The Role of Derivatives in the Financial Crisis – Credit Default Swaps and the Economic Meltdown
Law School Professor
University of Maryland School of Law
Financial Crisis Inquiry Commission Hearing
Dirksen Senate Office Building, Room 538
Wednesday, June 30, 2010, 9am EDT
I have been asked by the Commission to address the following four questions in my testimony:
- The history of derivatives and derivatives market regulation;
- The structure of the derivatives market at the start of the financial crisis;
- How derivatives and derivatives markets functioned during the financial crisis;
- The role of over the counter (“OTC”) derivatives in the financial crisis, distinguishing, if appropriate, between the role of credit derivatives and other OTC derivatives, and the roles they may have played in amplifying and spreading the crises.
I deal with these questions immediately below.
By removing the multi-trillion dollar swaps market from the traditional norms of market regulation, a highly speculative derivative bubble was created that was opaque to federal regulators and market observers alike. By removing all forms of ensuring the normal capital adequacy protections of market regulation, the swaps market permitted trillions of dollars of financial commitments to be made with no assurance that those commitments could be fulfilled beyond the highly illusory AAA ratings of the counterparties in question.
Had the norms of market regulation been applicable, these swaps transactions would have been adequately capitalized by traditional clearing norms; and the dangers building up in these markets would otherwise have been observable by the transparency and price discipline that accompanies exchange trading.
While the poorly capitalized underwriting of CDS and naked CDS triggered the meltdown, the crisis was further aggravated by the opaque interconnectedness of large financial institutions emanating from interest rate, currency, foreign exchange and energy swaps.
Because there was no road map outlining interdependency of those financial transactions, the worst was feared in the wake of the Bear Stearns, Lehman, AIG, and Merrill dysfunctions. Institutions became too big to fail because of these uncharted and feared interdependencies; and the fear that unwinding of these institutions (as proven in the Lehman bankruptcy) would be hampered by the lack of reliable pricing of the instruments in question.
The darkness of this huge multi-trillion dollar unregulated market not only caused, but substantially aggravated, the financial crisis. And, the American taxpayer funded the bailouts and rescued the economy from Depression. The banks are now stronger than ever. The taxpayer, however, is burdened by high unemployment, job insecurity, depleted pensions, and little access to credit. We are depending on this Commission to identify correctly the malpractices to ensure that a fiasco of this nature never happens again.
Be sure to read the entire testimony below.