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Greenberg: Disaster Waiting to Happen?

Wednesday, 2 Mar 2011 | 6:00 AM ET

The next big risk to the markets: sellers and buyers of securities not honoring their end of the deal on mortgage-backed securities and ETFs.

That's the word from a report from the Kauffman Foundation headlined, "Canaries in the Coal Mine."

On Wall Street, these incomplete deals are called "failures to deliver," though they are often rectified, for a higher fee. (Don't confuse this with a credit failure; it's not one.)

Lest your eyes glaze over: This is potentially serious (albeit arcane and complicated) stuff. And maybe it won't matter, but concerns over collateralized debt obligations (arcane and complicated) didn't matter either — until they did.

Failures can happen for any number of reasons – and conspiracy theories abound — but according to the report, regardless of the reason, "investors have been promised that they can claim their money at a reasonable and immediate value."

"This may be a promise markets can‘t keep when the plumbing breaks."

End Result: Markets Breakdown.

That's exactly what happened in 2008, when suddenly insolvent hedge funds couldn't honor their side of certain trades, leaving "pension funds and endowments as unwilling creditors in bankruptcy proceedings," the report says. "Fails thus represent a true canary in the coal mine of the financial markets."

Among the report's findings:

As failures of Treasuries and stocks have fallen, following a crackdown, they've risen in "markets where fails are not punished."

Surprisingly, settlements of 46.4 percent of all mortgage backed securities fail annually; in dollars the number has increased to $115 billion daily from $10.6 billion in 2008.

"With no penalty for failing MBS securities and with the government takeover of Fannie Mae and Freddie Mac effectively guaranteeing the principal risk by the Treasury, there is little incentive to correct a fail quickly."

Agency securities are next, at 3.9 percent. Then ETFs — 3.8 percent (compared with 0.1 percent for U.S. stocks). While that may appear paltry, ETFs stand out, the report says, because they fail at a rate that is 40-times higher than other exchange-traded securities. "This may imply that the main trading firms, which act as agents or intermediaries, are making money on fails of assets owned by others."

Like its attention-grabbing report several months ago, this Kauffman report zeroes in on ETFs. "While ETF failures are magnitudes of order smaller than MBS failures," it says, "they have the possibility of being the first in a string of dominoes to fall in a crisis."

The report adds: "Investors have been lulled into the belief that ETFs are just like equities through repeated assurances from brokers and the issuers."

"As an example, illiquid small cap companies are being repackaged in index ETFs such as the IWM, which derives its value from the stocks in the Russell 2000 index. Unfortunately, just because they are a component of a heavily traded ETF, the 13 underlying securities do not suddenly become liquid."

"The situation is analogous to the packaging of substandard MBS and asset-backed pools in more easily traded securities, which did not magically transform bad mortgages into high quality paper. Wall Street instead obfuscated the risk in a manner that was nearly impossible for the reasonable professional investor to discover. Some ETFs may be manifesting the same problem in a different way. This is the fatal assumption in tightly coupled systems."

Where are the regulators? An SEC spokesman told me, "It would be accurate to say we are actively engaged in discussions and continue to monitor."

The beat goes on…

Questions? Comments? Write to HerbOnTheStreet@cnbc.com

Follow Herb on Twitter: @herbgreenberg

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