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Did derivatives cause recession???????

determining the cause of the financial collapse has been sought by everyone from Congress to

the small business owner. This question has brought people to conclusions that rangefrom Wall Street greed to a poorly regulated system. Responses are based primarily onopinion because there have been very few verified facts that one can point to as thecause. This may be because the answer is that a confluence of factors, many of which are

 poorly understood, caused the collapse. One of these factors is financial innovation, whichcreated derivative securities that purportedly produced safe instruments by removing or diversifying away the inherent risk in the underlying assets. The question is: did theseinstruments really reduce the underlying risk or in fact increase it? (Learn more aboutderivatives in The Barnyard Basics of Derivatives and Are Derivatives Safe For Retail 

 Investors?)

Derivatives: An Overview

Derivative instruments were created after the 1970s as a way to manage risk and createinsurance against downside. They were created in response to the recent experience of the oilshock, high inflation and a 50% drop in the U.S. stock market. As a result, instruments, suchas options, which are a way to benefit from the upside without owning the security or protectagainst the downside by paying a small premium, were invented. Pricing these derivativeswas, at first, a difficult task until the creation of the Black Scholes model. Other instrumentsinclude credit default swaps, which protect against a counterparty defaulting, andcollateralized debt obligations, which is a form of securitization where loans with underlyingcollateral (such as mortgages) are pooled. Pricing was also difficult with these instruments,

 but unlike options, a reliable model was not developed.

2003-2007 - The Real Use (or Overuse!)The initial intention was to defend against risk and protect against the downside. However,derivatives became speculative tools often used to take on more risk in order tomaximize profits and returns. There were two intertwined issues at work here: securitized

 products, which were difficult to price and analyze, were traded and sold, and many positionswere leveraged in order to reap the highest possible gain.

Poor Quality Banks, which did not want to hold onto loans, pooled these assets into vehicles to createsecuritized instruments that they sold to investors such as pension funds, which needed tomeet an increasingly difficult-to-reach hurdle rate of 8-9%. Because there were fewer andfewer good credit-worthy customers to lend to (as these customers had already borrowed to

fill their needs), banks turned to subprime borrowers and established securities with poor underlying credit-quality loans that were then passed off to investors. Investors relied on therating agencies to certify that the securitized instruments were of high credit quality. This wasthe problem.

Derivatives do ensure against risk when used properly, but when the packaged instrumentsget so complicated that neither the borrower nor the rating agency understands them or their risk, the initial premise fails. Not only did investors, like pension funds, get stuck holdingsecurities that in reality turned out to be equally as risky as holding the underlying loan,

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 banks got stuck as well. Banks held many of these instruments on their books as a means of satisfying fixed-income requirements and using these assets as collateral. However, as write-

downs were incurred by financial institutions, it became apparent that they had less assetsthan what was required. When the average recovery rate for the "high quality" instrument was

approximately 32 cents on the dollar and the mezzanine instrument in reality only returnedfive cents on the dollar, a huge negative surprise was felt by investors and institutions holding

these "safe" instruments. (Learn more in The Fall Of The Market In The Fall Of 2008 .)

Borrowed FundsBanks borrowed funds to lend in order to create more and more securitized products. As aresult, many of these instruments were created using margin, or borrowed funds, so that thefirms did not have to provide a full outlay of capital. The massive amount of leverage usedduring this time completely amplified the problem. Banks' capital structures went fromleverage ratios of 15:1 to 30:1. For instance, by mid 2008, the market for credit default swapsexceeded the entire world economic output by $50 trillion. As a result, any profit or loss wasmagnified. And in a system that had very poor regulation or oversight, a company could getinto trouble fast . This was no more evident than with AIG, which had around $400 billion of credit default swaps on its book, an amount that unsurprisingly it did not have capital to

cover. (Read more about AIG in Falling Giant: A Case Study Of AIG.)

ConclusionThe arguments of the cause of the financial collapse may go on for a long time, and theremay never be a consensus explanation. However, we know that the use of derivativesecurities played a pivotal role in the system that collapsed; securities, whose true inventionwas to lessen risk, in fact seemed to have exacerbated it. And when margin was added intothe mix, a recipe for disaster was defined. (Learn more about the financial collapse in The

2007-08 Financial Crisis In Review.)