Could you explain what a derivative is and how this is part of the Wall Street problem?

BY busadmin  September 19, 2008 at 4:57 PM EDT

Question/Comment: On the NewsHour tonight, the speaker stated that some the problem with the fall of Wall Street is related to use of derivatives and lack of regulation of this. Could you explain further what a derivative is and how this is part of the problem?

Paul Solman: As law professor Frank Partnoy explained in a story we did a few years ago: “Derivatives are financial instruments whose value is linked to something else. They’re basically fancy instruments that have evolved over the last ten years that enable investors and institutions to bet on virtually anything, from interest rates or exchange rates to commodities.”

Our NewsHour story explains the derivation of derivatives, and I suggest you watch and/or read it. But what’s important today is that a multi-trillion dollar market in these bets has mushroomed without any real regulation, in part because in 2000, in the words of one account, hours before Congress was to leave for Christmas recess, Senator Phil Gramm slipped a 262-page amendment into the appropriations bill forbidding federal agencies to regulate the financial derivatives industry.

Forbidding indeed.

Now in point of fact, rather innocent bets like futures or options are also derivatives, but what the speaker meant was a TYPE of derivative known as a credit default swap. Very simple, really. It’s a bet on whether some entity – a company, a government agency – is going to default on its credit and go bankrupt.

An example: Someone who loaned money to Lehman Brothers (by buying their bonds) might bet on Lehman going belly-up. Why? To protect their bonds. Lehman fails; they lose on the bonds, but cash in on the bet. It’s a form of insurance. The price they pay for the “credit default swap” is, in essence, the insurance premium.

Why would someone else take the other side of the bet? WRITE the insurance, that is? Because it looked like easy money. How likely was it that Lehman Brothers would go bankrupt, a firm that had been in business, more or less, since 1844? Wouldn’t YOU have given someone 100-1 (assuming you like to bet)?

But now, with so many firms going bankrupt, such bets have turned out to be killers. Literally, it would seem. AIG is mainly an insurance company. So maybe it shouldn’t come as a surprise that it wrote lots of credit default swaps. Indeed, it even borrowed money to do so. But when the people with whom it bet – its so-called “counter-parties” – appeared ready to cash their bets, the lenders to AIG said, in effect: “Time for you at AIG to put up more collateral on your loans, because those bets of yours are looking shaky.”

But how was AIG going to raise more collateral? By selling off assets going down in value? That would simply drive them down more, lowering the value of AIG’s collateral, meaning they’d have to come up with even more collateral. A classic vicious circle, downward spiral, negative feedback loop – call it what you will.

Meanwhile, if AIG was in trouble with its lenders, its credit rating would drop, thus forcing AIG to put up even MORE collateral. More negative feedback. Down, down and down.

All kicked off in part because AIG went heavily into the credit insurance business, using derivatives known as credit default swaps.