Role of Derivatives in Creating Mortgage Crisis

The real cause of the 2008 financial crisis was the proliferation of unregulated derivatives during that time. These are complicated financial products that derive their value from an underlying asset or index. A good example of a derivative is a mortgage-backed security.

How Derivatives Work

Most derivatives start with a real asset. Here's how they work, using mortgage-backed securities as an example.

1. A bank lends money to a homebuyer.
2. The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.
3. Fannie Mae resells the mortgage in a package of other mortgages on the secondary market. This is a mortgage-backed security. Its value is derived by the value of the mortgages in the bundle.
4. A hedge fund or investment bank divides the MBS into different portions. For example, the second and third years of interest-only loans are riskier since they are farther out. There's more of a chance the homeowner will default. But it provides a higher interest payment. The bank uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
5. All goes well until housing prices decline or interest rates reset and the mortgages start to default. 

Role of Derivatives in the Financial Crisis

That's what happened between 2004 and 2006 when the Federal Reserve started raising the fed funds rate. Many of the borrowers had interest-only loans, which are a type of adjustable-rate mortgage. Unlike a conventional loan, the interest rates rise along with the fed funds rate. When the Fed started raising rates, these mortgage-holders found they could no longer afford the payments. This happened at the same time that the interest rates reset, usually after three years. 

As interest rates rose, demand for housing fell, and so did home prices. These mortgage-holders found they couldn't make the payments or sell the house, so they defaulted.

Most important, some parts of the MBS were worthless, but no one could figure out which parts. Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market. Banks and hedge funds had lots of derivatives that were both declining in value and that they couldn't sell. Soon, banks stopped lending to each other altogether. They were afraid of receiving more defaulting derivatives s collateral. When this happened, they started hoarding cash to pay for their day-to-day operations.

That is what prompted the bank bailout bill. It was originally designed to get these derivatives off of the books of banks so they can start making loans again.

It is not just mortgages that provide the underlying value for derivatives. Other types of loans and assets can, too. For example, if the underlying value is corporate debt, credit card debt, or auto loans, then the derivative is called collateralized debt obligations. A type of CDO is asset-backed commercial paper, which is debt that is due within a year. If it is insurance for debt, the derivative is called a credit default swap.