Innovation is the great strength of the American financial system. Innovation is the great weakness of the American financial system. There you have the regulatory challenge arising from the Great Unwind playing out on Wall Street.

Financial innovation taken too far got us into this mess. At first it was a good idea to pool together mortgages, slice and dice the income streams and create vast markets of new securitized products. It was an important innovation that built on the traditional mortgage market, a market that was well-understood, with a long history on which to base statistical risk models.

But look what happened. Financial innovators -- financial engineers, in Wall Street parlance -- took securitization one step further. Instead of slicing and dicing conventional mortgages, why not divvy up the risk from riskier mortgages? Bad credit risks could be managed, if the loans were bundled up and sold off the same way safer loans were packaged. No one really understood the implications of breaking the old connection between making a loan and holding a loan. As with any innovation, the new idea created new opportunities and new risks, risks that could not be fully understood until they were tested in a down market.

And we are not just talking about mortgages. Car loans and credit card bills are securitized. Big pools of debt are also back by synthetic credit products that raise new concerns about default and leverage on Wall Street.

Now we have reached the stage of innovation backlash. Policy makers want to apply regulatory patches to the system. New York's Insurance Superintendent is talking about limiting the risk bond insurers may take on. Congress is almost sure to require some form of national licensing for mortgage brokers. The SEC is considering new competition for the ratings agencies. Senator Hillary Clinton is stumping for a Financial Products Regulatory Commission. New is out, safe is in.

If Democrats win the White House, I suspect we will enter a new era of more activist and cautious regulation. That may help prevent or soften the next financial crisis, but it will also make it harder for our financial engineers to develop new products. And even with the added risks, it's those new products that keep our financial markets in front of the rest of the world.