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Has the Impact of Derivatives on the Financial Crisis Been Exaggerated?

Ryan Williams

Financial Markets, Banking, and Monetary Policy

Honors Program Research Paper

December 2012

Abstract: This paper analyzes the role of derivatives in the financial crisis of 2007-2008. The concept and history of the derivative are introduced, while assessing the potential benefits and risks associated with these instruments. The dangers of derivatives are examined within a historical framework. Events leading up to the financial crisis are examined.

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Introduction

As the global financial system slowly begins to recover from the events of 2008-2009, the

issue of how to prevent another “Great Recession” has taken precedence amongst both academic

economists and the mass media. Aside from the Great Depression, America has never endured a

longer and more grueling economic slump. World stock markets plummeted over 50% from their

year high in 2007. International trade levels declined approximately 20%.1 This recession has

been brutal and pervasive, affecting all socioeconomic classes. A simple internet search reveals a

myriad of underlying financial causes and origins of the recent economic crisis. Imprudent

mortgage lending allowed individuals to live in homes they could not actually afford. Financial

institutions had excessive leverage. Deregulatory legislation created an environment prime for

financial disaster. According to Mark Jickling, Specialist in Financial Economics, “Laws such as

the Gramm-Leach-Bliley Act (GLBA) and the Commodity Futures Modernization Act (CFMA)

permitted financial institutions to engage in unregulated risky transactions on a vast scale.”2

However, the issue most often blamed for the crisis is a financial instrument called a derivative.

The media often portrays these instruments as mysterious complex financial tools. The internet is

filled with scathing articles and op-eds blaming derivatives for the financial crisis. This paper

will examine the claims of those that blame the recent crisis on derivatives. Has the impact of

derivatives on the financial crisis been exaggerated?

Section one of this paper provides background information on what exactly defines a

derivative. Various types of derivatives are introduced. Section two consists of a historical

analysis of derivatives. The origin and growth of derivatives are examined. Section three

analyzes the dangers associated with derivatives. Section four elaborates on the precise role of

1 Barry Eichengreen and Kevin H Rourke, The Great Recession versus the GreatDepression, September 20092 Jickling, Mark. Causes of the Financial Crisis. Rep. Congressional Research Service, 09 Apr. 2010. Web.

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derivatives in the recent financial crisis. The implications of all the preceding information are

analyzed in a conclusion.

Background Information

What is a Derivative?

In order to properly examine the role of derivatives in the recent financial crisis, one must

understand what exactly defines a financial derivative. According to the International Monetary

Fund, “Financial derivatives are financial instruments that are linked to a specific financial

instrument or indicator or commodity, and through which specific financial risks can be traded in

financial markets in their own right.”3 A derivative is essentially a tradable contract between

parties whose price is derived from an underlying asset. In finance, this asset is referred to as the

“underlying.” Virtually any asset can function as the underlying for a derivative. Some of the

most common assets include: bonds, stocks, indexes, and interest rates. The price of the

underlying will determine the price of the derivative. If the price of the underlying changes; the

price of the derivative will change in response.4 This relationship illustrates the nomenclature of

a financial derivative.

Derivatives are mainly used for two purposes: hedging and speculation. Derivatives allow

corporations to properly deal with unwanted risk. Corporations often use derivatives to hedge

against foreign-exchange risk. As a result of the globalization of business, volatility in exchange

rates can have a negative impact on business profitability.5Companies also use derivatives to

hedge against fluctuations in commodity prices and changes in interest rates. Speculation using

31"IMF Committee on Balance of Payments Statistics - Financial Derivatives." IMF Committee on Balance of Payments Statistics - Financial Derivatives. N.p., n.d. Web. 15 Oct. 2012. <http://www.imf.org/external/np/sta/fd/index.htm>42"Derivative." Definition. Investopedia, n.d. Web. 15 Oct. 2012. <http://www.investopedia.com/terms/d/derivative.asp>.53"How Companies Use Derivatives To Hedge Risk." How Companies Use Derivatives To Hedge Risk. Investopedia, n.d. Web. 15 Oct. 2012. <http://www.investopedia.com/articles/stocks/04/122204.asp>.

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derivatives is essentially a form of gambling. Investors can bet on the movement of any asset,

and potentially profit immensely. For example, two investors may have opposing views about

the future price of oil. Using a derivative, they can bet on the future cost of oil, seemingly

making a profit from the other’s ignorance. These bets are highly leveraged.

Types of Derivatives

There are four major types of financial derivatives: forwards, futures, options, and swaps.6

These various instruments differ from one another, but ultimately seek to hedge against the risk

associated with a specific asset. According to Rene M. Stulz, Everett D. Reese Chair of Banking

and Monetary Economics at The Ohio State University, “Although some serious dangers are

associated with derivatives, handled with care they have proved to be immensely valuable to

modern economies, and will surely remain so.”7

A forward contract is a specialized agreement between two parties to buy or sell an

underlying asset in the future at a pre-agreed upon price. Both parties are obligated to engage in

this certain transaction in the future. Using forwards, buyers and sellers are able to lock in price

certainty.7 For example, take the hypothetical scenario of a farmer selling his wheat to a large

corporation.8 A farmer wants to sell his wheat in the future. He is worried that the price of his

wheat may fall as time passes. To guarantee a specific selling price, he enters into a short

forward position (short designates the selling party) with the corporation. Similarly, the

corporation is looking to purchase resources. They are worried about prices rising. To hedge the

risk of rising prices, they enter into a long forward position (long designates the buying party) 6 Nihalani, Monika. "Derivatives Market: Types of Derivatives." Goodreturns.in. N.p., n.d. Web. 18 Oct. 2012. <http://www.goodreturns.in/classroom/2011/06/derivatives-market-types-of-derivatives-09.html>.7 Stulz, Rene M. "Demystifying Financial Derivatives." The Milken Institute Review (2005): n. pag. The Ohio State University. Web. <http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf>.8 Adapted from: Hedging with Forwards. CMDT Training, 2012. Online.

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with the farmer. The forward states that 100 units of wheat are to be exchanged at a cost of $10

per unit. When the forward reaches maturity, this transaction will occur. But what has happened

to market prices during the duration of the forward? The movement of prices will determine

which party benefited from the derivative.

Farmer Profit Using Forward Contract

Price of Wheat End of Contract Contract Price(Fixed) Payoff per Unit

$20 $10 -$10

$10 $10 $0

$5 $10 $5

Corporation Profit Using Forward Contract

Price of Wheat End of Contract

Contract Price(Fixed) Payoff per Unit

$20 $10 $10$10 $10 $0$5 $10 -$5

As evident in the graphs, the payoff per unit between each party has an inverse relationship. If

the price of wheat rises, the corporation saves money and the farmer earns less. If the price of

wheat falls, the farmer earns higher profit, and the corporation loses money. Forwards bear the

risk of counterparty default.

A futures contract is simply a forward contract traded on a recognized exchange.9 Some of the

most commonly exchanged futures involve: commodities, currency, and interest rates. These are

traded on international futures exchanges such as the: New York Mercantile Exchange

(NYMEX), SOFFEX (Swiss Options & Financial Futures Exchange), and Shanghai Futures

9 Jatin. "DERIVATIVES -BASICS TYPES AND USES - Shares & Stock Articles - Chartered Accountants India,Taxpayers, CA India, CWA ,ICAI, Company Secretary ,CS, Cost Accountants, MBA, Finance Professionals." CAclubindia. N.p., n.d. Web. 18 Oct. 2012. <http://www.caclubindia.com/articles/derivatives-basics-types-and-uses-270.asp>.

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Exchange (SHFE.)10 Futures are “Marked to Market” at the end of every trading day. This means

that all outstanding futures are valued at the end of each day.

As the name implies, a financial option gives an individual the option to purchase or sell an

underlying in the future. Put options grant investors the right to sell an underlying at a certain

price. Conversely, call options allow investors to purchase an underlying at a certain price. The

price at which an option is exercised is known as the strike price of an option.11 Options may

have different characteristics. For example, an American Option can be exercised during the

option period. A European Option can only be used at the end of the option period. The price

paid by the buyer to utilize an option is called the option premium. The use of options can most

easily be observed in discussing common stock options. For example, an investor wants to

purchase a stock currently trading at $40. He believes in February, the stock will trade at $47 a

share. This is a 17.5% gain. He then decides to purchase a call option for February at a $45 strike

price with a $.50 option premium. In February, the stock is trading at $47 like the investor

predicted. The value of his option can be determined by the formula12:

Current Price- Strike Price= Value of Option

In the example, his option would be valued at $2. This is because in February, an investor can

pay $45 for a $47 stock. Having paid merely $.50, the investor has made a 300% return on the

call option. Using options, one can take advantage of gains in a stock price.

10 http://www.goodreturns.in/classroom/2011/06/derivatives-market-types-of-derivatives-09.html11 "Yahoo!Options Education." Yahoo!Options Education. N.p., n.d. Web. 18 Oct. 2012. <http://biz.yahoo.com/opt/basics4.html>.12 "Understanding Option Pricing." Understanding Option Pricing. Investopedia, n.d. Web. 18 Oct. 2012. <http://www.investopedia.com/articles/optioninvestor/07/options_beat_market.asp>.

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A swap is an exchange of cash flows or payment for another.13 Unlike other derivatives,

swaps are not traded on an exchange. Financial institutions dominate the swaps market.14

According to the Bank for International Settlements, during 2006 the swaps market had a

notional value of over 250 trillion dollars.15 Companies use swaps to hedge risk in a variety of

areas such as the foreign exchange market and commodity market. The commonly used “vanilla”

interest rate swap is an excellent example of how a swap operates. These “vanilla” swaps involve

one party paying a fixed interest rate, while another pays floating rate payments based on

LIBOR. LIBOR stands for “London Interbank Offered Rate.” According to Business Dictionary,

“LIBOR is the average of rates which five major London banks are willing to lend $10 million

for a period of three or six months, and is the benchmark rate for setting interest rates for

adjustable-rate loans and financial instruments.” For example, company A has a thousand dollar

loan with a 5% annual interest rate. Company B has the exact same loan. In order to hedge risk,

these companies engage in a swap contract. Company A receives a fixed 5% payment annually

from company B, whereas company B receives a floating rate from company A.

Company Loan Amount Rate on Loan Payment Received

Payment $

A $1000 5% 5% $50B $1000 5% LIBOR Rate ?

Depending on the current LIBOR rate, company B may other incur a gain or loss from this swap.

They entered into the swap based on their predictions for future interest rates. Company A has

successfully hedged any risk for interest rate fluctuations.

13 "Swap." What Is ? Definition and Meaning. N.p., n.d. Web. 18 Oct. 2012. <http://www.businessdictionary.com/definition/swap.html>.14 "An Introduction To Swaps." An Introduction To Swaps. N.p., n.d. Web. 29 Oct. 2012. <http://www.investopedia.com/articles/optioninvestor/07/swaps.asp>.15 "An Introduction To Swaps." An Introduction To Swaps. N.p., n.d. Web. 29 Oct. 2012. <http://www.investopedia.com/articles/optioninvestor/07/swaps.asp>.

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The History and Expansion of Derivatives

A Brief History of Derivatives

The underlying concept of a derivative can be observed throughout human history even

before the time of Christ. A derivative does not necessarily have to be used in a financial context.

For example, in Genesis Chapter 29 of the Bible, a man named Jacob promises seven years of

labor in return for the right to marry Laban’s daughter Rachel. Laban later denies Jacob’s request

to marry his daughter. Upon examination, this seemingly simple story is in fact an option

contract. Jacob promised Laban seven years of labor in order to marry Laban’s daughter. The

cost of the option was the seven years of labor. The underlying asset is Laban’s daughter. By

“purchasing” this option, Jacob had the opportunity to engage in marriage with Rachel. One can

also observe that Laban actually defaulted on this contract.16 An open-minded financier can

observe the usage of derivatives in everyday situations.

Financial derivatives have been around since the early 17th century. During the Dutch Tulip

Bulb Mania, individuals would engage in forward contracts to ensure a suitable price for the

flower. The desire for tulip bulbs was so insatiable, the most expensive traded for over six times

the average person’s annual salary. Ironically, this trading led to a massive financial crisis.

Dealers defaulted on their contracts. Individuals realized they had just traded their home for a

piece of plant. The resulting depression left a lasting impression on the Dutch, causing them to

be quite weary of speculative investments.17 In other parts of the world, the Royal Exchange in

London permitted the trading of forwards, and futures were used in the rice market in Osaka,

Japan.18

16 Chance, Don. "Essays in Derivatives." N.p., n.d. Web.17 "Market Crashes: The Tulip and Bulb Craze." Investopedia – Educating the World about Finance. N.p., n.d. Web. 24 Nov. 2012. <http://www.investopedia.com/features/crashes/crashes2.asp>.18 Chance, Don. "Essays in Derivatives." N.p., n.d. Web.

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In the United States, the creation of the Chicago Board of Trade in 1848 ushered in the age of

exchange traded futures similar to those still traded to this day. Farmers in the local area would

often bet on the price of grain. This practice became so widespread; the futures were

standardized in 1865. The derivatives market was relatively small up until 1970. An explosion of

financial engineering occurred, creating an environment where hedging risk became a necessity,

and the rewards for speculation were enormous.

The Derivatives Explosion

The economic climate of the early seventies was fraught with interest rate volatility and rising

foreign exchange rates. Deregulatory legislation allowed business to operate more freely, and

international trade boomed. Business needed ways to hedge risk, and that form of hedging was

found in the derivatives market. Corporations relied on futures and options to hedge many types

of risk.19

One development that propelled the use of derivatives was the creation of a powerful

financial formula by Fischer Black and Myron Scholes. These two men created what would

become the most famous formula in all of finance, the Black-Scholes Model. This formula

allowed investors to price option contracts with extreme precision.20 The model incorporates all

possible financial aspects in determining the fair price of an option.

19 Stulz, Rene M. "Demystifying Financial Derivatives." The Milken Institute Review (2005): n. pag. The Ohio State University. Web. <http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/milkeninstitute_pubpaper.pdf>.20 Chance, Don. "Essays in Derivatives." N.p., n.d. Web.

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As the late twentieth century began, the derivatives market began to grow far more complex.

Corporations began to make use of complex swaps and other exotic financial instruments. Firms

on Wall Street began to hire physicists and engineers to develop complex formulas in order to

turn a profit. Firms also began to experience massive losses due to derivative trading. Proctor

and Gamble lost over $157 million dollars. P&G entered into an interest rate swap to hedge

risk.22 When the Federal Reserve increased interest rates, P&G lost millions. Barings Bank

completely went under due the actions of a rogue trader misusing derivatives.

Derivatives Prior to the Financial Crisis

Derivative usage has grown exponentially over the past 30 years. The following data was

obtained from the quarterly report on bank derivative activities issued by the Office of the

Comptroller of the Currency.23This graph shows the total exposure of large banks to derivatives

from 2001-2011. Take note of the dramatic increase in total derivatives prior to the recent

financial crisis.

21 "BLACK - SCHOLES -- OPTION PRICING MODELS." BLACK - SCHOLES -- OPTION PRICING MODELS. N.p., n.d. Web. 01 Dec. 2012. <http://bradley.bradley.edu/~arr/bsm/pg04.html>.22 Malkin, Lawrence. "Procter & Gamble's Tale of Derivatives Woe." The New York Times. N.p., 14 Apr. 1994. Web. <http://www.nytimes.com/1994/04/14/business/worldbusiness/14iht-procter.html>.23 "Capital Markets Home." OCC: Trading: OCC's Quarterly Report on Bank Derivatives Activities. N.p., n.d. Web. 24 Nov. 2012. <http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/derivatives-quarterly-report.html>.

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Derivatives Purchased 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011Chase Manhattan Corp 10547024 13604220JP Morgan & CO 8434865 9422084Citigroup INC 7472675 7619065 8482937 9095928 11985484 11985484 20455547 25318298 34922757 41310119 31715734 42309903 53227940Bank of America CORP 4279830 5729989 7924677 9936045 13470762 13471038 19198737 23245886 29061100 38956352 77874726 71157841 72732448Wells Fargo and Company 269812 221706 320319 731924 757425 757425 695485 794532 869124 1425976 5184561 3722843 3534924JP Morgan Chase & CO 24604568 24017077 31188706 31310861 45722353 53760802 71696515 89831343 81108352 76890800 80380991

As evident in the graph, derivative exposure exploded prior to the financial crisis. It is

interesting to note that two largest holders of derivatives in the late nineties, Chase Manhattan

Corp and JP Morgan & CO, later merged in 2001. This merger perpetuated the systemic risk that

runs through the world’s modern financial system. According to Professor Rene Stulz of Ohio

State University, “In June 2004, the total notional amount of derivatives traded over the counter

was $220 trillion.” This is fourteen times the amount of the current US national debt. When the

housing bubble burst; the web of derivatives in the financial system proved to be lethal a force.

The Negative Effects of Financial Derivatives

Although corporations can greatly benefit from derivatives by hedging market risk, regulatory

agencies and policy makers have many concerns regarding the use of these financial instruments.

The very nature of certain derivatives creates a zero-sum game scenario for individuals involved

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in the contract. One party will profit based on the parameters set in the contract, and the other

will suffer a significant loss. The major dangers involving derivatives can be narrowed down into

two categories: leverage and systemic risk.

Leverage involves the use of financial instruments to greatly increase the potential return on

an investment.24 Imagine a scenario in which an investor has $10,000 to invest. He has decided

he wants to invest in IBM. The current price for a share of IBM stock is $192.88. If the investor

choses to simply purchase shares of the company, he can own 51 shares of IBM. His gains and

losses will be determined by the movement of the share of stock. However, he could also

purchase $10,000 worth of IBM stock options. Recall that an option contract gives an individual

the option to purchase stock in the future. Options are sold in 100 share lots. This investor

decides that IBM stock is going to increase in value, so he decides to purchase an option contract

with a strike price of $180. The current price for an option contract allowing an investor to

purchase IBM stock at $180 is $12.85. He then spends all of his $10,000 to purchase 7 option

contracts. This transaction allows him to gain on the movement of 700 shares of IBM stock. That

would normally cost this investor $135,016. If the investor exercises his option while IBM is

trading at $200, his profit will be $14,000. If he purchased the stock, it will be $363.12. One can

easily see the power of utilizing an option in this scenario. However, there is a dark side to this

seemingly perfect transaction. If IBM stock falls below his strike price, the option becomes

worthless; he will lose all of his money. This story illustrates how leverage can have the potential

to destroy a company. 25

24 "Leverage." Definition. N.p., n.d. Web. 26 Nov. 2012. <http://www.investopedia.com/terms/l/leverage.asp>.25 "Yahoo! Finance - Business Finance, Stock Market, Quotes, News." Yahoo! Finance. N.p., n.d. Web. 26 Nov. 2012. <http://finance.yahoo.com/>.

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In 1998, Long-Term Capital Management went under due to speculating with derivatives.

According to Randall Dodd of the Derivatives Study Center, “Long Term Capital Management,

LTCM, you may recall, leveraged $5 billion in capital to control $125 billion in assets and $1.4

trillion dollars in derivatives (mostly interest rate swaps).”26 In his article, Mr. Dodd warns the

financial sector that if firms do not learn from the fall of LTCM, it will prove disastrous for the

financial system. This article was written in 2000. Even before the recent crisis, individuals were

warning businesses about the dangers of derivatives. Mr. Dodd warns that eliminating leverage

requirements and derivative regulation for banks is reckless and will have negative effects in the

future. Later that year, the Commodity Futures Modernization Act was passed. This law

officially deregulated derivatives.27

Systemic risk is also a major factor that is augmented by derivatives. According to Federal

Reserve Chairman Ben Bernanke, “systemic risk can be broadly defined, including unsafe

amounts of leveraging by banks, gaps in regulatory oversight and the possibility that the failure

of a large interconnected firm could lead to a breakdown in the wider financial system.”28

Bernanke’s definition parallels the exact events of the recent financial crisis. One simply has to

look at the events of the financial crisis to see the dangers of systemic risk. The failures of Bear

Stearns, Lehman Brothers, and AIG wreaked havoc in the global financial markets. “Bailouts”

became necessary, and the Dow plummeted. The Dow fell over 500 points after Lehman

Brothers announced bankruptcy.29 The most active banks in the derivatives market often interact

26 Dodd, Randall. "Derivatives Study Center: Not Learning the Lessons of Long-TermCapital's Failure." Derivatives Study Center: Not Learning the Lessons of Long-TermCapital's Failure. N.p., n.d. Web. 26 Nov. 2012. <http://www.financialpolicy.org/dsclessons.htm>.27 "Commodity Futures Modernization Act of 2000." Wikipedia. Wikimedia Foundation, 23 Nov. 2012. Web. 26 Nov. 2012. <http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000>.28 "Bernanke Offers Broad Definition of Systemic Risk." Real Time Economics RSS. N.p., n.d. Web. 26 Nov. 2012. <http://blogs.wsj.com/economics/2009/11/18/bernanke-offers-broad-definition-of-systemic-risk/>.29 "The Collapse of Lehman Brothers." The Telegraph. Telegraph Media Group, n.d. Web. 01 Dec. 2012. <http://www.telegraph.co.uk/finance/financialcrisis/6173145/The-collapse-of-Lehman-Brothers.html>.

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with one another. The top five bank holding companies account for more than 90% of all

derivatives activity.30 This risk is intensified due to the illiquid nature of derivative contracts. If

any party happens to default on a contract, the effects are monumental. An environment is

created where banks cannot afford to fulfill their contractual obligations. Banks will be forced to

sell assets at a deep discount, and face insolvency. After financial firm Bear Stearns collapsed, JP

Morgan purchased their stock at $2 a share.31

The Role of Derivatives in the Financial Crisis

As previously discussed, financial derivatives have the potential to cause devastation in global

financial markets. The fall of Long-Term Capital Management and Proctor & Gamble’s loss

should have served as early warning signs that the misuse of derivatives can have significant

negative repercussions. Derivatives allow companies to riskily leverage their investments

exponentially. The systemic risk brought on by a global intertwined financial system can be

deadly. However, one question remains. What was the exact role of derivatives in the financial

crisis?

Financial Innovation: The Credit Default Swap

If any form of derivative is to blame for the financial crisis, it is the credit default swap

(CDS.) A CDS is a swap contract that essentially offers “insurance” to firms investing in

securities. The buyer of a CDS will make payments called a “spread” to the seller. In the event

that the underlying asset of the CDS fails, the seller must provide the buyer with the face value

of the asset.32

30 "Capital Markets Home." OCC: Trading: OCC's Quarterly Report on Bank Derivatives Activities. N.p., n.d. Web. 24 Nov. 2012. <http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/derivatives-quarterly-report.html>.31 "JP Morgan Agrees to Buy Bear Stearns for $2 a Share." CNBC.com. N.p., n.d. Web. 26 Nov. 2012. <http://www.cnbc.com/id/23663919/JP_Morgan_Agrees_to_Buy_Bear_Stearns_for_2_a_Share>.32 "Credit Default Swap - CDS." Credit Default Swap (CDS) Definition. Investopedia, n.d. Web. 01 Dec. 2012. <http://www.investopedia.com/terms/c/creditdefaultswap.asp>.

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The CDS was invented by JP Morgan CFO Blythe Masters in 1994.34 The use of these

derivatives boomed all the way up until the financial crisis. According to the Financial Crisis

Inquiry Commission, “In October 2008, CDS made up an estimated $35 trillion to $65 trillion of

the notional value of the unregulated OTC derivatives market.”35 The development of these

instruments provided companies with an incentive to speculate and take risks. Firms traded

trillions of dollars of derivatives carelessly due to the perceived “insurance” guaranteed by a

CDS. However, there was a major problem. Most of the underlying assets on these derivatives

were subprime mortgage loans. This factor combined with a housing bubble on the verge of

bursting would prove catastrophic. An environment was created where when these toxic

mortgage backed derivatives failed, firms needed to utilize their CDS contracts. However, the

financial interdependence firms had with one another created a contagion. All of these financial

firms owed one another trillions, but due to poor leverage, lacked the capital to compensate the

33 Created by Lamro: http://en.wikipedia.org/wiki/User:Lamro34 Teather, David. "The Woman Who Built Financial 'weapon of Mass Destruction'" The Guardian. Guardian News and Media, 19 Sept. 2008. Web. 01 Dec. 2012. <http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking>.35 "News at UM." UMB News. University of Maryland, n.d. Web. 01 Dec. 2012. <http://www.oea.umaryland.edu/communications/news/?ViewStatus=FullArticle>.

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buyer of their CDS contract. This is an excellent example of the inherent systemic dangers of

derivatives.

Investors also speculated using CDS. A “naked” CDS allows an individual to purchase

“insurance” on an asset he or she does not have any insurable interest in.36 For example, imagine

person A buys a brand new sports car on credit. Person B thinks person A is going to default on

his loan, so he purchases a “naked” CDS on person A’s loan. After a few months, person A

defaults on his loan. Because person B held a “naked” CDS on the loan, he is going to get paid

because of the default. The financial and ethical repercussions for this kind of behavior were

immense. Wall Street investors could profit by betting that an individual would fail to pay his

mortgage. During the financial crisis, these bets traded at three times the volume of CDS that

actually hedged against real risk facing a company.

AIG was one of the many companies that needed a “bailout” during the financial crisis due to

derivatives trading. In particular, AIGFP(AIG Financial Products) played a major role in

bringing down the massive insurance company. AIGFP was created in 1987 in order to capitalize

on the derivatives market and branch out company operations. By 1998, the financial products

division earned over $500 million in revenue trading derivatives. AIGFP opened offices all

around the world. Later that year, the division entered into an agreement to insure JP Morgan’s

debt in the event of a default. The agreement was expedited due to calculations offered by Gary

Gorton, a professor of Business at Yale and AIGFP consultant. According to Gorton, there was a

.15% chance that AIGFP would ever have to compensate JP Morgan. Financial journalists

Zachary Roth and Ben Buchwalter write, “Essentially, this would happen only if the economy

went into a full-blown depression, in which case, the AIGers believed, the counter-parties would

36 Ho, Lok Sang. "Why I Am Against Naked Credit Default Swaps - Seeking Alpha." Why I Am Against Naked Credit Default Swaps - Seeking Alpha. Seeking Alpha, n.d. Web. 01 Dec. 2012. <http://seekingalpha.com/article/303723-why-i-am-against-naked-credit-default-swaps>.

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be wiped out, and therefore would hardly be in a position to demand payment anyway.”37 This

contract was AIG’s first major deal involving CDS. Over the next few years, the division’s

profits soared to over a billion dollars annually. However, in late 2005, AIGFP realized that it

needed to stop all CDS activity. An internal analysis of the division’s CDS portfolio by AIGFP

executive Eugene Park revealed that the majority of the derivatives it was insuring were backed

by subprime mortgages. If the housing bubble burst, AIGFP would be in serious trouble.38

However, it was too late. From 2007-2008, AIG stock plummeted and the company lost over

eleven billion dollars. An investigation by Morgan Stanley revealed that the firm had “$2.7

trillion worth of swap contracts and positions, 50,000 outstanding trades with 2000 different

firms, and 450 employees in six offices around the world.”39 Other firms like Bear Stearns and

Lehman Brothers also crashed because of credit derivatives involving subprime loans. The

network of CDS contracts throughout the financial system played a massive role in the great

recession. The destruction caused by the CDS was exacerbated by the collapse of the housing

market.

Financial Innovation: The Collateral Debt Obligation (CDO) Another financial derivative that played an instrumental role in the crisis was the collateral

debt obligation. A CDO is a complex financial instrument that bundles individual loans into a

product that can be sold to an investor.40 CDOs were popular with firms prior to the financial

crisis because they enhanced liquidity and allowed banks to quickly obtain fresh capital. One

37 Roth, Zachary, and Ben Buchwalter. "The Rise And Fall Of AIGâ ��s Financial Products Unit." TPM News Combined. N.p., 20 Mar. 2009. Web. 01 Dec. 2012. <http://tpmmuckraker.talkingpointsmemo.com/2009/03/the_rise_and_fall_of_aigs_financial_products_unit.php>.38 "News at UM." UMB News. University of Maryland, n.d. Web. 01 Dec. 2012. <http://www.oea.umaryland.edu/communications/news/?ViewStatus=FullArticle>.39 Roth, Zachary, and Ben Buchwalter. "The Rise And Fall Of AIGâ ��s Financial Products Unit." TPM News Combined. N.p., 20 Mar. 2009. Web. 01 Dec. 2012. <http://tpmmuckraker.talkingpointsmemo.com/2009/03/the_rise_and_fall_of_aigs_financial_products_unit.php>.40 Amadeo, Kimberly. "CDOs (Collateralized Debt Obligations)." About.com US Economy. N.p., n.d. Web. 01 Dec. 2012. <http://useconomy.about.com/od/glossary/g/CDOs.htm>.

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type of CDO that contributed to the financial crisis was the mortgage backed security. A

mortgage backed security is a CDO that contains a grouping of different mortgages. Banks

would break these derivatives into different groupings called tranches based on risk.41 There was

a CDO available for every investor, whether conservative or risky. However, toxic subprime

mortgages were the underlying assets on these instruments. If a borrower defaulted on his loan,

the security was worthless. This factor would prove to be devastating during the crisis.

The credit rating agencies have been blamed for marginalizing the risk associated with the

different tranches of CDO. According Nobel Laureate economist, Joseph Stiglitz, “I view the

rating agencies as one of the key culprits. They were the party that performed the alchemy that

converted the securities from F-rated to A-rated. The banks could not have done what they did

without the complicity of the rating agencies."42 Investors were deceived by these seemingly safe

mortgage backed securities. When the housing bubble burst, the value of these instruments

completely collapsed. During 2008, Barclays Analysts reported, “U.S. mortgage assets in

complex pools of securities have lost so much value that the least-risky classes of the securities

may be worth as little as 20 cents on the dollar.”43 The housing bubble truly created a disastrous

chain of events involving derivatives.

Conclusion

Derivatives played a monumental role in magnifying the financial havoc caused by the

housing bubble. All collateral debt obligations owned by investors became worthless. This

decline affected pension funds, mutual funds, corporations, and families across America. Credit 41 Amadeo, Kimberly. "CDOs (Collateralized Debt Obligations)." About.com US Economy. N.p., n.d. Web. 01 Dec. 2012. <http://useconomy.about.com/od/glossary/g/CDOs.htm>.42 Smith, Elliot Blair. "Bringing Down Wall Street as Ratings Let Loose Subprime Scourge." - Bloomberg. N.p., n.d. Web. 01 Dec. 2012. <http://www.bloomberg.com/apps/news?pid=newsarchive>.43 07, December. "Mortgage-backed CDOs' Value Falls." Los Angeles Times. Los Angeles Times, 07 Dec. 2007. Web. 01 Dec. 2012. <http://articles.latimes.com/2007/dec/07/business/fi-wrap7.s2>.

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default swaps created a liquidity crisis in the banking system. The Federal Reserve loaned

financial institutions trillions during the course of the great recession to rescue the global

financial system.44 The impact derivatives had on the financial crisis cannot be stressed enough.

Has Wall Street learned its lesson? These instruments can be lethal. Derivative legislation

such as the Dodd-Frank Act is currently being reviewed by financial regulatory agencies to

prevent another crisis. However, shockingly derivative exposure continues to increase. In the 2nd

quarter of 2011, banks increased holdings in derivatives by over 11%.45 One cannot help but

wonder what role these instruments will play in the future. Will there be another financial crisis?

Throughout history, countries have been crashing and recovering their way through the business

cycle. This crisis has been brutal and pervasive, yet also a unique educational experience.

Perhaps years from now, economists will prevent another crisis because of the lessons learned

during the recession.

44 "What Did the Documents Reveal?" PBS. PBS, n.d. Web. 01 Dec. 2012. <http://www.pbs.org/wgbh/pages/frontline/business-economy-financial-crisis/money-power-wall-street/did-the-feds-emergency-lending-prop-up-too-big-to-fail/>.45 Protess, Ben. "DealBook." DealBook Banks Increase Holdings in Derivatives Comments. Wall Street Journal, n.d. Web. 01 Dec. 2012. <http://dealbook.nytimes.com/2011/09/23/banks-increase-holdings-in-derivatives/>.