Despite What the Financial Crisis Commission Says, Derivatives Did Not Cause the Crisis

Some of the Financial Crisis Inquiry Commission's conclusions are on the right track; others aren't too far off; but some are simply wrong. Just reading the summary, one clearly misguided claim surrounds the role derivatives played in the crisis. In fact, the FCIC places quite a lot of emphasis on derivatives, as it dwells on them throughout its broad summary of conclusions. The fact is that the presence of derivatives was completely incidental to the problems during the crisis, not causal.

One of the FCIC's major conclusions is that "over-the-counter derivatives contributed significantly to this crisis." In particular, it names two types of derivatives as having screwed things up: credit default swaps and synthetic collateralized debt obligations. The commission's emphasis on these two types of derivatives itself shows that it was not over-the-counter derivatives in general that made the crisis worse, but these two kinds of derivatives in particular, which played a major role. So they must have somehow been different from the rest of the crowd.

Credit Default Swaps

First, for those who aren't familiar with credit default swaps (CDS), they're basically just insurance on bonds, but in security form. For an example in very broad strokes, if I want to insure some exposure I have to Apple's debt, I can buy Apple CDS. If Apple goes bankrupt or its debt declines in value, then I get paid through my CDS.

The problem, however, is that nobody regulated CDS creation. So companies, like AIG, could write as much CDS-based insurance as it wanted unchecked. No regulator actually stood by to make sure that firms had money to back up the CDS contracts that they were writing.

So the flaw here wasn't that CDS was a derivative, but that the insurance regulators were too unsophisticated to realize they should be regulating these derivatives in a similar way that they do other insurance. If AIG had instead had created regular insurance contracts for bonds that the regulators also failed to monitor, the same thing would have occurred. The fact that these were derivatives is irrelevant.

Synthetic Collateralized Debt Obligations

These are a little harder to explain. First, think about securitization. That's when you get a pool of loans and slice it up into bonds to sell to investors. Now, let's take that a step further and say that any asset with a cash flow can be put into a security called a collateralized debt obligation (CDO). For example, a CDO can contain a mortgage-backed security, since it holder gets paid a cash flow each month. Now imagine creating a CDO, but instead of containing actual assets, it just references assets, and pays cash flows accordingly. Some investors on the other side of the transaction are the ones who pay, instead of actual borrowers who might be paying the loans indirectly referenced.

Synthetic CDOs are complex derivatives. Because they're so complex, that's why many people believe the rating agencies failed miserably in accurately determining their risk. But their failure came less from mathematical errors and more from bad assumptions. Like mortgage-backed securities, synthetic CDOs suffered from generally relying on the housing market. They just did so in a magnified manner due to their structure, so their losses were even greater than many pure vanilla mortgage-backed securities.

Would synthetic CDOs have failed if the housing market hadn't tanked? It's hard to see how. Imagine if a synthetic CDO instead all referenced the debt of Dow Jones Industrial Average corporations. Those cash flows would have continued to arrive, and the deals would have been fine. Synthetic CDOs exploded because they were priced with the assumption that the housing market would continue to flourish and prices would always rise. Again, the presence of derivatives here is irrelevant.

There are thousands of types of derivatives, and two played a part in the crisis. So why would the FCIC think that derivatives could have been a major cause of the crisis? Unfortunately, people often fear what they don't understand, which is why derivatives have been a focus of both financial regulation and now the FCIC's conclusions. All that jargon just sounds dangerous, doesn't it? In reality, the failure of these two types financial products were not due to their inherent nature as derivatives, but a weakness in regulatory oversight and poor market assumptions. So derivatives should not serve as a scapegoat for other these problems, which much better convey real causes of the crisis.