Derivative Instruments and the Financial Crisis 2007-2008: Role and Responsibility 1

Derivative Instruments

and the

Financial Crisis 2007 – 2008:

----------------------------------------------------------------

Role and Responsibility

Joe Sammut

This Paper is submitted in partial fulfilment of the requirements for

Doctorate of Finance

SMC University

Zurich

March 2012

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 2

Abstract

Following what might be considered as the closest call ever with financial armageddon, the

surviving audience reels in Judgement Day array in search of the degenerated players and

products responsible for this predicament. After more than three years from the ominous

September 2008, the financial world has still to close its account with the events that brought

the world within clasp of catastrophe.

This Paper delves into the mechanics that led to the clogging of the financial system with

specific focus on the role of derivatives, namely CDOs (Collateralised Debt Obligations) and

CDSs (Credit Default Swaps), and their degree of responsibility in this financial cause

celebre’.

The trajectory taken is univocal in that the hypothesis being pursued is that the business in

CDOs would not have been so gargantuan had their purchasers not have been able to hedge

their positions through CDSs. Logically this leads this Paper into shaping the crux argument

that CDSs might have propagated the crisis but not necessarily originated it.

Following the customary excursions into the historical and factual facets of the debacle, the

Paper progresses towards a technical analysis encompassing the epicentre of the crisis leading

to a critical understanding of the role played and the responsibility inferred by the said

derivatives in the financial quandary.

The Paper is not intended to pass judgements or to ascribe onuses of accountability. There

exist other fora where this can be attained with the necessary constitutional safeguards in

place. Its pursuit, nonetheless, is to probe and present knowledge which is valuable enough

to deter or, as a minimum, discourage a repeat replay of the crisis. Within the backdrop of

memory being short and greed always omnipresent, the task permeates into the daunting.

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 3

Table of Contents

Introduction................................................................................................................................4

Financial Crisis 2007-2008 – Historical Background................................................................6

CDOs and CDSs Demystified...................................................................................................7

Role of CDOs and CDSs in the Crisis.......................................................................................9

Rating Agencies.......................................................................................................................12

Analysis and Responsibilities...................................................................................................14

Conclusion................................................................................................................................18

Recommendations and Further Reading..................................................................................19

References............................................................................................................................... 20

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 4

Introduction

Presumably two of the reminiscent phrases representative of the term ‘derivatives’1 ventilated

in the immediate aftermath of the Financial Crisis2 are that they typify “financial weapons of

mass destruction”3 and that they represent the “bet that blew up Wall Street”.4

This may symbolize an extreme synopsis of the financial instruments but nevertheless is

evocative of the general sense of culpability that these devices bear5 in the wake of a financial

crisis, the magnitude of which may have never been evidenced before.

Are derivatives then the prime suspects?

The answer to this question is elementary, given the centrality of the role of derivatives in the

crisis. It is when the issue transposes itself from plain indictment to solid culpability that the

lines become blurred. Within this nebulous ambience this Paper strives to provide valuable

interpretation and contribution.

Beyond the facts of the crisis per se,6 there are apparently two schools of thought coveting to

unearth the real and fundamental reason why credit markets froze in the fall of 2008. The

legal profession claims that it has not only understood the origins of the crisis but may have

well predicted it (Stout,Lynn A, 1995 and 1999). It argues that the roots lay not in market

changes but in modification to law, the most impactful of which was the US Congress’s

1
Amongst the many coined through and after the Financial Crisis 2007-2008;
2
Except otherwise indicated, any reference to the Financial Crisis refers to that of 2007 – 2008;
3
Paternality ascribed to Warren Buffett;
4
“The Bet that blew up Wall Street,” CBSD, 60 minutes, Oct. 26, 2008;
5
At least, popularly, in the media and within the fringes of the financial industry;
6
Which shall be described in some detail in the subsequent chapter;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 5

decision to deregulate financial derivatives with the Community Futures Modernization Act7

of 2000.

The main contentions of the financial8 school of thought is that derivatives contributed to the

crisis by amplifying an artificial credit boom, by creating systemic risk9 and by their lack of

transparency, including their OTC10 trading as against via regulated exchanges (Stulz, Rene,

M, 2009).

To these, one may peremptorily add the non-deductibility function11 of CDSs, contributing to

the misaligned ‘popular’12 idea that CDSs do not contribute any financial or economic

substance but are mere financial gambling devices. The contemplation that swaps and

derivatives are there to make money for the banks (Gilani, Shah, 2008) does provide the

remaining impetus needed for a layman’s judgement that derivatives do in fact lay at the root

of the financial crisis.

It is probably within this discourse that the exigency exists to sift the ‘technical’ from the

‘popular’ and consequently to procure a clinical understanding which could not only be

equitable and just in the predicament suffered as a result of the crisis but could also dispense

the mechanisms which can spare the world from such catastrophes.

The task is nonetheless astounding due to the inane human nature to glorify greed and the

accompanying human deficiency to forget, provoking thus the possibility of a repeat

performance of similar crises, irrespective of volumes of objective analyses and studies,13 as

close to one.14

7
CFMA;
8
And naturally, economic;
9
Massive exposures that necessitated the bail-outs of Bearn Stearns and AIG;
10
Over The Counter;
11
As against traditional insurance policies where the insured has to have an insurable interest in the insurance
policy;
12
As discerned by the non-technical public;
13
Similar to this Paper;
14
That is, ‘real’;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 6

Financial Crisis 2007-2008 – Historical Background

Appropriate departure points for ingesting the origins of the crisis may be taken as the

enactment by US Congress of the Gramm-Leach-Bliley Act15 in 1999 and of the Commodity

Futures Modernization Act16 a year later. The former deregulated the financial industry by

allowing financial institutions to act as both commercial and investment banks whilst the

latter allowed ‘over-the-counter’ trading of financial derivatives17 as unregulated instruments

with minimal oversight. Their contributory aggregate effect on the financial system, although

illusory at this stage, will be assimilated further on in the Paper.

As to the directly attributable, a plethora of financial press and academic research has tended

to focus on three susceptive factors (Schwartz, A, J, 2009), namely, expansive monetary

policy,18 flawed financial innovations19 and the collapse of trading.20

In the mundane substrata, the choking of the credit markets is popularly associated with the

implosion of the housing market which, in turn, was a predictable event, albeit for theoretical

and historical reasons. Schiller (2005) argues that the housing boom that preceded the crisis

was a bubble phenomenon driven primarily by the over-optimism of a new era in which the

blanket assent was that housing prices would only rise.

Relaxed fiscal policy and low interest rates21 kick-started at the beginning of the Millenium22

created a consumer-led boom in the US faster on average by circa three times that prevailing

15
Also known as the Financial Modernization Act of 1999 which repealed the Glass-Steagall Act of 1933;
16
Contains provisions affecting the regulatory and supervisory roles of the Commodity Futures Trading
Commission (CFTC) and the Securities and Exchange Commission (SEC);
17
This Paper shall eventually place major focus on one particular derivative ie Credit Default Swap;
18
Read, the monetary policy setting for the housing price boom, represented mainly by the easing of the Fed
rates as from 2001;
19
New investment instruments such as securitization, derivatives and auction-rate securities; the fundamental
flaw common to all was the difficulty in their respective pricing;
20
Lesser bidders than the securities on offer;
21
Federal Reserve Chairman Alan Greenspan has been accused of creating an environment ripe for crisis due to
the lowering of interest rates;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 7

in the core of the EU.23 Given the US society’s endemic low savings ratio, the boom could

only be sustained by a vertiginous rise in household and business debt. Life on credit became

standard (Szyszks, A, 2011).

With a combination of continuous foreign trade imbalances, expansive fiscal policy and low

interest rates, the US Dollar started haemorrhaging against all currencies provoking nervous

markets and by default suggesting a correction in USD interest rates. When24 rates started

their ascend, life on credit became an incubus.

Had the predicament been ring-fenced to the lowest creditworthy,25 the crisis would have

probably been contained. Market considerations however dictated otherwise. The issue

became a full-blown crisis when property values began to fall causing the advent of the

phenomenon of negative equity.26

The rest, to follow the popular motif, is history, contemporary history.

CDOs and CDSs Demystified

In their essence, derivatives27 provide a simple way of understanding financial markets as

well as offering early warning signals28 (Chen, J, 1999). Their sensitivity to environmental

changes places them in a unique setting wherefrom inferences are drawn and positions taken.

22
Mainly to offset the effects of the dot com bubble and the attacks on the World Trade Centres;
23
ie the 15 member European Union (as per pre-2004 accession and subsequent);
24
In 2006;
25
Popularly known as NINJA Loans, that is, loans granted to borrowers who have No Income, No Jobs and No
Assets;
26
ie the value of the property declines to a point where the amount of the loan exceeds it;
27
CDOs and CDSs are derivatives; instruments the price of which is dependent upon and is derived from one or
more underlying assets, hence derivatives;
28
In the case de quo derivatives provided neither warning nor signal;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 8

Their major contribution to the financial markets stem from their ability to optimise the price

of risk, to increase market liquidity and to streamline market participants into managing their

respective risks (Financial Stability Board, 2010). Their ‘Achilles Heel’ lies halfway between

their potential for contagion29 and the limited transparency of counterparty relationships.30

CDOs were born out of securitisation – the process of transforming financial assets, which

are typically illiquid31, into marketable securities to be sold in the secondary market,

providing more liquidity to the market (Hoje et al, 2009). Factually, it is the financial assets’

income stream which is packaged and marketed as a distinct32 piece of investment

instrument.33

The onset of CDSs in the market34 came by way of protecting bondholders against bond

issuers’ default. Albeit participants are ebullient to avoid the term35, intrinsically, CDSs are

insurance policies.36 They hedge creditors37 against debts, thus transferring risk onto

counterparties. Ingeniously,38 and supplemental to insurance, they also allow investors to

speculate about a company’s prospects. Within this milieu, CDSs assume a protective role

over CDOs holders whilst in turn can themselves be churned into CDOs through a process

called synthetics.39

Prima facie, both derivatives are lauded as accomplished market instruments with an

ostensible degree of magnitude when appended to each other. However, their respective and

29
Due to the interconnectedness of the derivatives market players;
30
That is, there exists no mechanism to certify the adequateness and viability of the arties entering into OTC
derivatives contracts;
31
Financial assets securitized include mortgages, car loans, credit card debt and other corporate debt;
32
Safe to add, “upgraded”;
33
It is in fact this transformation (from a bundle of doubtful financial assets into a new product) which attracted
most of the attention in the post crisis autopsies;
34
Circa 1999;
35
For regulatory purposes;
36
Against default, thus the term ‘Credit Default Swaps’;
37
Investors;
38
Academic research and financial opinion would rather use the term “precariously”;
39
Bundled CDSs are securitized into CDOs and are called Synthetic Collateralized Debt Obligations. Instead of
financial assets, they own credit exposure to such assets through CDSs.

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 9

aggregate potential for systemic risk40 and mispricing of credit might have been the subject of

misunderstanding and underestimation. The mispricing and relative ease of credit plans41

which are bundled into better-rated42 CDOs, the highly leveraged bets on their associated

CDSs and the consequent rush to unwind a vast array of interconnected contracts, provide the

perfect concoction not only for serious liquidity problems in the financial markets but for

possible convulsions throughout the entire international financial markets (Skeel, D, A and

Partnoy, F, 2007).

Within an arc of a few weeks this possibility first metamorphosed into a probability and

eventually into a reality.

Role of CDOs and CDSs in the Crisis

The financial crisis is not inherently due to the financial innovations as presented by CDOs

and CDSs but because people43 underestimated risk in applying these financial instruments

(Qing-Ping, M, 2009). Underestimation and mis-pricing of risk is considered44 as one of the

three factors, the interaction of which engendered the crisis.45

Postulating from the advantageous side of hindsight, there seems to be enough reasons to

argue that should their46 risk been adequately and realistically assessed and priced, the

40
Risk of the collapse of the entire financial system and markets as against the risk associated with only one or
two entities;
41
Dubious credit such as Ninja Loans, commonly known as ‘liar loans’ because they are obtained by fraudulent
misstatements by prospective borrowers;
42
In most cases, poorly rated credit was transformed into highly rated CDOs;
43
And the market;
44
As a unified reason;
45
Together with US Current Account Surplus and loose monetary policy;
46
That is, “derivatives’”;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 10

predicament would have probably been averted or at least contained. The IMF (2008) in its

deliberations on the global financial crisis concluded that certain structured finance products

“............likely exacerbated the depth and duration of the crisis by adding uncertainty to their

valuation as the underlying fundamentals deteriorated”.

The ‘ignorance’ of these innovative financial products by mature and sophisticated banking

and financial conglomerates is unexplainable in the normal course of business but is

explicated once the ingredient of self-interest is factored in. In retrospect it is unimaginable47

how banks invested so heavily in derivatives without understanding their impact on their

capital and liquidity positions (Criado, S and van Rixtel, A, 2008).

Considering that the over-the-counter48 notional value of derivatives in the US is estimated at

US$ 300 trillion,49 that is twenty times the size of the US economy, the only consternation

justifiable at the havoc unleashed by the crisis is of the consensual type. Discounting for the

obvious endangerment created by leverage and the ubiquitous consequence for participants to

accumulate large positions with a relatively small outlay, the Orthros50 of the financial system

presents itself in the form of a multifaceted web of common dependence between participants

and the markets’ vagueness to decipher the consequences emanating there from (Thinking

Bookworm, 2012).

It is now almost universally accepted that this unregulated multi-trillion Dollar OTC

derivatives market first fomented a mortgage crisis, then a credit crisis and finally a “once-in-

47
Naturally, if greed is not factored in;
48
As against those traded on regulated exchanges;
49
Testimony by Gary Gensler, Chairman of the Commodity Futures Trading Commission (CFTC) before the
Financial Crisis Inquiry Commission, July 1st 2010; The Financial Crisis Inquiry Commission (FCIC) is a ten-
member commission appointed by the United States government with the goal of investigating the causes of the
financial crisis of 2007–2010. The Commission has been nicknamed the Angelides Commission after the
chairman, Phil Angelides;
50
Orthros (Greek mythology) was a two-headed dog born to Greek mythology's most infamous monster parents
Typhon and Echidna.

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 11

a-century” systemic financial crisis (Greenburger, M, 2010). Securitization51 and the

insurability52 of the products blended from the process, together, probably represent53 the

core of the crisis but not as its casus belli.54 They seem more to characterize the means by

which participants crystallized their self-interest, in the interim artfully risking their entire

self.

Banks escalated their use of securitizations55 in their quest for avarice, not only out of the

profit motive but also because securitizations permitted them to remove assets and liabilities

from their balance sheets, thus optimizing their capital base by requiring less equity capital to

operate56 (Petrova, I, 2009). Irrespective and in spite of the negative publicity, the process

and products of securitizations do not by default translate themselves into delinquent

banking. It is only when banks and financial institutions act solely in their self-interest that

the activity becomes nebulous and dangerous.

The ‘original sins’ of the crisis can safely be located to when investors became unmoored

from the essential risk underlying loans to non-credit worthy clients specifically by the

continuous reframing of the form of risk,57 to the purported ‘insurance’ offered on CDOs in

the form of CDSs as a seeming safety net to these risky investments and to when credit rating

agencies started giving false assurances and misleading high evaluations of CDOs

(Greenberger, M, 2010).

Having negotiated the way through the first two,58 the Paper now turns its attention towards

the latter original sin of the crisis.

51
ie CDOs
52
In the form of CDSs;
53
According to various academic and scientific surveys;
54
That is, (not) the actions that started the war........in this sense the crisis;
55
Mostly CDOs;
56
So called “regulatory arbitrage”; to be taken in the light that capital requirements for mortgages are high;
57
From sub-prime mortgages to MBSs to CDOs;
58
Within the spatial limitations of the Paper

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 12

Rating Agencies

Credit rating agencies failed to adequately account for large risks when rating CDOs and

other asset-backed securities. In October 2008, within a month of the crisis epicentre,59 they

admitted that their ‘methodology’ of ranking mortgage-backed securities in the period 2005 –

2008 failed (Petrova, I, 2009).

The vast majority of sub-prime mortgages60 ended up being rated AAA by at least two and

sometimes three credit rating agencies61. As a result, investors that bought into triple-A may

not have been cognizant of the precise risk encircling the underlying loans. Given the rating

agencies’ good track record and the low spreads offered, it may have daunted upon investors

that any thorough and independent analysis would have been a waste of time (Weaver, K,

2008).

The fact that many participants felt the AAA rating provided sufficient protection played a

key role in facilitating the sub-prime crisis. Should the instruments been accurately rated, the

credit facilities that conveyed the securitization process would not have been so poorly under-

estimated and mis-priced and the crisis contained.

The problematic in the rating misalignment acquired additional impetus because big players

in the banking and financial industries were gung-ho in taking on risky investments and credit

rating agencies were happy to play along with the charade that the risk was not that bad

(Knapp, A, 2008). No one was holding a gun to the rating agencies’ head to assign higher

59
The epicentre is considered as 15th September 2008 when Lehman Brothers filed for Chapter 11 Bankruptcy
Protection;
60
Approximately 82%;
61
Fitch, Moody’s and Standard & Poor’s between them provide 95 – 98% of securities ratings. The other seven
members with NRSRO (Nationally Recognised Statistical Rating Organizations) status are minor players in the
ratings arena;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 13

ratings than the instruments so deserved. Actually, delving into the agencies’ role and

business in the securitization mechanism,62 one can safely deduce that there was never ever

the need for such a ‘gun’ for ratings to be generously upgraded.

Both the structuring as well as the rating of securities is lucrative business for the rating

agencies. Of particular interest for the intents of this Paper is the fact that agencies were

allowed both to assist in the structuring as well as in the rating of securities (Wolfson, J and

Crawford, C, 2010), notwithstanding Congress had the opportunity for safeguards in 2006 by

the enactment63 of the Credit Rating Reform Act. Self-interest is irresistible even when the

wider picture64 is expected to assume ‘super partes’65 dimensions.

This Paper risks66 advancing the sentiment that the Act67 did in fact ‘sanctify’ the rating

agencies’ abusive practices. If they had no legal cover before, in the new Act they have

discovered the right one.

The ratings agencies’ sins were eventually lumped together by Securities and Exchange

Commissioner Kathleen L. Casey:68

For many years, and increasingly after the fall of Enron and WorldCom there

have been widespread concerns about the rating industry, including inherent

conflicts of interest relating to compensation arrangements, oligopolistic pricing

and practices, mediocre ratings quality, failure to issue timely upgrades or

downgrades, lack of transparency as to how ratings are determined and a virtual

62
Most probably this applies to other processes also;
63
And naturally regulation for the first time in rating agencies’ history since their advent on the market in 1860
when Henry Varnum Poor first published a statistical analysis of railroads and canals in the US;
64
ie the economy, the market and the whole system;
65
Above all parts;
66
In any case, this Paper dwells on the subject of risk;
67
Credit Rating Reform Act 2006;
68
K. Casey, Commissioner “SEC Speaks”, February 6th, 2009;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 14

absence of any accountability to investors, markets and regulators.

Casey’s tirade should not be surmised as a summation of agencies’ market imperfections or

‘for the occasion’ magnified peccadilloes69 but is probably reflective of a regulatory

admission that the agencies, acting in the manner they did, were in fact first-fronted players

in the crisis, both in its creation as well as in its exacerbation.

Analysis and Responsibilities

The aforementioned, both narrative and argumentative, has as a minimum exposed nineteen

(19) plausible candidates70 to covet, singularly or in association with others, the encumbrance

of the crisis’ responsibility. Except for the customary sacrificial lambs,71 the day of reckoning

seems to be kept on permanent postponement mode, complicit undoubtedly the financial

muscle wielded by Wall Street.72

Notwithstanding the absence of a fully-blown and rapid recriminations and reformatory

regime, academic research and financial analysis owe the public73 due identification of the

mould of degenerative behaviour which is representative of the prevalent part of the

dynamics of the financial crisis.

This Paper finds that it was probably the ‘unmooring’ of investors from fundamentals that

triggered the whole crisis. Other causes may have acted in a supplementary or

69
Minor sins or slight transgressions;
70
They are, in no particular merit: vagueness to decipher consequences – leverage – deregulation – inflating an
artificial credit boom – systemic risk – limited transparency of counterparty risks – regulatory weakness –
unmooring of investors from fundamentals - CDSs as bets – CDSs as non-insurance insurance – self-interest –
Fed expansion of monetary policy – financial innovation not well understood – rating agencies – collapse of
trading – false sense of security – web of inter-connectivity and contagion – mis-pricing/underestimation of risk
– housing market collapse;
71
The most monumental of which is Lehman Brothers;
72
Self-interest, once again.
73
Mainly, the market and market participants;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 15

complementary role and have by no doubt exacerbated the crisis but to place culpability

straight on their doorstep might be an analytical exaggeration.

CDSs for example may be held guilty by association. Contrary to public perception, the

development of CDSs referencing mortgage-related securities was more of an effect than a

cause of the rapid growth in mortgage-related securitization. It was more the possibility of

misuse of certain CDSs that enabled mortgage-related security risk to become over-

concentrated in some financial institutions (Shadab, H, 2010).

Securitization, likewise, is a genius financial innovation capable of attracting new liquidity in

the market by transforming illiquid assets into liquid ones, in the interim lowering the cost of

capital and increasing the availability of credit. The problematic lays in the complex financial

engineering which was used to produce more exotic derivatives capable of being sold and

resold. The relationship between the mortgage originator and investor became progressively

disconnected (Steen, A, 2011). In other words, the purchasers74 of securitizations, mainly

CDOs, abandoned fundamentals in favour of innovation.

Sober consideration should also be given to the question of speculation. It is within this

sphere that derivatives most probably find both an ally and a nemesis. Stout,75 probably

derivatives’ most vociferous critic, concedes that it is essential for policymakers to

distinguish between “using derivatives to hedge and using them for speculation”.

CDSs seem to have been rife with speculation. Data emerging at the epicentre of the crisis in

2008 suggest a disquieting scenario. Whilst the notional value of the CDS market had

reached USD 67 trillion, the total value of all the underlying bonds outstanding was only

USD 15 trillion. It becomes a natural consequence to state with mathematical certainty that

almost eighty per cent (80%) of CDS trading was for speculative purposes.

74
Investors, mainly institutional;
75
Vide References;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 16

A further fine point to be addressed pertinent to the issue of the ‘unmooring of investors from

fundamentals’ is that relating to the insurance controversy surrounding CDSs. To date it

seems that there is a dearth of academic and financial research discussing the problems

related with the issue of whether CDSs should be treated as insurance instruments or not

(Kimball-Stanley, A, 2008).

A principal challenge levied against CDSs not treated as insurance policies, and the natural

consequence of its non-regulation, is that they create disincentives for mortgage service

providers to work out new agreements with borrowers as an alternative to foreclosure.76

Compounding this issue is the fact that CDS contracts are often sold by the same banks that

package and service mortgage-backed securities, leading to significant conflict of interest in

the evaluation of the securitization process and the payment under a CDS contract. It is

within this context that the argument77 of the misuse of derivatives in pursuit of self-interest

as a plausible reason for the crisis, gathers speed.

The deregulatory ambience in which the derivative markets operate is possibly the best arena

where the financial crisis can be objectively gauged and serenely debated. As a starting point,

one consideration which should take overall precedence is whether self-regulation in effect

exists!78 Gensler’s79 testimonial apex at the Financial Crisis Inquiry Commission came in the

form of a solicitation for derivatives markets to be regulated.

76
Because for them, foreclosure might well be a better deal overall;
77
In conformity with the central theme of the Paper;
78
Given the various self-interests at play by market participants;
79
Gary Gensler, Chairman of the Commodity Futures Trading Commission testifying in front of the Angelides
Commission (Financial Crisis Inquiry Commission);

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 17

Greenberger,80 taking the stand in front of the same Commission, took an analogous view of

the crisis, stating that “had the norms of market regulation been applicable, these swap

transactions would have been adequately capitalized by traditional clearing norms and the

dangers.....would have been observable..................” Further on, he states that “the darkness of

this huge...........unregulated market not only caused, but substantially aggravated the financial

crisis.”

This Paper interprets Greenberger’s testimony81 as suggestive that it was the ‘unregulated’

and not the ‘market’ which caused the crisis. The efficient and successful functioning of

(unregulated) markets in derivatives, and naturally in CDOs and CDSs, has been ongoing for

materially long periods of time,82 not to advocate otherwise.

Derivatives could83 destabilize the entire global financial system not out of any inherent

deficiency or defect but specifically as a result of their capability to create systemic risk, their

ability to exacerbate any crisis that may develop and because of the lax environment in which

they operate.

It is within this arena of culpabilities that derivatives should be made answerable for their

responsibilities and not because of any technical or market incapacities.

80
Michael Greenberger, Law School Professor – University of Maryland School of Law – testifying in front of
the Angelides Commission;
81
That part where he attributes the crisis directly to the unregulated derivatives market;
82
Without any hint of a crisis;
83
And in fact they did;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 18

Conclusion

This Paper ascribes its argumentation as to the cause of the crisis on the consequences

emanating from the disconnection84 between investors and fundamentals. This is where the

case rests.

Of utmost relevance in support of this thesis are the issues of financial innovation and default

protection. Market participants placed excessive and unjustifiable degrees of certitude in

innovative financial products because they were under the false impression that innovation

works and in case it did not, there were always the safeguards afforded by default protection

in the form of CDSs.

In proceeding upon this trajectory, little did the major financial players85 realize that they

were departing from a well-entrenched maxim in finance, that of beholding fundamentals!

Derivative business was considered as ‘fair’ means to accelerate trading profits and not to

hedge against losses. In their ecstasy for self-interest and profit, they became distracted from

the obvious86 and tellingly disconnected from established safe practice.

The fact that the ‘playing field’ had no demarcations and boundaries and the players no rules

and regulations created the perfect environment for the most lethal of cocktails ever

experienced by the financial world.

In more mundane language, this Paper considers that the roots of the financial crisis lie in the

avarice and self-interest that seep their way into the higher echelons of financial institutions

propped by a continuously increasing market demand to perform.

84
Or ‘unmooring’ as repeatedly referred to in the Paper;
85
And the minor players copying them;
86
ie fundamentals;

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DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 19

Recommendations and Further Reading

Out of the foregoing, the overriding lesson should be that self-regulation and deregulation are

exercises not only in futility but dangerous experiments capable of wrecking havoc in

financial markets and systems. Additional to the inane deficiency of profit-seeking and greed,

humans suffer also from dementia where crises are concerned. It could not be otherwise; else

financial crises would not have repeated themselves in close succession.

Regulation should not be considered as a cure-all financial medication. It could however

provide effective rules and standards which, if properly implemented, could dispose of most

of the detritus from the system.

The second issue in immediate need of attention concerns transparency. No market can be

effective and efficient if its environment is nebulous and possibly one which entices

malpractice. Eliminating inconsistencies and incongruencies might be easier suggesting than

doing but their presence not only distorts markets but is an ideal breeding ground for rogue

and delinquent trading.

Recommendations concerning capital standards, margin requirements and other associated

financial virtues can be assembled within the framework of the two aforementioned

recommendations.

Cascading from the difficulties encountered in conducting this research, this Paper considers

that further knowledge needs to be accumulated in respect of the price-risk relationship when

two derivatives are correlated to each other such as when CDSs are attached to a mortgage-

backed security such as CDOs. Following the collapse of David X. Li Gaussian copula, the

price-risk theory of two correlated derivatives seems to remain impregnable, thus rendering

itself ideal pasture for academic ‘grazing’.

Electronic copy available at: https://ssrn.com/abstract=3444270

DERIVATIVE INSTRUMENTS AND THE FINANCIAL CRISIS 2007-2008: ROLE AND RESPONSIBILITY 20

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