The onset of the current financial crisis has raised many questions that go to the very core of American corporate practice and we are only recently learning about the underlying causes of this recession. But if we examine these financial markets we recognize a common denominator, a word that many have used but only a few understand: derivatives. Before we continue don’t forget to visit this article “Myths About Business General Counsel“, this is a must read.
The fundamental cause of the mortgage crisis was irresponsible lending practices. Historically, banks investigated with due diligence to ensure that a borrower was capable of making all of the payments. This kind of discipline evaporated during the mortgage craze when banks indiscriminately offered loans to undesirable borrowers. Then, banks bundled these sub-prime mortgages and sold them to large financial institutions, which resold them as stock. Essentially, the banks loaned to risky borrowers, then passed the risk on to investors through the markets.
Speculators did not buy mortgage-backed stock. Rather, they used “derivatives,” a financial instrument that allows speculators to bet against each other on whether the value of the mortgage-based stock will rise or fall. If we were talking about the Kentucky Derby, then the stockholders would be the horses’ owners and derivative traders would be placing bets on the outcome of the race.
What incentive could motivate one to participate in this risky trading? Many expected that the value of the underlying real properties would rise exponentially. With this rosy outlook, insurers failed to save adequate capital to pay off these policies should they be called in.
Many have been surprised at the lack of regulation of the derivatives market.
How did all of this happen? Understanding derivatives as a financial instrument is key to recognizing their role in the current economic crisis. Even so, the crisis could never have occurred if regulations had been in place to slow the flow of money. In light of the catastrophic result of unchecked derivatives trading, perhaps it would be wise to regulate the securities markets to the extent necessary to protect taxpayers from ultimately being forced to rescue these speculators.
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