Derivatives and Synthetics Did Not Amplify the Housing Bubble

It's time again to dispel a common misconception: derivatives didn't cause the housing bubble. That's a topic today in another hearing conducted by the Financial Crisis Inquiry Commission. The chairman Phil Angelides got the Q&A rolling by asking whether derivatives and synthetic securities amplified the housing bubble. Despite what the some panelists say, the answer is "no." In fact, it's probably the opposite.

First, a very brief primer. The derivatives blamed here are credit default swaps (CDS), which acted as insurance on mortgage exposure. Synthetic collateralized debt obligations (CDOs) allow investors to bet on mortgages without actually owning the assets themselves.

Let's start with CDS. The first witness on the panel, University of Maryland Law Professor Michael Greenberger, argued that CDS inflated the mortgage market. He claims that investors became more comfortable buying more mortgage-backed securities because they could hedge their bets with CDS. Without CDS, they would have purchased fewer mortgage securities. This is false.

The rise of CDS did not amount to a new, innovative financial paradigm. It amounted to a fancy new suit for a very old concept: insurance. Bonds were also wrapped with regular insurance by companies like MBIA. CDS was just another way to do this. The failure wasn't with the CDS, but that those who created this CDS stupidly didn't charge adequate premiums to ensure against the risk of losses it reflected. If CDS had never been invented, people would have just used bond insurance instead. It might have been a little less convenient, but the rise of subprime mortgages would still have occurred, probably to the same outrageous level.

Synthetic collateralized debt obligations also weren't the enemy: they actually may have slowed down the mortgage market's growth. There was enormous investor appetite for mortgage exposure during the boom. But origination of new loans was limited. So banks began creating these synthetic securities instead. The alternative would have been to for banks to written even more mortgages to satisfy investor demand. That would have inflated the bubble even further. In other words, if synthetics had any effect on the mortgage market, it was to restrain its growth, since it satisfied investors' desire for more mortgage market exposure without actual loans being written.

Now, there was a problem in the CDS market. Those who wrote these securities should have been treated like they were creating insurance, rather than derivatives. But this is a regulatory failure -- not a feature of an inherently dangerous or bad security. Such regulatory changes are desirable to ensure that those who create CDS can sustain losses they might incur. But even if that change had been in place, the mortgage market would still have grown in the same manner, because the regulators' loss assumptions would almost certainly have been too low, since everybody -- including the regulators -- was drinking the same housing boom Kool-Aid. Unfortunately, you can't regulate away stupidity.