in October 1987, the Dow Jones Industrial Average (^DJI) dropped an astounding 22.61 percent. The plunge was nearly twice as deep as Black Tuesday, which triggered the Great Depression, and it remains leaps and bounds larger than anything we’ve experienced since.

The culprit? Portfolio insurance.

Developed to give investment managers a hedge against declines in the stock market, it turned an otherwise typical drop into a total rout, as computers programmed to execute the strategy flooded the New York Stock Exchange with orders to short the market.

3. Special-purpose entities

The Enron debacle wasn’t an isolated incident. It was rather a byproduct of the accounting rules that governed publicly traded companies at the time.

One rule in particular, known as FAS 140, allowed companies to set up separate legal entities, which they continued to own virtually outright, and then offload copious amounts of debt onto them.

To the unwitting investor or regulator, it was as if the liabilities had evaporated into thin air.

But, then, of course, they had not — as we came to find out in 2001, when Enron was forced to absorb its off-balance-sheet liabilities and file for bankruptcy. All told, it’s estimated that shareholders lost $74 billion in the four years before the company’s bankruptcy.

4. Stock-index futures

Whatever one thinks about Wall Street, there’s simply no question that it serves the important purpose of making the capital of those with an excess (savers) available to those who need more (growing businesses, homebuyers, etc.). Stocks do this by giving investors equity in a business. Bonds do so by offering a claim on the underlying assets.

But not every financial product marketed by the gurus on the southern tip of Manhattan serves such a utilitarian purpose. One of the worst offenders in this regard is the stock-index future, which amounts to a zero-sum bet on the direction of stocks. It doesn’t raise capital. It doesn’t give the owner a stake in any business. It’s a wager — nothing more, nothing less.

It’s for this reason that Warren Buffett tried to stem the proliferation of stock-index futures, arguing to Congress in 1982 that “We do not need more people gambling in nonessential instruments identified with the stock market.”

5. The leveraged buyout

The leveraged buyout is perhaps the greatest financial travesty of modern capitalism.

Resembling a home mortgage, the tactic allows financiers, typically private-equity companies like Kohlberg Kravis Roberts (KKR) or the Blackstone Group (BX), to buy an entire company with a comparatively tiny down payment. The rest of the purchase price is financed by debt that is — and this is the critical point — collateralized by the assets of the company being acquired.

And herein lies the problem. The company that’s acquired becomes so overwhelmed with interest payments that it’s forced to cut back in other places. Thus, while a handful of financiers make off like bandits, employees become the unwitting beneficiaries of lower pay and unemployment.

The bottom line

At the end of the day, Wall Street is no different from any other industry. Pharmaceutical companies produce bad drugs. Car companies manufacture lemons. And restaurants serve bad food. As a result, what matters is the consumer’s ability to distinguish between good products and bad.

Motley Fool contributor John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase. Try any of our newsletter services free for 30 days.

  • Brand Value: $27.8 billion

    Percent Change v. 2012: 34%

    What Happened: MasterCard’s rank flew up nine spots this year to the 20th most valuable brand in the world, and Millward Brown VP Oscar Yuan attributes that ascent to “the growth of mobile technology.” As consumers up their online shopping habits, brands like Mastercard and Visa reap the rewards for offering noncash payment methods.

    20. MasterCard

  • Brand Value: $34.36 billion

    Percent Change v. 2012: 34%

    What Happened: “They’re really into the big data,” Yuan explained of the German tech brand, “So [the increase in value] is reflective of a consistent storyline: The growth of mobile shopping.” SAP has the big data solutions enterprise companies need.

    19. SAP

  • Brand Value: $36.2 billion

    Percent Change v. 2012: 5%

    What Happened: Walmart, however, has mastered the art of brick and mortar shopping. “You can’t buy milk online,” Yuan said. The retail giant has a large and loyal consumer base that is constantly growing – even internationally.

    18. Walmart

  •    ↵

    Brand Value: $39.7

    Percent Change v. 2012: -8%

    What Happened: Vodafone’s 8% drop in value can be attributed to O2 and Orange’s recent success. But at almost $40 billion, it is still one of the largest mobile carriers in the UK.

    17. Vodafone

  • Brand Value: $41.1 billion

    Percent Change v. 2012: -1%

    What Happened: While Americans might have never heard of the Industrial Commercial Bank of China, Yuan explains that in its home country, “the logo is ubiquitous.” ICBC is the first of two Chinese brands in the top 20, a number which is largely due to the countries growing middle class.

    16. ICBC

  • Brand Value: $42.7 billion

    Percent Change v. 2012: 15%

    What Happened: “I think a lot of the growth is really tied to several consumer trends – and I’m talking about the need for consumers to shop online mobile devices,” Yuan told BI. Consumers need to get the products they bought on the internet somehow, and that’s where UPS comes in.

    15. UPS

  •    ↵

    Brand Value: $45.7 billion

    Percent Change v. 2012: 34%

    What Happened: It’s almost impossible for brick and mortar shops to compete with Amazon’s wide selection, low prices, and mastery of the mobile marketplace – easily allowing consumers to buy anything from anywhere on their phone or tablet. Recent acquisitions of Audible.com and Goodreads also show the company’s determination to dominate all aspects of mobile book consumption and sharing.

    “There’s no stopping amazon as they go international,” Yuan said.”

    14. Amazon

  •    ↵

    Brand Value: $47.7 billion

    Percent Change v. 2012: 20%

    What Happened: After acquiring Wachovia in 2008, Wells Fargo successfully expanded from a California-based bank to a national name. Coming from California also helped Well’s Fargo’s image with consumers considering that it was one of the few banks to remain unscathed during the financial crisis. “It also started a major rebranding strategy expansion,” Yuan said.

    13. Wells Fargo

  • Brand Value: $53 billion

    Percent Change v. 2012: 8%

    What Happened: Verizon got a boost after Apple opened its services to carriers other than just ATT. While Verizon and ATT’s rivalry heats up, Yuan predicts that the competition will up both brands’ game. “As data devices continues to proliferate, we will continue to see Verizon do well,” he said.

    12. Verizon

  • Brand Value: $55.3 billion

    Percent Change v. 2012: 21%

    What Happened: “GE … continued to be one of the most well respected consumer and industrial brands in the world,” Yuan said. And the public is starting to see that it makes more than just light bulbs. General Electric has dedicated major marketing dollars to making sure that consumers know it produces everything from airplane engines to wind turbines to medical equipment. Hammering in its dedication to innovation, a recent ad campaign even enlisted the help of famous robots.

    “In terms of B2B, GE is one of the most well respected brands,” Yuan continued, citing that it was often used in business school case studies.

    11. GE

  • Brand Value: $55.4 billion

    Percent Change v. 2012: 18%

    What Happened: China Mobile is the largest mobile carrier and brand in China, so it’s a no-brainer that it’s one of the most valuable brands in the world. “There are more mobile phone subscribers in China than in the U.S.,” Yuan said.

    10. China Mobile

  • Brand Value: $56 billion

    Percent Change v. 2012: 46%

    What Happened: A key way to bolster global presence is to sponsor the Olympics. But that’s not the only thing that upped Visa’s brand value so drastically. As one of the most trusted names in non-cash payments, Visa has gained clout in the world of online shopping and mobile payments.

    9. Visa

  • Brand Value: $69.4 billion

    Percent Change v. 2012: -6%

    What Happened: Marlboro is a top 10 regular, which goes to show that even though smoking is restricted in the U.S. doesn’t mean that the rest of the world has laid off the habit. “Marlboro has consistently invested in the brand ever since its inception,” Yuan said. “The rugged cowboy is very strong and consistent globally.”

    To put it another way, “about 25% of world’s population are smokers, and they use it 5 to 10 times a day. I don’t drink 10 bottles of water a day.” That’s getting your brand out there.

    8. Marlboro

  • Brand Value: $69.8 billion

    Percent Change v. 2012: -9%

    What Happened: As a $70 billion brand, Microsoft is in great shape even in spite of a 9% value decrease. Microsoft is a powerhouse and has a reputation as one of the strongest tech brands in the business. But, Yuan notes, “with consumers, there’s confusion as to where Microsoft fits.” The company’s fortune is largely tied with the PC business, but it has emerged on the mobile scene with the Surface and other devices. The company went through a major rebranding in the summer of 2012 to stay relevant.

    7. Microsoft

  • Brand Value: $75.5 billion

    Percent Change v. 2012: 10%

    What Happened: ATT is another company to gain value due to the increasing U.S. consumption of mobile products. For a long time, the service provider had an exclusive deal with the iPhone, so it became synonymous with the new technology. What’s really interesting, however, is that even when Apple opened the iPhone up to Samsung and T-Mobile, ATT’s value didn’t go down.

    6. ATT

  • Brand Value: $78.4

    Percent Change v. 2012: 6%

    What Happened: “What’s consistently impressive about Coca-Cola is its ability to innovate,” Yuan said. “People think that soda consumption is declining, but Coke is turning the business on its head.” For example, this year Coca-Cola released a series of freestyle machines which allows consumers and retailers to mix their own flavors of the soda syrup to make their own individual Coca-Cola. The company is constantly innovating and staying fresh.

    5. Coca-Cola

  • Brand Value: $90.3 billion

    Percent Change v. 2012: -5%

    What Happened: Yuan noted that one of McDonald’s gifts was the ability to listen to consumers’ sentiments and adapt, particularly to growing health concerns. “It has come out with a much healthier menu with apple slices, oatmeal, and a Chicken McWrap which has done well,” he said.

    McDonald’s is also gaining a stronghold in the coffee space, which should be an interesting new endeavor to follow.

    4. McDonald’s

  • Brand Value: $112.5 billion

    Percent Change v. 2012: -3%

    What Happened: At $112.5 billion, IBM’s three percent value decrease is not a substantial figure. IBM is known as a company that consistently delivers year after year, Yuan told BI. And it is particularly hailed in the B2B sphere.

    Yuan also noted that its Ogilvy-made “Smarter Planet” campaign, in which the company explained its plans to help clients innovate and make the world a better place, inspired consumers to believe in the brand.

    3. IBM

  • Brand Value: $113.7 billion

    Percent Change v. 2012: 5%

    What Happened: Google has effectively taught consumers that it is more than just a search-based company. With maps, mail, shopping, and more, Google is integrated into everyone’s lives. The company also made recent headlines about its new contribution to the hardware world in the form of Google Glass. “It will be interesting to see how Google Glass will contribute to the brand value, but now it’s too soon to tell,” Yuan said.

    2. Google

  • Brand Value: $185 billion

    Percent Change v. 2012: 1%

    What Happened: In spite of harsh Wall Street analysis and media speculation regarding Tim Cook’s leadership capabilities, Apple continues to be a strong brand in the eyes of consumers – a major value measurement for Millward Brown. “Despite what the press says and stock market says,” Yuan noted, “Apple in the eyes of the consumers is the gold standard.”

    In the last eight years, Apple’s value has increased 1,045% – only topped by Subway’s meteoric 5,145% rise. (Although Subway still hasn’t broken the top 20.)

    Those companies are constantly innovating to stay on the top.[Those companies are constantly innovating to stay on the top.]The gay pride Oreo, from Kraft’s Facebook page.

    1. Apple

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