"So, My Friends, What is This ... 'Financial Innovation' You Speak Of?"

I've sometimes wondered what would happen if aliens teleported in to Washington and -- since they're aliens, of course, and naturally inquisitive -- began asking questions about anything and everything ("You peel it before you eat it? Ah yes, fascinating. So this Seinfeld, he is like a king to you?"). Eventually they'd get around to the financial crisis and how we plan to prevent such a disaster in the future. And our "wise men" (Geithner, Summers, with some bespectacled lackeys in tow) would patiently explain how we have to restrain bad behavior in the system, while not discouraging financial innovation.

At which point I imagine the lead alien, Zrigfryx, would scratch his ample, hairless dome and say:

"So, my friends, what is this ... 'financial innovation' you speak of?"

And if I were sitting in the back row of the small assembly -- lucky enough to have snagged one of the lottery tickets for the the limited seats available to the public -- I'd thrust my hand high in the air and say, "Oh, I know. I know. Let me answer that one."

Because I'm really starting to understand what this "financial innovation" is that the industry is so hellbent on preserving.

Just the other day, I happened to come across this Bloomberg story about how the investment bank Macquarie Group hired a guy by the name of Christopher Hogg. What particularly caught my eye was Hogg's signature accomplishment: "a developer of one of the most popular financing tools of the 1990s."

So what did he innovate? A way to finance infrastructure projects in poor countries, expanding GDP and turning generous profits at the same time, a real win-win? A more efficient pipeline for getting capital to struggling small U.S. businesses that deserve it?

Nope ... and nope. Hogg came up with "Mips." Cute name. Sounds like a Christmas stocking stuffer that turns into a runaway bestseller. Mips are actually "monthly income preferred securities." They're described as "a type of preferred stock that resembles debt." Now you may wonder, "Why the heck do we need these things? What greater purpose do they serve?"

Well, it's sort of like this: You look at "Mips" through your right eye and you see an equity, like a preferred share of stock. But you look at "Mips" through your left eye and you see a bond -- or debt. Mips involve special purpose vehicles (what doesn't these days, eh?) and an appropriate amount of complexity that I'll skip over here.

The bottom line is, after all the innovating, here's the payoff:

The shares provide benefits of stock because they’re considered equity by debt-rating companies while offering tax advantages of bonds because companies can deduct the dividend payments from income they report on their tax returns.

Got that? Basically Mips are a tax dodge. It's not that Mips have found a way to provide capital more efficiently or smartly ... in fact, in a world with an ideal tax code, Mips probably contribute to the less-efficient allocation of capital. Remember those CLO "innovations" that appeared to offer higher returns for the same risk as other similarly rated products? And how they started inefficiently sucking in capital and no one bothered to ask, "Hey, is the risk just being mispriced here or is there really a free lunch sitting out there on the sidewalk?"

Of course with Mips the rejoinder might be: the U.S. doesn't have an ideal tax code. To which one might reasonably reply: Okay, so which option is better (1) Try to fix the tax code (2) Let people exploit whatever loopholes they can find and the hell with it; happy Easter egg hunt!

Mips are hardly a rare example of loophole-seeking "innovation." Just this week in Dealbook, Andrew Ross Sorkin nailed another one: dividend payments that are embedded in derivatives so investors can avoid paying any taxes on the income. Nice huh? While you and I are faithfully mailing off checks to the IRS for our dividend taxes every year, certain wealthy people, helped along by "innovators," aren't playing by the same rules (note: this loophole is being closed, thank God).

I imagine that after I finish explaining all this to Zrigfryx, and he extends a spindly forefinger to scratch his dome again in puzzlement, he might say something like:

"So why is preserving all this financial innovation so important to you Americans?"

And I guess I'd say:

"Larry? Tim? You want to take that one?"