A good friend of mine was one of the early practitioners in Europe of complex financial engineering for large corporate clients.  I vividly remember a conversation with him on a vacation some 20 years ago, when he told me about a deal that was meant to remove energy cost risk from a company and sell that risk off separately.  At the time he made the argument that this allowed for better hedging on part of the company and allowed investors to take a position in this risk alone.  I took the position that any time you do this you are likely to run into huge incentive problems.  A company that thinks they have sold off all their energy risk has no incentive to try to improve their energy efficiency.  A lack of such improvements is likely to bring with it many other things that don’t get improved (e.g., production processes) that will ultimately come back to bite the company!

I have thought back to this conversation many times over the unfolding of the financial crisis.  Given my involvement with innovative companies as a VC, I am generally excited about innovation and have an open mind for financial products innovation.  But it continues to strike me how much of financial products innovation suffers from severe incentive problems.  The latest case in point are the revelations around the creation of CDOs by Goldman Sachs and others for Paulson to bet against.  It will be up to courts to determine whether there was any punishable offense here, but it is clear that there is a profound incentive problem when one party pays a fee to another party to help create and market a product that the initiating and paying party wants to fail!

I don’t know how this can be fixed other than requiring that folks retain a certain amount of risk.  For instance, mortgage securitization itself wouldn’t have gone so horribly wrong if the original issuers had to have retained meaningful default risk.