Quora Answer: What Role did Derivatives Play in the 2008 Financial Meltdown?

The following is my answer to a Quora question: “What role did derivatives play in the 2008 financial meltdown?”

This is a brief summary of what happened.  Derivatives were the root cause of the 2008 financial meltdown.  And one derivative in particular was culpable: credit default swaps, also known as collateralised debt obligations.  This was made possible due to deregulation under the Clinton Administration when the Glass-Steagall Act was repealed in 1999.  This allowed banks to operate as brokerage houses.  The Glass-Steagall Act was enacted in 1933, after banks, operating as brokerage houses, caused the Great Depression.

By the 3^rd quarter of 2008, the sum notional value of all derivatives grew by over 600% for commercial banks and stood at US$234 trillion.  To put that in perspective, the entire GDP of the US was just over US$30 trillion in that same period.  Clearly, this was unsustainable.  What fueled this at a corporate level was the way remuneration was packaged.  Bonuses were pegged as a percentage of revenues.  This encouraged risky trades and reckless bets.  This meant that the interests of clients was not as paramount as it should have been.  The bank were betting with people’s money.

Under accounting standards for banks, assets essentially represent loans.  The deposits are categorised as a liability on the balance sheet.  Generally, a bank’s assets approximate the value of their deposits.  I will not go into the technical details here since they may be found in numerous sites online.  In summary, although on paper there seemed very little risk, the banks were hedging and the leverage was high.

The derivative of choice was the CDO.  A CDO is technically a type of structured financial product bundling assets that generate cash flow and repackaged into tranches.  In simple terms, it is essentially an entity, making a bet with another entity, that a particular group of debtors are able to pay a particular group of creditors.  The interesting thing about this is that the entities in question need not have any direct relationship with the debtors or creditors.  It is fancy way of gambling.

In theory, the debt obligations that serve as collateral vary substantially in their risk profile.  Senior tranches were considered relatively safe because they have first priority on the collateral in the event of default, and the credit rating is successively degraded for each tranche thereafter.  But due to the way they were packaged, and coupled with the asset bubble, they were all eventually worthless.  The debt securities packaged were home loans and mortgages.  The coupon rates were higher with the riskier products.  This put pressure on the small debtors.  When the market crashed, it was a domino effect of epic proportions, and the exposure of banks to riskier securities on a large scale meant that they were bankrupted.  The market did not consider the ramifications if the entire market crashed, only defaults on individual security tranches.  When the underlying asset, the houses dropped in value such that servicing the loan was not rational, this led to more defaults, and this fed a further drop on housing prices as demand dried up.  And that is what caused the 2008 financial meltdown.