THE BLOG

Red Light Swaps

03/18/2010 05:12 am ET | Updated May 25, 2011

If you don't work on Wall Street then most financial products probably look complex and risky.

As the House of Representatives debates the Wall Street Reform and Consumer Protection Act (HR 4173) several Republican representatives, including Scott Garrett, have questioned whether derivatives helped create the financial crisis.

Well... here is what the Federal Reserve Bank of St. Louis says about the credit crisis:

Many analysts blame the financial crisis on at least three interrelated causes:

  1. Rapid growth and subsequent collapse of U.S. house prices;
  2. a general decline in mortgage underwriting standards, reflected in a growing proportion of home purchases financed by nonprime mortgages; and
  3. widespread mismanagement of financial risks by firms engaged in originating, distributing, and investing in mortgages, mortgage-backed securities, and derivative financial instruments.

Mortgage delinquencies and foreclosures rose sharply after U.S. house prices peaked and began to fall in early 2007. Banks and other financial intermediaries then began to experience large losses on their holdings of nonprime residential mortgages and mortgage-backed securities.

By August 2007, these losses sparked a widespread loss of confidence in banks and other financial intermediaries, as investors suddenly became much less willing to bear credit risks. Banks tightened their lending standards, which reduced the availability of loans and increased their cost. As investors retreated to the safety of government bonds and other low-risk securities, the market yields on risky debt securities were driven up relative to yields on U.S. Treasury securities.

Investor concerns intensified during 2008 as financial losses continued to mount. The crisis reached a boiling point in September 2008 when the bankruptcy of Lehman Brothers and near-bankruptcy of American International Group (AIG) sparked panic selling in the stock market and drove the yields on risky securities sharply higher relative to those on risk-free securities.

Did derivatives cause the financial crisis? You bet... red light swaps...