[effn]

The vast majority of OTC derivatives was far less disruptive to the banking sector than your average vanilla home mortgage loan during the crisis.

An overwhelming majority of all the banks that failed during the crisis had zero OTC derivatives on their books, but plenty of average vanilla home mortgage loans.

Internal documents from the banks that did deal in more sophisticated financial products show that they had a good understanding of how these products exposed them to risks in the home mortgage market, they just didn't think that housing prices would fall that much.

Despite all this, people like to blame OTC derivatives for the crisis rather than overconfidence in the housing market.

Why is this?

[malandrew]

Not really. OTC derivatives greatly contributed to what happened because it obscured who your counterparty was in a transaction. This is really important because as the world falls apart around you, you don't know if your OTC derivatives happen to be based indirectly and at least in part on some other failing financial institution. Multiply this by everyone you do business with and you have a complete dissolution of trust and ability to properly assess risk. Those institutions that failed and only had vanilla home mortgage loans failed because they themselves were the ones responsible for the irresponsible lending or because they got caught up by it at the end of the unraveling that destroyed enormous amounts of value.

There is no way that the markets would have fallen that far and that fast if most participants, and the rating agencies, had the capacity to accurately and directly determine how much risk they and their counterparties had.

I imagine that the complicitness of the rating agencies in the whole thing never would have even gotten so egregious if most institutions had vanilla instruments on their books that were straight forward to value. OTC derivatives made it very easy to hide finagling and create an environment where rating agencies feel comfortable playing the tit-for-tat game with banks because they thought no one would notice ethical transgressions among all the indirection of derivatives.

[yummyfajitas]

This is really important because as the world falls apart around you, you don't know if your OTC derivatives happen to be based indirectly and at least in part on some other failing financial institution.

This is simply incorrect. The cash flows involved in an OTC derivative are explicitly stated in the contract itself.

I imagine that the complicitness of the rating agencies in the whole thing never would have even gotten so egregious if most institutions had vanilla instruments on their books that were straight forward to value. OTC derivatives made it very easy to hide finagling...

You imagine incorrectly. Pricing most of these contracts is 8'th grade math given a specific scenario - fancy math comes into play only in estimating the probabilities of each scenario. In principle, the pricing formula is this:

    price = P(housing goes down) x BIG LOSS + P(housing goes up) x MODERATE GAIN

That's the price, regardless of whether it's a straightforward vanilla mortgage or a fancy synthetic CDO. The ratings agencies, banks and government all assigned a very low value to P(housing goes down). Using vanilla instruments doesn't change this basic calculation.

[sseveran]

In OTC trading by definition you know who your counter party is since you called them on the phone or they called you. What you are really trying to say is that you had no idea whether they had an off setting contract or if they were taking the other side of your position directly. I am not sure the exchange system we have for derivatives now has made things any better.

[onebaddude]

I take issue with the connotation as you describe derivatives; they hide and obscure. They are a tool, nothing more.

Other than that, I agree. It was the lack of a central clearing house for the derivatives -which would have allowed issuers to determine counter party risks and price it properly -that was the failing. But that's a human error. There's no need whatsoever to blame the securities themselves.

[CamperBob2]

Are you thinking of CDSs?

[DanielBMarkham]

Wow. This is 180 degrees away from the mainstream narrative of how the crisis developed.

I'm not trying to bait you or argue, but do you have any links? I'd be interested in some supporting documentation for your claim.

[mcphilip]

It's 180 degrees against the mainstream narrative because it is a ridiculous oversimplification of the crises and misleading in its claims about OTC derivatives. For a serious look into the complex causes of the crisis, I recommend Econned by Yves Smith [1].

My (weak) take on the crisis TL;DR:

Prolonged, low interest rates set by the Fed in the aftermath of the dotcom bubble led to investors looking for better returns outside of AAA bonds. With the introduction of CDOs, investors were given the option of purchasing AAA rated tranches that paid better rates than bonds. The interest in CDOs exploded, leading to weakening of lending standards allowing the housing boom to really take off. From there it gets much more complex, but ultimately the maths on CDOs didn't work out and everything came crashing down.

[1]http://www.amazon.com/gp/aw/d/0230114563

[onebaddude]

>I'd be interested in some supporting documentation for your claim.

No offense, but it starts with having an understanding of what a derivative is and how they are used. There is nothing sinister about them in any fashion, nor were they the "cause" of anything. The mainstream, as usual, has it wrong.

At the base level, excessive risk was the problem, and because derivatives employ leverage, that risk is amplified.

[DanielBMarkham]

I'm going to have to categorize that as being non-responsive.

Let's assume I know what a derivative is. We can go from there. The specific accusation made in the mainstream press was that by the time the instruments were sliced and diced a dozen times, risk was not made clearly visible to derivative purchasers, and that the buying and selling of derivatives got way ahead of the banks' ability to track the risk inside of them. At high leverages, it became such that being wrong by just a few percentage points could mean financial disaster. The guarantee that Freddie and Fannie made contributed to a general feeling that the market was mostly protected from huge systemic risks, when that wasn't the case at all.

[yummyfajitas]

Consider a plain vanilla housing package. Payoff = homeowner_payments.sum().

Now consider the least risky tranch of a CDO. Payoff = min(homeowner_payments.sum(), 0.7 x MAX_HOMEOWNER_PAYMENT).

Is it unclear that if homeowner_payments.sum() goes way down, you lose money? Of course not. For every derivative on the market, computing your gains/losses given a specific scenario is straightforward.

The only difficulty is computing the probability of each scenario, but derivatives don't change that calculation at all.

[tedunangst]

You are generalizing from one specific derivative to all derivatives.

[glesica]

Why was there so much pressure to write absurd loans? Because the derivatives market was so lucrative. It's all connected. The housing bubble wouldn't have been what it was without all the extra money made available by people buying and repackaging mortgages.

[tptacek]

Could it be because OTC derivatives forced us to bail out AIG?

[preempalver]

Ahem : http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony...