Five Financial Innovations to Avoid

Nine times out of ten -- heck, 98% of the time -- financial innovation is a good thing. Think of the command, the control and the convenience. It’s rare that you’ll need to transfer money from a checking account to your IRA over a weekend, but at least you can. And once you exercise that power, you’ll want more. That’s why we’re sure to face a never-ending parade of new financial products and services -- many of them good but some just plain bad, as you’ll see in the list below.

This creativity is born largely from technology, which reduces trading and investing costs, extends the business day, and connects the world as never before. That’s why you can slip a bankcard into a machine in Brazil and get cash as if you were tapping an ATM in your hometown. A concept as simple and useful as a mutual fund that tracks Standard & Poor’s 500-stock index would be impossible to execute without the high-speed computers that let Vanguard, Fidelity and the rest transfer millions of shares of stock faster than it used to take a runner to cross the floor of the NYSE.

But there’s a dark side to this capability, and when the skies turn black over our money, the cost is immense. The series of tornadoes that rampaged through Wall Street in 2007 and 2008 and came within a whisker of causing another Great Depression owes its destructive force to the technology that enabled mad scientists to invent many poisonous financial bets. Regular rip-offs, too, are easier to push in the online world than back when boiler-room callers desperately hawked questionable investments.

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Here are five lousy financial innovations plaguing investors today. Consider yourself warned.

1. Credit default swaps

Let’s start with the worst disaster to hit taxpayers in the recent credit crisis, a bailout bill estimated at $180 billion on account of one company. That’s what the government paid when these swaps sank AIG, whose failure came shockingly close to immolating the whole financial system. Who knew? Few other than some insiders, because AIG masqueraded as a venerable property-casualty insurer that also sold life insurance and annuities.

But an obscure division of AIG sold oceans of credit swaps -- essentially, insurance against an investment’s default -- to banks and Wall Street firms. In exchange for immediate income, the swaps shifted the risk to AIG if certain investments lost value or failed to pay interest on time. When leveraged mortgage-backed securities full of toxic loans lost value and then defaulted, AIG owed impossible amounts to much of the world’s financial industry.

Since AIG didn’t have it, massive write-downs of these loans ensued, requiring fire sales of stocks to raise cash, hedge-fund liquidations, and other spiraling punishments to ordinary investors who had nothing to do with these transactions. It was one thing if AIG and other credit insurers simply went belly-up. Instead, the government had to throw money at the mess once it emerged that giant banks and investment firms were wagering with swaps. The government couldn’t let them all go under, righteous as that might seem. And, amazingly, credit default swaps are still legal.

2. Online currency trading

The ultimate video game for suckers, this lets you bet on the immediate -- literally, the overnight -- gyrations of the dollar against other major world currencies, such as the euro, the pound, the yen and the Swiss franc. For businesses that earn income and have expenses in different currencies, hedging makes sense. But to reduce this legitimate financial-management task to a glorified slot machine, often accompanied by “advice” that you can win more if you borrow money to make even bigger bets, is nuts.

The sponsors of this activity spend heavily on marketing the message that currency trading is diversification of your investment assets. It’s not. A foreign bond fund, some gold or Canadian cash in a bank account is diversification. The currency game is just gambling.

3. Payment-option ARMs

You know the joke about the ultimate fool’s lottery: It pays $1 a year for a million years. Real-life version: A bank lends you $1 million to buy a house you can’t afford -- except that the loan lets you choose how quickly, or how slowly, to pay it off. Interest is always accruing, but so what? You can refinance, right? Then real estate turned sour and these loans had a part in staggering numbers of foreclosures and walk-aways. Without this overly creative lending, most of these buyers would’ve bought for less, home prices wouldn’t have become so overextended, and banks wouldn’t own so much real estate.

So good riddance to these bubble-era loans that in the past were sometimes advertised with cunning names, such as “freedom” mortgages. This liberty lets you pile up interest on interest without paying much, if any, of the debt -- sort of like a maxed-out credit card with a $15 minimum payment. Millions of these borrowers now owe far more than their home is worth, and that’s before interest-rate adjustments add to the loan balances.

4. Non-traded REITs

Time and again, Finra or the Securities and Exchange Commission files a complaint about brokers’ misleading sales practices for products such as the Apple REITs, a series of non-traded, illiquid real estate investment trusts. The investigations usually lead to sanctions against the sellers for misleading investors about how and when to sell the shares back to the issuer or for camouflaging the fees and costs.

Even without the regulatory troubles, the non-traded, or private, REIT is a loser. It’s a case of taking something that’s fully liquid, has a good disclosure record and is easy to buy and sell -- the regular, publicly traded REIT -- and twisting it so that brokers and fund managers can siphon extra money from the uninformed public. It’s a shame these can even be called REITs (which they are for tax purposes), but it’s also legal to sell mystery meat and say it’s beef if it comes from a cow. That doesn’t mean you should eat it.

5. Equity-linked annuities and CDs

The general idea with these offers is that your earnings on a linked savings account, CD or annuity vary with the performance of the stock market, usually as measured by an index, such as the S&P 500. But you don’t get the full return of the index. You get some “participation” in the market’s gains without moving your money out of insured or guaranteed accounts and into actual stocks or funds.

This idea isn’t completely without redeeming value, especially when stocks are falling. The problem is that insurers and bankers program their computers to make it all but impossible to know what you’re actually going to earn in these accounts under different scenarios. There are so many variations of your results -- from “high water marks” to caps on returns to “point to point” calculations -- that insurance agents risk breaking the compliance rules every time they make a presentation. The solution, if you want tax-deferred growth, is to buy a regular deferred variable annuity (from a low-cost provider) and divide your savings among the available mutual funds.