Credit default swaps are the most widely traded form of derivative. One commentator called CDSs "pure gambling": "They are wagers on whether people will default on their debts, such as mortgages. They are not to be confused with insurance against loans going bad. Insurers must hold reserves against risk."
In a 2003 letter to his company, Warren Buffet famously and prophetically called derivatives "financial weapons of mass destruction," and a ticking "time bomb" for the world economy. Derivatives used to be used as insurance on investments. Starting in the 1990s they became a source of investment on their own.
A derivative is any financial instrument which derives its value from another financial instrument. Logically, if the instrument upon which a derivative is based loses all its value, so should the derivative. Enormous wealth can be built up with derivatives, but that wealth is often not based on any kind of reasonable debt-to-asset ratio.
The Bank for International Settlements estimated that total derivatives trades exceeded one quadrillion dollars – 1,000 trillion dollars! That's greater than the value of the entire world economy.
Hedge funds, by the way -- which are totally unregulated and purposely take on huge risk -- invest heavily in derivatives. How heavily? Nobody knows, not even the banks like Goldman Sachs that lend the hedge funds money. How many hedge funds are there? Again, nobody knows. How much wealth do they control? It's a mystery. Only very wealth investors are permitted to invest in hedge funds; and many of them operate outside the U.S.
According to one example:
"And there's the catch: what if the hedge fund doesn't have the $100 million? The fund's corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have 'hedged their bets' by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.
"The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. ... It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots."
Here's what former Fed Chair Alan Greenspan had to say about regulating hedge funds [italics and emphasis mine]:
"The hedge funds, as far as I can see, cannot be regulated directly in this country. Two things will happen: either you regulate them and they will disappear because the nature of their business, they would perceive, cannot be effective if it's regulated, or far more likely, they will move to a different venue and trade, because they don't need the United States particularly. Now, starting with the premise that we can't do anything, the question really then gets to what do we do in lieu of that to protect the American financial system, which is what it's all about. And in my judgment, the most effective, indeed, really the only significant, effective means that we have to make certain that they, that group of hedge funds, does not create a problem is by making certain that the banks and others who lend them money have direct supervision themselves, as they do, and due diligence to make certain that when they lend money, they're doing it most sensibly."
Alan Greenspan, although he didn't understand derivatives, defended them against government regulation, banking "on the good will of Wall Street to self-regulate as he fended off restrictions." A fellow Fed board member remembers Greenspan "as consistently cheerleading derivatives." In the late 1990s, Clinton Administration officials Robert Rubin and Larry Summers joined Greenspan in opposing regulation of derivatives, warning that regulation could cause a "financial crisis" and "chaos." Congress certainly didn't understand derivatives, and it bowed to Greenspan's unassailable opinion, denying the federal government a mandate to oversee derivatives trading.
A few members of Congress were worried though. In 2000, Rep. Bernie Sanders (I-VT) asked Greenspan, "Aren't you concerned with such a growing concentration of wealth that if one of these huge [Wall Street] institutions fails that it will have a horrendous impact on the national and global economy?"
"No, I'm not," Greenspan replied. "I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged." By "hedged," Greenspan meant that financial markets were fully "insured" by derivatives.
Greenspan, now defending his legacy, blames the current financial crisis on Wall Street bankers, not on a lack of government regulation. "They gambled that they could keep adding to their risky positions and still sell them out before the deluge," he wrote. "Most were wrong."
And testifying before the House Committee on Oversight and Government Reform in October, Greenspan said, "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief."
When experts talk about the "financial house of cards" and the mortgage crisis, they're talking about derivatives. If poor people had simply defaulted on their home loans, the U.S. economy would not be in a crisis today. Small banks would have been able to recoup some of the value in those homes by re-possessing and re-selling them. At the end of a mortgage is an asset, a house. At the end of a chain of derivatives is... nothing. Catastrophically for us, Wall Street's derivatives market inflated thousands of small mortgage loans into huge pyramids of debt, based on no real assets. As long as housing prices stayed high and nobody had to pay out, everything was great, and Wall Street, which thought up all these derivatives, was making record profits as late as last year. Today, more than half of Wall Street's profits from 2004-07 have disappeared.
Those record profits came from derivatives trading and mortgage-backed securities. Mortgages generated by small banks and mortgage lending companies sold so well as mortgage-backed securities, that those mortgage lenders borrowed more money themselves in order to issue more loans, so that they could turn around and sell them! The getting was too good for everyone involved to stop. The profits were big and easy.
Then housing foreclosures started to increase in 2006 as sub-prime borrowers couldn't pay their adjustable-rate mortgage hikes. Housing construction slowed, as new housing couldn't compete with existing housing selling at big discounts. More vacant homes on the market depressed housing prices. Some homeowners suddenly had "upside-down" payments, where they owed more on their home than it was worth (i.e. negative equity). All this had a ripple effect on the economy, essentially affecting everyone.
Even still, this should not have frozen credit markets and threatened the country with depression. No, it was the abundance of mortgage-backed securities held by the Wall Street banks which suddenly lost most of their value, which caused our current financial crisis.
This was wealth, quite frankly, that never should have existed. Nor should there have been the easy credit that such wealth permitted. It seems all we have left now is the "full faith and credit of the United States" to provide our economy with credit. Maybe it's time to think up a new financial system, one where the government plays a much stronger role, either as direct lender, and/or strong regulator.
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