Financial Hacking -- Giving Creative Accounting a Good Name

The subject of the next edition of Release 2.0, available next week, is the collision between Wall Street markets and Web 2.0 markets. The intersection between technology and finance is a busy one, and there might just be some hacker spirit hiding behind those suits.

I came across this article in Business Week last week about shared-equity mortgages, and it struck me as a bit of a "mortgage hack", a clever way of solving a very common problem (particularly in the still overheated -- if cooling -- housing market here in Boston).

Most people have a negative opinion of "creative accounting" in much the same way that most people have a negative opinion of "computer hacking", and I think there are some surprising parallels there. Yes, there's a lot of bad actors, like Enron's Andrew Fastow, using financial shell games to enrich themselves and conceal their actions (kind of a financial root kit). But there's also been -- and continues to be -- some amazing innovation, which perhaps is viewed as guilt by association or "too complex" for the general public to understand (again, sounds a lot like perceptions of computer hackers).

Just a few examples (among many) of this kind of innovation:

• Financial "derivatives" like futures and options contracts: These allow risk to flow smoothly from those who have more than they'd like (insurers with a lot of coastal customers) to others willing to assume that risk in exchange for substantial upside potential (speculators with models suggesting hurricane season will be mild).
• Exchange Traded Funds (ETFs): These bundles of stocks, bonds, or even futures traded together, offer tax and cost advantages to many investors compared with more traditional investments. They emerged themselves as alternatives to the standard Index Fund, another classic financial innovation, courtesy of John Bogle at Vanguard (his 2006 appearance on the Venture Voice podcast is well worth a listen).

More recently, with the aversion to IPOs seen in the wake of the dot-com bubble, there's been an increase in the hacking of IPOs themselves (arguably something Google did in their Dutch Auction) with things like "reverse mergers", which manage to separate the "going public" part of an IPO from the "raising capital" part. For smaller companies looking for funding, it's become a very attractive option: Looking at deals under $50 million, in 2001, there were 30 IPOs and 12 reverse mergers -- by 2004, that ratio had nearly inverted, with 64 IPOs but 117 reverse mergers.

Those numbers come from this PDF overview of reverse mergers, which includes the following text that sounds like it would be right at home in make:

Technically, reverse mergers are not the intended way for companies to go public.

Of course, just as with technology, there's plenty of opportunity for things to go badly -- the current subprime mortgage shakeout shows that it's clearly possible to get too creative with financing, especially when consumers are involved. But just as the latest news of data theft or site cracking should be viewed in the context of all the benefits that also accompany the technology that made it possible, we should keep in mind that most of the "creativity" that happens in the financial world is the good kind.