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 range from Wall Street greed to a poorly regulated system. Responses are based primarily on opinion because there have been very few verified facts that one can point to as the cause. 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, which created derivative securities that purportedly produced safe instruments by removing or diversifying away the inherent risk in the underlying assets. The question is: did these instruments really reduce the underlying risk or in fact increase it? (Learn more about derivatives 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 create insurance against downside. They were created in response to the recent experience of the oil shock, high inflation and a 50% drop in the U.S. stock market. As a result, instruments, such as options, which are a way to benefit from the upside without owning the security or protect against the downside by paying a small premium, were invented. Pricing these derivatives was, at first, a difficult task until the creation of the Black Scholes model. Other instruments include credit default swaps, which protect against a counterparty defaulting, and collateralized debt obligations, which is a form of securitization where loans with underlying collateral (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 to maximize 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 positions were leveraged in order to reap the highest possible gain.
Banks, which did not want to hold onto loans, pooled these assets into vehicles to create securitized instruments that they sold to investors such as pension funds, which needed to meet an increasingly difficult-to-reach hurdle rate of 8-9%. Because there were fewer and fewer 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 the rating agencies to certify that the securitized instruments were of high credit quality. This was the problem.
Derivatives do ensure against risk when used properly, but when the packaged instruments get 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 holding securities that in reality turned out to be equally as risky as holding the underlying loan, 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 assets than 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 returned five 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.)
Banks borrowed funds to lend in order to create more and more securitized products. As a result, many of these instruments were created using margin, or borrowed funds, so that the firms did not have to provide a full outlay of capital. The massive amount of leverage used during this time completely amplified the problem. Banks' capital structures went from leverage ratios of 15:1 to 30:1. For instance, by mid 2008, the market for credit default swaps exceeded the entire world economic output by $50 trillion. As a result, any profit or loss was magnified. And in a system that had very poor regulation or oversight, a company could get into 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.)
The arguments of the cause of the financial collapse may go on for a long time, and there may never be a consensus explanation. However, we know that the use of derivative securities played a pivotal role in the system that collapsed; securities, whose true invention was to lessen risk, in fact seemed to have exacerbated it. And when margin was added into the mix, a recipe for disaster was defined. (Learn more about the financial collapse in The 2007-08 Financial Crisis In Review.)