[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.